By Dean Curnutt
The five-year anniversary of the Lehman bankruptcy and onset
of financial crisis is here and so too is the raft of opinion
pieces around what caused the meltdown and how it is different
this time. In a recent interview with Charlie Rose, when asked
about the risk of another 2008 event, Morgan Stanley CEO James
Gorman said, "The probability of it happening again in our
lifetime is as close to zero as I could imagine." Pointing to
higher levels of liquidity, better management practices
embraced by banks, and more frequent communication with
regulators, Gorman sees the banks as "dramatically
Gorman's confidence reminds us of the rock solid certainty
professed by none other than Joseph Cassano, architect of AIG's
impressively sized derivatives portfolio. In 2007, when asked
about the riskiness of the credit positions his team was
amassing, Cassano said, "It is hard for us, without being
flippant, to even see a scenario within any kind of realm of
reason, that would see us losing one dollar in any of these
(credit default swap) transactions".
We can only hope that Gorman's highly sanguine views on the
state of global market risk are not symptomatic of excessive
optimism felt by CEOs of other systemically important financial
institutions. Ongoing vigilance is a must. True, as Gorman
stated, securities firms like Morgan Stanley have smaller
balance sheets and more liquidity. They also take far less
proprietary risk and their shares have recovered well.
But while there has been a deleveraging of risk exposures
since the crash, today's markets are vexed by a potent mix of
new and unwelcome sources of instability. Since the 2008 crisis
alone, at least six distinct systemic threats have emerged: 1)
sovereign/banking system contagion 2) cyber attacks 3)
technology and market structure vulnerabilities 4) policy
dysfunction 5) Middle East unrest and 6) the withdrawal of
Central Bank stimulus. Each of these can easily underwrite the
next substantial market volatility event.
While economic green shoots are emerging from Europe, we
should not forget just how close to complete collapse the
Eurozone was at various points between 2010 and 2012.
Unprecedented volatility plagued the sovereign debt markets of
southern European countries, banks saw their market caps
plunge, and investor confidence was severely damaged.
Tighter sovereign bond spreads, higher share prices for
banks, and a Eurozone PMI that recently surpassed 50 are
positive developments. But these should not be confused with
the system's underlying fragility. This month, Luc Coene, an
ECB Governing Council member said, "We will have to make some
extra efforts - certainly once, perhaps twice", when referring
to the need to provide
further capital to Greece.
Most professionals agree that Eurozone banks remain vastly
undercapitalized and bank stress tests performed were largely
criticized as failing to reflect the risk of a true tail event.
In its most recent economic forecast, the OECD stated, "Euro
area banks are insufficiently capitalised and weighed down by
bad loans". This capital shortfall leaves banks less prepared
to absorb the next market uncertainty event, especially given
that their host countries have limited capacity (and appetite)
to lend a hand should trouble arise.
According to data compiled by Bloomberg, 27 of the top 100
companies in the US have disclosed being the victim of a cyber
attack. Among these firms are systemically important financial
giants AIG, Goldman Sachs, Morgan Stanley, JP Morgan, and
Citibank. Also among them are ubiquitous telecommunications
firms Verizon and AT&T. While no material financial loss
has yet been reported, breaches are clearly happening with
Outgoing head of US homeland security Janet Napolitano
recently stated, "Our country will, at some point, face a major
cyber-event that will have a serious effect on our lives, our
economy, and the everyday functioning of our society."
From a systemic uncertainty perspective, the cyber threat is
somewhat like the risk of a global airborne pandemic or
catastrophic natural disaster. When contemplating the impact of
these, investors recognize the possibilities, but until an
event occurs, do not react because the risk cannot be priced.
Similarly, the risk of a cyber attack is not priced into
markets. However, what differs for the cyber threat is that
each day, evidence suggests that the risk of a substantial and
disruptive attack is becoming less remote.
Technology and Market
Another risk factor is the unsettling trend in disruption
related to weaknesses in technology and market structure. In
May of 2010, the Flash Crash caused a sell-off that saw the
DJIA shed 1,000 points, the largest intra-day point decline in
the history of the index, before recovering.
In March of 2012, BATS suffered a massive technology break
down on its own IPO that prevented the stock from opening. Two
months later, Facebook's IPO caused an estimated $500 million
of losses to the Wall Street firms involved in the deal. Three
months after that, Knight Capital Group lost $440 million from
a programming error in which old software was mistakenly
reactivated. Nearly bankrupted from the loss, Knight was
acquired by Getco a few months later. More recently, Goldman
Sachs took losses after a software glitch caused it to launch
hundreds of unintended orders in US stock options.
When combined with the previously discussed increase in
cyber attacks, these technology and market structure related
issues should be viewed as a serious threat to market
stability. Does it sound unreasonable to think that a malicious
group could infiltrate a financial institution, create a rouge
algorithm, and implement it with the intention of causing the
firm to suffer potentially catastrophic loss?
The experience of 2011's debt ceiling negotiation remains a
fresh lesson on the unpredictable path of outcomes that our
modern day, highly polarized legislative branch may put the
market on. The brinksmanship that resulted in a US credit
downgrade caused market volatility to skyrocket. Over a
four-day period in early August 2011 (8/8-8/11), the SPX
experienced an average high/low swing of 5.1%. This 4-day
volatility of ~82% ranks among the most significant bursts of
volatility since the credit crisis.
Two years later, as a government shutdown looms and another
debt ceiling showdown could be in the offing (according to
Treasury Secretary Lew, the limit will be reached in mid
October), we are no less polarized and consensus no less
elusive. It is reported that House Republicans will seek to tie
increases in the ceiling to substantially limiting the scope of
and funding for Obama's signature health care legislation.
The weakened ability for lawmakers to forge consensus,
especially when it pertains to matters such as the debt ceiling
and military action, is a new risk dynamic. It is also one that
has proven challenging for markets to understand, creating the
potential for spikes in volatility.
While this area of the world has been associated with
geopolitical uncertainty for a long time, risks have recently
become more multi-dimensional and have intensified to an
alarming point. The military coup in Egypt and intervention in
the civil war in Syria threaten to destabilize the already
delicate regional balances of power among Iran, Saudi Arabia,
Israel, Turkey, Russia, and others. The potential for US
entanglement in the area and the implications for global
instability are significant.
US policy dysfunction complicates the dynamic around Syria.
The unintended consequences of either a decision to strike or a
decision not to strike Syria, at this point are quite
unpredictable. Iran and Syria's defense ministers this week
threatened to attack Israel if Assad was in danger. All of it
is fast moving and most everyone agrees, there are few good
options on the table. We will know more soon.
The Withdrawal of Central Bank
The uncertainty around the tapering of Fed policy should
remind us all of just how unconventional monetary policy has
become. In total, the Fed has accumulated $3.4 trillion of
securities on its balance sheet, and with the decision not to
taper on 9/18 that number will only continue to increase with
Of central importance is the undoing of the risk on / risk
off framework in which changes in US government bond yields had
been highly correlated to changes in equity prices. In the year
from May 2012 to May 2013, the daily % changes of 10-year
yields exhibited a 63% correlation to those of the SPX. Since
May 2013, as Bernanke introduced the intention to taper bond
purchases, this correlation has been zero. This dramatically
different relationship has vast implications for how investors
will need to manage risk going forward. Ultimately, if stocks
and bonds move in the same direction, a portfolio of the two
becomes more risky, and perhaps much more so.
Two More Risk Factors…
While they are not new, there are two additional risk
factors that are important to keep in mind. First, crowded
trades are a source of risk. Turbulent market episodes like the
bond market bloodbath of 1994, the LTCM debacle of 1998, the
Amaranth natural gas unwind in 2006, the quant meltdown in
2007, the crude oil plunge in 2008, and the huge sell-off of
AAPL in 2012 all resulted from the accumulation of concentrated
What causes such risk taking? The second important risk
factor is overconfidence and the way in which investors succumb
to recency bias. As investors, we cannot help but extrapolate
to the future based on what has happened in the recent past.
This explains why the VIX dipped below 10 in early 2007 even as
systemic risk was likely at its highest point. We must ask
ourselves what vulnerability investors will have to recency
bias when it comes to expectations around the future
environment for interest rates. There is a good deal of
duration risk sitting in portfolios that has resulted from
accumulating bonds at very low interest rates over the past
several years. Are investors prepared?
Five years post Lehman and there are many positive
developments on the systemic risk front. But the rich history
of financial crises teaches us that no two are alike. And this
brings us back to James Gorman's interview. Let's hope that he
turns out to be correct, but set against the backdrop of the
risk factors discussed, an overly benign outlook on risk itself
looks like a source of risk.
Dean Curnutt is CEO of Macro Risk Advisors, a specialist
in derivatives research and trade execution.