The movie The Big Short, based on Michael Lewis’s book of the same name, tells the story of three early short sellers of the US housing market running up to 2008. The movie itself is engaging, especially its use of big screen and pop stars to explain CDOs, leverage and MBS. Our question is how much of this is ancient history vs. what should be taken as warning signs going forward?
The Big Short movie (which is different enough than the book to make the distinction) focuses on the build-up of leverage through mortgage derivatives and credit default swaps on those derivatives. There is also an entertaining discussion about the daisy chain of CDS options. The premise is that the original MBS were simple, high quality assets that deteriorated over time when no one was paying attention. As a few early investors looked into the details of MBS quality and the poor quality of the underlyings, they were a) vilified, b) dismissed as lunatics, and c) made a fortune as their large swap positions proved accurate.
The parallel we see today is the excessive build-up of derivatives positions in place of physical liquidity. We ran the numbers on why this is happening in our report “Regulatory Costs of OTC Derivatives vs. Securities Finance Transactions,” December 2015. While regulators have of course clamped down on private label CMOs, CDSs and the like, a whole new door has opened owing to an accidental preferencing of OTC derivatives overs securities finance transactions on bank balance sheets. This move has direct negative impacts on physical market liquidity and hurts all investors in underlying securities, especially the retail players that regulators are supposed to love and protect the most. Derivatives also fare poorly in this set up: the less liquidity in the underlying, the more volatility in the derivatives and the chance that derivative prices are actually driving underlying prices, not the other way around. While this works for some people, we think it is a poor outcome for investors and market structure.
In support of our thesis, we suggest a look at the recent Bloomberg story, “That Giant Sucking Sound You Hear Is the ETF Options Market.” While the article ran through the data, the punchline hit the nail on the head: “The question is how much more liquidity can ETFs drain from other markets—be they stocks, commodities, or bonds—before they become the only market?” We’ll have more on this in a February 2016 Finadium research report.
The current derivatives-based frenzy is the result of regulatory action. The 2008 debacle happened because of regulatory inaction. What’s the right balance between conservatism and letting the free market do as it wants. Its easy to say that packing crap into a gold-plated AAA rated shell is not good, but how much should regulators intervene after that given the laws of unintended consequences? That’s hard to know, but the answer starts with regulators determining what’s the best outcome for the markets. We vote for physical transactions having more liquidity than derivatives, and derivatives being transparent and regulated.
The Big Short has some useful analogies for looking at market structure today. The movie showed in an Hollywood way what happened when the markets went over the cliff of enthusiasm for derivatives. The current market environment isn’t that crazy and the derivatives are more transparent, but a market that is prone to excessive volatility and instability is only good for people who profit on those trades. For everyone else, it is destabilizing and unhelpful. Regulation can be the cause or solution of the problem – we advocate and early recognition of the problem and taking a better road this time around.
