Who is going long on volatility?

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.