Arnold re-asks Kevin Drum's question.
But this is mysterious. After all, not everyone is going short on volatility. In fact, by definition, only half of the punters on Wall Street are doing it. The other half are taking the other side of the bet.
A bank makes a mortgage to a potentially dubious borrower with little or no money down. The bank receives an upfront fee, and holds a potentially profitable loan, but accepts the obligation to buy the house at a forty or so percent discount to market value, should the borrower decide to, or have to, stop mortgage payments, thus inducing foreclosure. In the short run, the borrower is long volatility. A strong economy means "end up owning the house," while a very weak economy means "mail in the keys," no damage no harm.
In lots of world-states the buyers are better off and that is why it is politically popular to allow and indeed encourage banks to take on this kind of net position, however dangerous it may be in the longer run. The real scorpion's tail to this financial trick is that both special interests and populism will favor it, politically. Politicians, like banks, also prefer to go short on volatility and embrace the ticking time bomb. As with bankers, there is no "boil in oil" penalty worse than dismissal and the cost of that penalty does not vary much with the badness of the crisis.
The synthesis of CDOs out of tranches makes this basic logic much more intense, in a non-transparent way; read this post on the entire logic.
Of course this mechanism interacts with the real economy to (sometimes) help feed or encourage a real estate bubble, thus boosting systemic risk. This individual home buyer position, done collectively and in sufficiently large numbers, damages the interest of the buyers by inducing macroeconomic volatility and thus altering the distribution of their job market and equity market returns (note that in simple options pricing the overall distribution of returns is taken for granted).
It is appropriate to observe that many buyers are failing to cash in on the value of their "mail in the keys" option, perhaps for reasons of custom and conscience.
When various banks hedged their risk with AIG, they shifted some of the risk but most or all of them remained with net exposure to the real estate market and net exposure to volatility. AIG nonetheless played the same strategy as the banks did.
By what definition? By my definition neither side know what the heck they are doing. Also, not everything is a trade. Sometimes trades affect the real world. It's possible for everyone to go long or short something. That's how you end up building more houses than you need.
The homeowner is not "in the short run" long volatility. He is long volatility until his "option" expires.
A Call option is nothing more than a "leveraged long" position. To buy a "stock" [or house] with a loan or some percentage of its value is a call option.
As the value of the "stock" goes down, I sell a little bit of "stock" and repay part of the loan. If the value goes back up, I can buy more of the stock on the way back up and even make money. In the end, all I can lose, if I play it theoretically, is my "option price" [equity].
The analysis to a "standard" or "vanilla" option does vary with the "send in the keys" aspect.
The house cannot be partially sold and paid off in bit by bit. It happens all at once.
A standard option's volatility increases with the amount of leverage, time to expiration, distance from the exercise/strike price (loan balance).
Because the homeowner can "send in the keys" he effectively is handing in his option value, making it more like an exotic "knockout" option. The "knockout" occurs when his conscience or societal norm-following behaviour vanishes and he just sends in the keys.
This wouldn't occur very near the "strike" price where there is a good deal of volatility value left in a 30-year amortizing home.
My question to you: when do societal norms begin to change our perception of Nearness/distance to strike price? Put another way:
How far away from strike was the walkaway number 2 years ago than it is now?
@ anon
It's true that Nassim Taleb, and a small number of other speculative investors, are explicitly long volatility.
However, these investors represent only a tiny fraction of the overall investment asset base, and, perhaps more troublesome, even when these investors are "right" on the fundamentals, they risk losing their money due to the bailouts sought by the politicians/banks.
This is true of many hedge funds who lost money when the SEC decided to ban short-selling on the banks, and after TARP was announced, and after the Fed converted MS and GS to bank holding companies (therefore granting an explicit gov't guarantee).
Insurance companies are long equity volatiltiy through variable annuities and GICs (they buy put options). They are a massive source of demand for long vol.
One could in principle hold compensation above some threshold in escrow for 15 years, but for potential loss of the held compensation to make a real punitive difference, a setback from the 99.9th percentile to the 80th percentile, then it also becomes a mandatory savings plan for the top 20% of wage earners. Not that that would be a bad thing. But to be meaningful and broad enough to escape evasion, measures meant to encourage responsible behavior among the richest of the rich are likely to have some affect on upper-middle earners.
Add on to my last post: It also occurred to me that you don't know what the ROI of that $100MM is. If he did it with $50MM of capital, he could probably justify getting more like 20%.
Mortgage's used to be one-year balloon payments, that both parties would rollover. The thirty-year mortgage was a New Deal instrument. When I worked in Puerto Rico in the late 1990s very few people had mortgages. They simply built on land they or their families had somehow aquired and built them piecemeal as they could acquire materials.
The 30-year mortgage has always been a disaster for banks without the Federal Government supporting it in some fashion. Of course at the moment, the Feds are the only ones buying the mortgages. It is hard to know where housing prices would be if the Fed stopped buying. Since they have been tightening up, we may get a little feel for that shortly.
This appears to say that the financial system is ALSO long on volatility. While I'm sure there is some of each, you can't have it both ways, are they more short or more long on volatility?
Seems to me that instead we have a classic oligopoly where a small number of people have access to an important market, and are allowed to extract larger fees than they would otherwise. In what fair world does it cost me essentially $0 to place an through with craigslist, and $20 to place an order with NYSE? The business models are similar and the actual effort is roughly equivalent, but one has a gated market and one does not.
If you opened up day to day trading and IPOs I would imagine that the financial sector would shrink to less than a quarter of the size it is today.
Tyler,
As a finance guy, let me say that you really nailed it in your original piece. Nuanced, but you got all the main points exactly right. Just want to add a few things:
- The social welfare consequences of having the finance-types have a disproportionate share of the money and status are depressing to me. It's unfortunate that a very bright, highly educated cancer researcher has trouble making ends meet in San Francisco or New York City, or competing for real estate, private schools, etc., with finance guys. This does have implications for the real economy, and is an underappreciated (re)calculation story.
- In addition to being long skew / short vol, everyone is really levered-long asset inflation. Asset prices, both in CPI-adjusted terms, and in relation to underlying cash flows, have been on an ever-increasing trend since 1981 (alternatively, both risk premia and real rates have been in decline). The relative winners in this game tend to be owners of real and financial assets, and lenders to them (the lenders benefit from the increasing value of the collateral, generating beneficial credit outcomes). This demographic skews older, more educated. The losers in relative terms are the young, the less educated, immigrants, those who don't inherit financial assets, etc. The problem here is that an emphasis of monetary and fiscal policy in propping up asset prices has the unintended consequence of exacerbating inequality (with the caveats you rightly note in your piece). You don't have to be Misesian to see that QE and the like have asymmetric distributional consequences.
- Lastly, even WITHIN the finance industry, the policy bias towards increasing asset prices ("the Greenspan/Bernanke put") has the consequence of redistributing prestige and wealth toward those who are more willing to take risks. Jeremy Grantham has famously said he lost 2/3rds of his clients in 98 and 99 when he refused to participate in the TMT bubble. He at least had the satisfaction of eventually being shown to be right. But what about those fund managers who steered away from leveraged credit bets, only to see the Fed reinflate those bets during 2009? Analogously, a patient saver and renter can only be chagrined to see the Fed attempt to prop up house prices just as he finally sees price/rent ratios mean-reverting.
Agency costs are really, really important. They have both distributional consequences and real economy consequences. Some of these agency problems are, as you point out, artifacts of our modern world, technology, and institutional arrangements. But some of these agency problems are exacerbated by shortsighted monetary, regulatory or fiscal policy.
Lastly, you were right to worry about Geithner's incentives (and not just those of the bankers).
Really? Would the welfare of most people in say New York City be better off if the income of financial sector employees was slashed if half? Would cancer research somehow be better off?
About cancer research, I don't know, but finance does siphon off many young PhDs in scientific fields. These are diverted from research, but also industry, which has to compete salary-wise with Wall Street for talent. The added costs, as usual, are offset to customers…
There may be other social problems, but I don't see why a cancer researcher being unable to live in New York or San Francisco is a big deal. Cancer research doesn't care too much about where it's done.
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