"The Threat of Contagion"
By Jim Rickards
“On Monday, February 5, 2018 the stock market fell a record 1,175 points. Yesterday, March 22, 2018 the market fell 724 points. It is not clear where markets go from here. What is clear is that the Pandora’s box of volatility has been opened and greater volatility will be a feature of stock trading for the foreseeable future. But getting back to Monday’s record fall, markets came much closer to a catastrophic meltdown than many investors realize. The reason for the near-catastrophe was the same as the reason for actual catastrophic losses in 1987, 1998 and 2008 - derivatives, leverage and opaque financial structures.
’Normal’ contagion arises when declines in one market spill over into another, usually uncorrelated market, typically because losers in one market are selling liquid securities in another market. Why do they do that? To raise cash to meet margin calls on the losses.
When this type of linked selling arises, uncorrelated markets become highly correlated. That is called “conditional correlation.” This kind of correlation arises upon a specified condition happening, such as large losses or liquidity demands. But there’s another kind of contagion that’s even more dangerous.
To understand the risk of contagion, you can think of the marlin in Hemingway’s 'Old Man and the Sea'. The marlin started out as a prize catch lashed to the side of the fisherman Santiago’s boat. But, once there was blood in the water, every shark within miles descended on the marlin and devoured it. By the time Santiago got to shore, there was nothing left of the marlin but the bill, the tail and some bones.
In this metaphor, the marlin is XIV. During regular trading hours on February 5, there was not much blood in the water. But, once traders saw the damage to VIX, they smelled blood in terms of the value of XIV. At that point, markets (the sharks) no longer traded XIV in relation to other instruments. Instead markets systematically traded against XIV in an effort to force every holder, sponsor and guarantor to suffer a total loss. They were out to break it. Markets intended to pressure the price of XIV until there was a suspension of redemption, a collapse to zero, or ultimately noteholder litigation.
I apologize if this sounds a bit technical. The bottom line is, the damage seems to have been contained. But, what if the XIV ETN holdings had been concentrated at just one or two hedge funds? What if those holders themselves were highly leveraged and were losing money on stocks and XIV at the same time? What if rumors had leaked out into the marketplace about “hedge funds in distress?”
An even greater danger for markets is when these two kinds of contagion converge. This happens when market losses spillover into broader markets, then those losses give rise to systematic trading against a particular instrument or hedge fund. When the targeted instrument or fund is driven under, credit losses spread to a wider group of fund counterparts who then fall under suspicion themselves. Soon a market-wide liquidity panic emerges in which, “everybody wants his money back.”
This is exactly what happened during the Russia-Long Term Capital Management (LTCM) crisis in 1998. The month of August 1998 was a liquidity crisis involving broad classes of instruments. But, the month of September was systematically aimed at LTCM. I was right in the middle of that crash. It was an international monetary crisis that started in Thailand in June of 1997, spread to Indonesia and Korea, and then finally Russia by August of ’98. It was exactly like dominoes falling.
LTCM wasn’t a country, although it was a hedge fund big as a country in terms of its financial footings. I was the general counsel of that firm. I negotiated that bailout. The importance of that role is that I had a front-row seat. I’m in the conference room, in the deal room, at a big New York law firm. There were hundreds of lawyers. There were 14 banks in the LTCM bailout fund. There were 19 other banks in a one billion dollar unsecured credit facility. Included were Treasury officials, Federal Reserve officials, other government officials, Long-Term Capital, our partners.
It was a thundering herd of lawyers, but I was on point for one side of the deal and had to coordinate all that. It was a 4 billion dollar all-cash deal, which we put together in 72 hours with no due diligence. Anyone who’s raised money for his or her company, or done deals can think about that and imagine how difficult it would be to get a group of banks to write you a check for 4 billion dollars in 3 days.
Systematic pressure on LTCM persisted until the fund was almost broke. As Wall Street attacked the fund, they missed the fact that they were the creditors of the fund. By breaking LTCM, they were breaking themselves. That’s when the Fed intervened and forced Wall Street to bail out the fund. Those involved can say they bailed out Long-Term capital. But if Long-Term Capital had failed, and it was on the way to failure, 1.3 trillion dollars of derivatives would’ve been flipped back to Wall Street. In reality, Wall Street bailed out itself.
The panic of 2008 was an even more extreme version of 1998. We were days, if not hours, from the sequential collapse of every major bank in the world. Think of the dominoes again. What had happened there? You had a banking crisis. Except in 2008, Wall Street did not bail out a hedge fund; instead the central banks bailed out Wall Street.
And today, systemic risk is more dangerous than ever. Each crisis is bigger than the one before.Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system, and have much larger derivatives books.
New automated trading algorithms like high-frequency trading techniques used in stock markets could add to liquidity in normal times, but the liquidity could disappear instantly in times of market stress. And when the catalyst is triggered and panic commences, impersonal dynamics take on a life of their own.
These kinds of sudden, unexpected crashes that seems to emerge from nowhere are entirely consistent with the predictions of complexity theory. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.
The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which despite some movement in that direction, still have not been normalized since the last crisis.
For now, it’s not clear which way things will break next. Markets are still in a precarious position and volatility is high. Regardless of which direction markets go from here, Monday’s story of contagion from the Dow Jones to VIX to XIV is a scary reminder of the hidden linkages in modern capital markets. Next time we may not be so lucky."