Scapegoats, ETFs and Greek Threads

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Markets are weird.

The S&P 500 was up as much as 2.9 percent yesterday before collapsing in the last hour of trading and closing down 1.35 percent. The Shanghai Composite Index closed down 1.27 percent Wednesday, which is pretty good for the Shanghai Composite these days. As I look at about 8 a.m., Europe is down, but U.S. futures are up. 

In China, the government "is again on the prowl for scapegoats" for the crash:

Authorities announced a probe of allegations of market malpractice involving the stocks regulator on Tuesday, while the official Xinhua News Agency called for efforts to “purify” the capital markets. The news service also carried remarks by a central bank researcher attributing the global rout to an expected Federal Reserve rate increase.

And there are those who wonder whether prime minister Li Keqiang himself might "take the fall for Beijing’s perceived mismanagement of the stock market crash and the country’s broader economic slowdown." One question to ponder is: If China settles on a scapegoat for its crash -- which has seen a 43 percent drop in the Shanghai Composite since the June peak, and which sparked the destruction of $5 trillion in global equity value in the last two weeks -- will it punish that scapegoat more or less harshly than the U.S. wants to punish Nav Sarao, its apparent scapegoat for the 2010 flash crash that caused a momentary blip in U.S. equity prices? In other news, "China’s margin debt has plunged by 1 trillion yuan ($156 billion) from its June peak," and here is an annotated chart of the rise and fall of the Shanghai Composite. And Goldman remains overweight China.

In the U.S., here is Myles Udland on the financial media's epistemic humility: "Everything as it currently stands is basically an admission that no one knows what stocks are doing, and efforts to the contrary are usually met with scorn." Here is a Funny or Die parody Q&A that reads like every other markets Q&A this week. Here is Scott Sumner on "Why bubbles are so hard to spot":

If you bought the S&P 500 at the peak (10/5/87) you've earned a 9.3% CAGR over the past 28 years.

If you bought at the subsequent trough (12/4/87) you've earned a 10.8% CAGR.

Note that the S&P500 fell 31.75% over that period. Both of those subsequent returns look fairly reasonable to me. If you forced me to guess, I'd say the 9.3% return seems a bit more consistent with market efficiency (recall that inflation and nominal interest rates have fallen since 1987). And if I'm right this would imply that prices were more "rational" at the peak of the "bubble."

Here is Helaine Olen on societal pressures to panic over the stock market. Jackson Hole will be interesting. And U.S. presidential candidates who have bothered to weigh in on the crash were ... not good.

People are worried about ETF liquidity.

The classic bond-market liquidity worry was that people were using exchange-traded funds as a liquid way to get access to broad swathes of the bond market, but that in a crash the underlying bonds would not be liquid enough to support the liquidity expectations of the ETF investors. What's fascinating about Monday's crash is that that completely happened, but in stocks: Many stock ETFs fell much further than their underlying holdings did, because some of those underlying holdings were halted by stock exchange circuit-breakers. 

In order to protect their positions, when market makers buy ETF shares, they often sell the shares of an ETF’s holdings as a hedge. The price of ETFs is a derivative of the underlying stocks it represents, so this allows them to mitigate some of the risk. The number of trading halts in underlying stocks made this type of hedging impossible, traders said. Unable to properly hedge, they traded less because it was too risky, they said.

The article contains complaints about how this is a problem that needs to be solved. ("They weren’t as liquid as they should have been," says a financial adviser.) I don't know though. The exchange-traded fund is a very clever device for using market mechanisms (hedging market makers, creation/redemption) to build a single security that tracks a broader portfolio in real time. It works, you know, ninety-nine-point-whatever percent of the time. It would be awesome if it worked 100 percent of the time. But those market makers are not wrong to widen their spreads when they can't trade the underlying, are they? Sometimes stocks are kooky, and it's plausible that ETFs would concentrate and magnify that kookiness. A big problem in financial markets is that if you build a thing that works ninety-nine-point-whatever percent of the time, you will attract people who rely on its 100 percent reliability.

People are not even the teensiest bit worried about bond market liquidity.

Meanwhile in bonds, the classic worry just didn't come true. "Junk-bond investors were largely calm Monday, and trading volume was relatively low, according to several traders." Markit isn't worried: "Credit markets have remained calm compared to previous periods of market unrest." Goldman Sachs isn't worried:

“Our slogan is bonds in the passenger seat -- they haven’t been the epicenter of this move,” Francesco Garzarelli, co-head of macro and markets research at Goldman Sachs in London, said in an interview with Jonathan Ferro on Bloomberg Television’s “On The Move” program. “People are just not focused on that asset class.”

Again, the fact that all the predictions of a liquidity-driven bonds crisis have utterly failed to occur in the recent crash is not definitive proof that they were wrong; some other, future, more bond-centered crash might trigger that crisis. But it does seem like a good time to be a bond-market liquidity skeptic.

On the other hand, if you need to worry, consider worrying about options liquidity:

With regulation and risk limits crimping the market-making role of big U.S. banks, traders are relying more on automated and high-frequency firms to keep trading lubricated. Liquidity was at a premium when the wildest markets in four years threw off bid-ask spreads and inflated options costs.

“When you have this degree of volatility, market makers widen out and get small because they don’t want to commit capital,” said Jim Strugger, a derivatives strategist at MKM Holdings LLC in Stamford, Connecticut. “People’s jaws drop and they stare. Part of it is volatility. The other part is liquidity.”

I feel like ... spreads for volatility products widen when volatility gaps up? ("Pricing options is almost impossible on the kind of move you had that day," said a trader.) Where did people learn to talk about all their directional worries in terms of liquidity?

Some insider trading.

Tuesday's civil and criminal insider trading case against a former JPMorgan analyst and his buddies is a very, very standard insider trading case. The analyst, Ashish Aggarwal, worked in JPMorgan's San Francisco office in technology, media and telecommunications banking. He allegedly got information about JPMorgan TMT deals (not the ones he worked on) and passed it along to his college friend, who then passed it on to another friend whom he worked with at Greek Life Threads, which of course makes clothes for fraternities and sororities. And then the friends would allegedly go buy piles of relatively thinly traded short-dated out-of-the-money call options on acquisition targets. You know how I feel about short-dated out-of-the-money call options on acquisition targets. Everything here is a cliché, and the weirdest part is that the guy worked at JPMorgan. Don't investment bankers know about this by now?

Elsewhere in (alleged) fraud, here's a Securities and Exchange Commission case against a former Tibetan Buddhist monk for EB-5 fraud. Under the EB-5 Immigrant Investor Pilot Program, "foreign citizens may qualify for U.S. residency if they make a qualified investment of at least $500,000 in a specified project that creates or preserves at least 10 jobs for U.S. workers." So it's a program that allows foreigners to buy U.S. residency from private third parties, not from the U.S. government. It can't be too much of a surprise that some of those private third parties are not spending all of the proceeds on the proposed projects, but are instead skimming some for themselves.

Puerto Rico pulled a bond deal.

Puerto Rico is having trouble paying the debts of various municipal entities, and is trying to change its bankruptcy law to make it easier to get out of those debts. But it was nonetheless marketing $750 million of bonds for one entity, Prasa, its water and sewer authority, which seemed to be in better shape. Then this happened:

But the deal started to come unglued on Friday, after Puerto Rico filed its petition to the Supreme Court. It sought a review of the legality of its so-called Recovery Act, which tried to create a bankruptcylike restructuring framework for public corporations on the island. Among other things, the petition said that it needed to have a legal framework in case Prasa’s debts have to be restructured.

“That’s not the phrase you want in the middle of a bond deal,” said Mr. Fabian.

True! The problem is that you probably do want some sort of predictable resolution mechanism for Puerto Rico's agency bonds, rather than the current weird limbo in which investors are encouraged to lend too much by a legal regime that does not seem to allow for restructuring. Like, that's probably even good for investors. It's just that you don't want to be arguing about what that mechanism looks like while selling the bonds.

Me yesterday.

I wrote about the "solely for the purpose of investment" exemption to the Hart-Scott-Rodino antitrust notification requirements.

Things happen.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net