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 healthier”.
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 greater frequency.
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 Structure
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 Stimulus
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 global implications.
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 risk exposures.
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.