Putting Market Mayhem into Perspective

We talked briefly about CDS. We might mention them a bit more here, for there is a great deal to say about them, and their role in the current credit/equity crisis. We'll go on to discuss our opinions on what the next-next big thing might be. But for now, let's get the current equity picture into some perspective. This is instructive, because a "debt crisis" is a crisis ultimately because of its impact on equity.

Allow me to reintroduce the CBOE VIX Index. The VIX is a measure of expected near term market volatility, as implied by the S&P Index options market. Because volatility is a proxy for uncertainty, and uncertainty, in large enough doses and especially in matters financial, is synonymous with fear, the VIX is affectionately known as the "Fear Index."

Here's a chart of all the VIX data there is, from January 1986 through today, September 17, 2008. Every spike in the index is associated with an adverse market event. The spikes over 40 in the recent past are still familiar to us all. The grandaddy of all spikes is the one that occured on October 19, 1987, when the S&P 500 lost over 20% in a day.

Now, to where we are, and aren't, today.

We are in the midst of a major turmoil. In their efforts to describe it, the best and brightest in markets and economics have taken to using terms like "credit market seizure," and "once in a century event (Alan Greenspan)." Yet the VIX is still in ho-hum territory.

I think the VIX is highly instructive because, beginning with Bear Stearns, the financials equities have collapsed. In the case of Bear, the question of whether or not a "bear raid" took place -- that's predatory short selling with the aim of driving a stock as far down as possible -- led to the discovery of massive options trading on the stock just before and during its collapse. This options activity is what keeps the VIX so relevant. Even if by some as yet inexplicable mechanism the volitility is somehow distributed through derivative markets, the ultimate effect on US equity as measured by the S&P 500 Index will register in the VIX. And right now, it's just not showing a "once in a century" reading. This suggest some more shock to come.

Cause and Effect

Purchasing put options (a bet on the decline of a stock) causes the market-maker of the option to hedge his short option position by shorting the stock. In the normal give and take of market activity, there's nothing in that to be concerned about. The market maker will hedge the sale of a call with a long position, and things remain in a sort of balance. However, a large purchase of puts (a sale of them by the market-maker) will entail a large short sale of stock for hedging purposes. And if the stock declines substantially, his hedge ratio will increase and he'll need to sell more. In extreme cases, a self-reinforcing decline can take place.

There's been much talk about predatory short selling being responsible for driving firms' equity prices down. A collapse in equities prices can cause a firm's trading counterparties to question its ability to post more capital or rollover existing debt, something that would threaten its very ability to endure in a capital intensive business. Lenders may therefore balk putting more capital into what they see as an increasing risk. At the very least, they will charge far more to do so, which can have a substantial adverse impact on earnings expectations and therefore, equity values. The credit question then becomes a self fulfilling prophecy, and that's what kicks the CDS effect into gear.

A CDS is a position on the health of a company's debt. A CDS transaction occurs between a seller of protection and a buyer of protection. The seller is insuring the principal of the debt for the buyer. If the company defaults on the debt issue in question, the seller must pay face value of the debt to the buyer. The buyer, in turn relinquishes ownership of the defaulted note to the seller. The buyer pays the seller a premium for the "protection." So, the seller sees cash flow, the buyer sees safety of principal.

There is no limit to the amount protection that can be bought and sold. A firm may have $100 million in debt outstanding, but many multiples of that amount may be bought and sold in protection on that debt. The effect is to leverage the risk and returns in the CDS market.

There is much to say about this fascinating market, but what we wish to focus on at the moment are the incentives for the buyer of protection. A conservative fund with a portfolio of corporate debt is a likely buyer of protection. Often, the sellers have been the major investment banks; when mortgages began defaulting, sellers of mortgage CDS protection were forced to post additional capital as collateral on their obligations. In the case of major banks, the assets were written down in order that the balance sheet would reflect actual values as much possible -- they were marked to market. The problem there is that the CDS market is both negotiated and illiquid, and therefore marking to market is often an excercise in futility: the market may simply not reflect real value. This doesn't necessarily mean that the securities have no value, only that their value is temporarily impossible to objectively ascertain.

But we've been through that part, at least for the worst of the mortgages, and for the biggest of the banks. On the horizon, of course, are the "less worst" mortgages, and credit card securites, too. But that's another post.

Getting back to incentives, if a firm's equity value starts detiorating markedly, either because of predatory short selling or legitimate selling or overall market conditions, the firms debt risk increases. The CDS market, being frequently highly leveraged, realizes a multiplied effect from the debt risk. Certainly, the buyer of protection stands to gain, but only if the seller can pay the buyer's claim. The seller realizes losses that must be written down, creating a demand for capital -- in a highly leveraged market, lots of capital. Hence the "credit crisis."

As a CDS portfolio at one firm loses value, its credit condition is affected, and the seller of protection on that firm's debt is also faced with writedowns, creating the need for capital. Counterparties to those trades will get cautious, and that firm may be left without refinancing capabilities in a capital intensive business, and the cycle repeats.

To complicate matters, the buyers of debt protection have an incentive to see the reference firm default -- and the sooner the better. If they are in a position to influence that eventuality, would they be tempted to? We've already seen how naked short selling can cause just such a downward spiral. Fortunately, the SEC finally reinstated restrictions on it today. But in between August 12, when the previous restrictions came off, and today, Fannie Mae, Freddie Mac, Lehman Brothers and AIG have entered some kind of massive reorganization, thier equity value has dropped to pennies per share, Merrill Lynch sought a merger, the bond and commodities markets have been in the paroxysms of a flight to quality. The horse is a long way out of the barn.

And we haven't even gotten to the seventh inning stretch yet.

source data: CBOE VIX Website