Con-tango

Captain Morgan’s pirates

Morgan’s Rum. Courtesy of Don Maitz.

Continuing with my previous post, a salient feature which has allowed Morgan’s pirate traders to make trillions of USD is the fact that they have shown their abilities to navigate a deep sea of liquidity, with low volatility winds.

VIX Index. Monthly. Courtesy of Ensign.

As the VIX index chart clearly shows, volatility in the equities
markets has been making historic lows for, what it seems, years by
now.

But, how is low volatility explained by higher liquidity? In very
simple terms, if liquidity is high, it’s very difficult for any company
–even the poor performers– to go belly-up. Clients have better
incomes and are more willing to spend, therefore sales are good; and if
not, a company has a chance to mend its ways by borrowing
inexpensively–banks have plenty of merchandise to move. In other
words, the passing grade for any enterprise is lower.

But the story does not end here. Morgan’s pirates unveiled
that playing and selling credit insurance –through
derivatives– was the appropriate thing to offer and trade… and, they
were bloody right.

The story started with a group of JP Morgan derivatives traders;
brainstorming and boozing at a reunion they had in Boca Raton, a few
years back. The FT has a wonderful series called Wizardry,
that I highly recommend, which goes into the detail of all the
derivative instruments which have sprouted to take advantage and…
exacerbate liquidity.

From Gillian Tett’s FT article,

The idea that attracted most excitement was the concept of mixing
derivatives with credit. One of the pernicious problems that have
always dogged business is so-called “credit risk” – or the danger that
a loan (or bond) might turn sour. And as they sat in their conference
room in Boca Raton, some of the bankers started to wonder if there was
a way to create derivatives that could bet on whether bonds or loans
would default.

And, this is where I wanted to get to. If banks can pay an insurance
premium on their loans to cover their loan defaults (NPL), the risk of
lending for the bank… disappears. Voila, great idea, it spread like
wildfire within the banking and trading community. Banks can grow
beyond their reserve requirements –someone else is assuming the risk
of a loan default– which further feeds global liquidity.

But, who is assuming this risk? Well, the pirate traders which are
sailing the low volatility winds. In other words, as long as the deep
waters of the financial ocean of liquidity are there, they will continue to sail this ocean reaping a pirate’s bounty.

Now, I’m a little worried… doesn’t it seem like the Central Banks have lost control of the liquidity spout?

A few disquieting remarks from Trichet, at Davos:

“There is now such creativity of new and very sophisticated financial
instruments … that we don’t know fully where the risks are located.”
He added: “We are trying to understand what is going on but it is a
big, big challenge.”

It may not be the case, but it sure looks to me like the pirates
will have hell to pay when things turn around… and I hope we don’t
all get caught up in the high volatility storm to ensue.