Into the Swarm #2: The Greatest Trick Wall Street Ever Pulled
Down the Market Hole
The French version of Michael Lewis’ book The Big Short is intitled Le casse du siècle, which literally means the “heist of the century.” This idea is interesting, as going short can be regarded as finding the weak points of the financial system and hacking into it.
However, that game is not easy. Firstly, because “there is a difference between knowing the path and walking the path,” as Morpheus said to Neo. Indeed, even if many people seem to understand problems and to see the answers, most of them will never dare to act. It is true for investors aware of heavy speculation on capital markets, but also for so-called political leaders noting that the trajectory of public debt is unsustainable. Many know what is going wrong, but how many of them will try to do something about it?
The second difficulty is that the greatest trick Wall Street ever pulled was convincing the world that an asset would never go down. Which means that even if one is willing to take a stand against the financial system, there is still a high probability that he or she will make the wrong bet because of that misperception of risk.
There are a lot of things that can be learnt from past crises, and especially from the events of 2007-2008. Today, most people in finance (apart from TikTok investors?) know that investors like Dr Michael Burry or Steve Eisman made huge profits thanks to credit default swaps on mortgage-backed securities or on collateralized debt obligations. But does it mean that such a trade could easily be replicated?
The answer is “no” as going short on housing securitized debt before 2007 required to agree to keep paying a premium while waiting for an event that never happened before. In fact, everyone laughed at CDS buyers, as betting against the US residential market was seen as the stupidest thing ever. In other words, it is not something that the average Joe would do, and people should bear in mind that Burry even had to prevent Scion Capital’s investors from taking their money back as his scenario was regarded as pure madness.
The second problem was that investors willing to short the housing bubble had to properly identify the source of hidden risks in the system. This problem could be summarized by what I call “the Hubler paradox“ (see The Great Wall and the Big Short).
Howie Hubler was a trader at Morgan Stanley, famous for making the second largest trading loss in history. And it was all the more ironical as his analysis on RMBS securities was 90% right. As he realized that many households would default on their mortgage everywhere in the country, he decided to short risky BB tranches of CDOs while buying AAA tranches which were supposed to be “risk-free.“
The problem is that financial crises occur because risk was underestimated. Said differently, they occur because of excessive concentration on assets bearing hidden risks. That is what happened with AAA securities of RMBS or CDOs. The fact that many people suddenly realized that those tranches were riskier than previously thought put the whole system in a corner, with too many persons willing the leave the room at the same time using a small exit door. The outcome was a massive spike of credit default swaps.
Meanwhile, part of the risk of BB tranches was already priced in. That does not mean that their valuation did not drop after 2007, but the overall impact was less severe than for so-called AAA securities.
Note that the mortgage delinquency rate peak was around 10% in 2009, meaning that most loans were not affected by payment issues. Somehow the crisis may have never happened if upper tranches had been rated AA instead of AAA.
How can we explain such a collective failure? We do know the answer thanks to decades of academic research: herding behavior and positive feedback loops leading to severe imbalances on capital markets, such as over concentration and increasing short volatility positions.
To summarize, opportunistic players had better focus on hidden sources of risks rather than obvious sources of risks. Betting against obvious sources of risks can be profitable, but assets embedding hidden sources of risks offer the best risk-to-return profile (i.e. the most convex behavior).
Red Queens Narratives
A simple look at social media shows you that today almost everyone is able to identify sources of risk in the system. And some people are even willing to bet against things like Tesla, Peloton, ARK, bitcoin, dogecoin or whatsoever. Those are probably smart moves. But they are also obvious sources of risk. They are at best the BB tranches of current capital markets. So, what is the equivalent of AAA tranches?
I already answered that question in a previous post (see To Be Passive Is to Let Others Decide for You). Today, I believe that the biggest risk is the excessive concentration on US equities, and especially on exchange-traded funds tracking large cap indices.
For the past years, most fund managers have increased their exposure to the S&P 500 or to the Nasdaq, mainly by being overweight on mega caps like Apple, Microsoft, Amazon, Alphabet or Facebook. Worse, many participants have gone passive, buying tons of shares of large cap ETFs such as SPY or QQQ.
In 2021, Apple or Amazon are regarded as risk-free names. Indeed, everyone knows that those companies are unlikely to go bankrupt anytime soon. And since everyone loves them, then what could possibly go wrong? Well, that is precisely what the story of securitized debt obligations taught us. Once again, “the greatest trick the devil ever pulled was convincing the world he didn’t exist.“
During the mid-2000’s, most households did not default on their mortgage. However, some defaults occur and one of the biggest crises ever occurred because most investors thought that AAA tranches were risk-free.
Even if FAANGs are unlikely to fail, misperception of risk is tricky and dangerous. Valuations are so stretched that there is no margin safety in case of serious bad news. Besides, what will happen if everyone suddenly realizes that the time has come to reduce the exposure to US mega caps? Will the market be able to absorb selling flows from ETFs and active fund whatever their size?
Of course, people will answer that such a scenario is highly unlikely. That there will always be a bid if people start to sell. To address that objection, I have already mentioned that interesting Twitter thread on the absence of liquidity in the market when people start to panic (see @FadingRallies).
However, anyone willing to short SPY or QQQ must be ready to pay premium and/or to face margin calls as long as it takes before something ugly occurs. And yes, it may seem crazy. But somehow, such trade could be worth it.
Betting on a 25% drop of Apple’s shares before July 16th would cost you a premium of 0.25% of the share price. Meanwhile, the same bet on Tesla would cost 1.58% of the share price. Despite that difference, most people would prefer to go short on Tesla rather than on Apple. Probably, because there are obviously more fundamental reasons to bet against Tesla. And perhaps also because investment professionals are fed up with Elon Musk while being indifferent to Tim Cook. But we must never forget that “it’s not personal, it’s strictly business.“ What is more, obvious risks lead to more expensive protections, and thus less convexity (i.e. suboptimal strategies).
This entire post is not an investment recommendation. But it is interesting to bear in mind that most people naturally underestimate the occurrence of extreme events. From a statistical perspective, participants believe in Gaussian distributions, while asset prices are distributed following power-tailed functions. The subprime crisis was an event that was supposed to happen once in the universe lifetime according to securitization specialists, while it only took a few years before the whole thing blew up.
Therefore, everyone is free to believe that US large caps will never crash. After all, this is what it takes for a new “heist of the century,“ or at least of the past fifteen years. Once you realize that, it will probably be too late to act.
Remember what Kint added about the devil at the end of The Usual Suspects? “And like that… He’s gone.“