Volatility Regime Change and Central Banks - a key driver

"If you do not change direction, you may end up where you are heading." -  Lao Tzu

While we recently asked ourselves about the possibility of a regime change in the volatility space in early January:
"Long dated volatilities a regime change?"

and touched as well on the change in volatility regime in both the US and Europe:
"The Change in volatility regime - a follow up"

A note from Goldman Sachs entitled "The Buzz - The Great Compression - VIX regimes over the last 23 years" from the 22nd of January seems to confirm the shift into a lower vol regime:

"Our VIX analysis back to 1990 shows that the VIX has been through seven “statistically” distinct volatility regimes over the past 23 years. The model currently assigns an 89% probability that the VIX has shifted into an even lower gear, and is currently transitioning into its 8th regime characterized by lower volatility levels."

- source Goldman Sachs.

More interestinggly has we have been discussing in our recent credit conversations, we have to agree with Goldman Sachs note, namely that when it comes to a lower volatility regime, Central Banks have been a key driver:

"Our statistical test allows us to track the probability of a regime shift over time. The probability of a new lower vol regime hit a low of 14% in mid-summer 2012, and then accelerated higher post ECB President Draghi’s comments in July to do “whatever it takes” to preserve the Euro. After the official launch of QE3 in the US and ECB monetary stimulus in September the probability moved from the low 30’s to where it stands now in the high 80’s, over 6x its mid-July level. Our simulations show that a replay of VIX levels over the last two months would push our regime shift probability to 95% and make the new VIX regime official from a statistical perspective." - source Goldman Sachs.

Following the footsteps of our recent conversation relating to the regime change in the volatility regime, Goldman Sachs in their note argue the following:

"While much has been written on the imbalances which led to the “Great Recession" and the unprecedented volatility levels reached, understanding the common post-crisis volatility patterns can have strong implications for volatility investors. The VIX averaged 17.8 in 2012, on par with 2007 levels, and has averaged 13.7 in the early stages of 2013, similar to the average level from January 2004 through mid-2007. The VIX transition from the Great Recession to the Great Compression has been a long, slow healing process, and the number one question we have gotten from investors in 2013 has been: “Is the VIX shifting into a lower vol regime?” The short answer: The statistics say YES."

- Source Goldman Sachs, Krag Gregory, Ph.D., Jose Gonzalo Rangel - 22nd of January 2013.

When it comes to measuring or not the probability of regime change, according to Goldman Sachs, the probability of a new VIX regime has increased six-fold since mid July 2012 and stands currently at 89%. The chart below from Goldman Sachs shows the probability of rejecting the hypothesis of "no regime change". Data as of January 18, 2013:

- Source Goldman Sachs, Krag Gregory, Ph.D., Jose Gonzalo Rangel - 22nd of January 2013.

Goldman Sachs makes the following points in their research note:
"-Supply/Demand: Trading behavior could also put pressure on the back-end of the volatility curve. In low vol environments investor behavior often changes. From a supply/demand perspective, in lower realized volatility environments investors become reluctant run pure long volatility strategies and often try to minimize carry. That is often done through calendar spread trades which sell the back to fund the front-end of the volatility curve. That flow would put downward pressure on the back-end of the VIX and S&P curves. 

-Investors continue to search for yield: In an environment where rates are exceptionally low, investors have had to look to other asset classes to generate income. Low vol regimes typically bring out the vol sellers. Investors often wait for persistently low levels of VIX and realized volatility to sell puts, straddles and strangles. This shift in trading behavior from long vol to short volatility risk premium generation strategies may also push vol lower. 

-Caveat: Shouldn’t the VIX curve be steeper now than in 2007 given VIX ETN’s? One issue which makes comparisons to 2007 and quantifying potential term structure shifts difficult is that VIX ETN’s and ETF’s did not exist in 2007. These products by their construction have a tendency to steepen the VIX curve. So we may not see the same flatness we saw in 2007 unless volumes on these products decline considerably." - source Goldman Sachs

More importantly, Goldman Sachs makes the following important points in regards to a sub-14 VIX level:
"What is a sub-14 
-VIX telling us?What is a sub-14 VIX telling us? The VIX landed at 12.5 last Friday, and has averaged 13.7 YTD. The VIX has traded at an average spread of 4.4 vol points above S&P 500 one-month realized volatility back to 1990. If taken literally, VIX levels below 14 in early 2013 suggest that the VIX is "forecasting" sub-10 realized market volatility, at least for the near term. S&P 500 realized volatility was 12.8 in calendar year 2012, one- and three-month realized are around 13, and ten-day has dropped below 6.
-Equity volatility and the business cycle: Our US Economics team is currently forecasting real GDP growth of 1.5% for 2012Q4, with an expectation for 1.5% in 2013Q1. The ISM manufacturing index has been hovering around the 50 mark over the past few months and our economists expect little change in 2013Q1. Over the last 50 years S&P 500 realized volatility has typically averaged about 14 in months when the ISM was between 50 and 55 and 14.8 in quarters when GDP growth rates were in the 0%-2.5% range.
-Our economic model for S&P 500 one-month realized volatility suggests that volatility should currently be trending around 14 based off of current levels of manufacturing, consumer spending, and labor data. So benchmarking relative to the ISM, GDP, or our own formal model, suggests realized volatility should be around 14.
-But benchmarking relative to the economics may be less relevant now. In our view changes in volatility are about changes in information content. So low but steady levels of ISM and GDP growth for prolonged periods may not be indicative of higher volatility levels. We have been in this macro environment for a while and we argue it is sharp changes in the macro and financial information sets that are volatility inducing. We are also in the unchartered territory of unprecedented global Central Bank liquidity which may make comparisons to typical volatility levels in past economic states more difficult. In short, no bad news equals good news for lower VIX levels, especially if we get through the debt ceiling and sequester debates unscathed." - source Goldman Sachs.

As we argued in March 2012, in our conversation "The two main drivers of equity volatility":
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates."

VIX since 2005 - Source Bloomberg:

One thing for sure, the on-going excessive search for yields could have a long-term impact (relative immunisation risk of credit versus equities).

"Consequences are unpitying." - George Eliot, British author.

Stay tuned!

Markets and Macro Update - Dude where is my Risk?

Trigger happy rating agencies strike again.

4 notches downgrade yesterday from Moody's for Portugal straight from Investment grade to junk. Moody's clearly in a downgrade mood, racing against S&P in the cutting contest...It's getting nasty.

Same rating agencies that were handing out AAA ratings like candies on dodgy structured credit transactions before 2008 (can you spell Abacus?), collecting big fees paid by the investment banks.

As a reminder: 11 Apr 2007 – Landsbanki received a 5 notch upgrade, from A2 to Aaa, when Moody's announced its new JDA rating methodology on 24th of February 2007. We know what happened to Landsbanki bank in Iceland. Can you spell default? This was one year after Icelandic banks experienced a liquidity scare and their 5 year CDS went through the roof in 2006.

JDA analysis: Moody’s fights back - Risk.net

And it wasn't only a joke on Landsbanki's rating...

"Glitnir was one of three Icelandic banks that found themselves at the centre of the JDA furore after receiving multi-notch upgrades that placed them above European heavyweights such as ABN Amro. Glitnir was promoted from A1 to Aaa in the first round of the JDA rollout on February 23, and then down to Aa3 when the refined methodology came out in April."

Funding was the issue for Icelandic Banks, the market knew it at the time, except Moody's:

Icelandic Banks - Not what your are thinking - Merrill Lynch - 7th March 2006.

And the rating agencies are failing again:

Iceland Credit Raters Miss Resurrection After Failing to Predict Collapse - Bloomberg

"While Moody’s kept a Aaa rating on Iceland until five months before its banks collapsed, reluctance to raise the island’s credit grade now is blocking the country’s access to a broader investor base. Debt derivatives show the low ratings may be unwarranted as credit default swaps on Iceland indicate it’s less likely to default than euro member Spain."

"CDS on Iceland’s debt have eased 14 percent this year. Contracts on five-year debt were 229 basis points last week, compared with 257 basis points for Spain, the fourth-largest euro member."

But back to the Portugal story:
Two-year Portuguese yields jumped 3.8% points to a new record high of 16.74%.

Leading to European Banks stocks getting hit and CDS 5 year spreads widening as well.

Ireland and Portugal 5 year CDS, displaying a correlation of 1 and moving up in tandem. Here is the picture, courtesy of CMA:


And the picture for the rest of Europe - wider:


Contagion to Italy?


Portugal Sovereign CDS wider than some Portuguese corporates:


Portugal and Ireland cumulated probabilities of default according to their respective 5 year CDS levels amount to around 50% chance.

CDS market watch: Think you are protected on Greek default risk because you're long CDS protection? Think again...

Greek debt rollover plan unlikely to be credit event-ISDA - Reuters

"Current proposals tabled by France to involve the private sector in sharing the burden of a second bailout for Greece are unlikely to trigger the payout of default insurance, ISDA's general counsel David Geen told Reuters on Monday."

Macro picture:
US ISM Non-Manufacturing PMI, not 53.9 verus previous number of 54.6.

China raised its benchmark interest rates for the third time this year, to 6.56 percent from 6.31%. The nation’s first audit of local-government debt found liabilities of 10.7 trillion yuan (1.7 trillion USD) at the end of 2010 and warned of repayment risks. The heat is on...but The World Bank forecasts the Chinese economy will expand 9.3% this year, compared with 8%for India, 2.6% for the U.S. and 1.7% for the euro area.

Good news for Estonia upgraded to A+ by Fitch. The rating is the second-highest in eastern Europe, behind the Slovenia at AA and on a par with the Czech Republic and Slovakia. Estonia’s 19 billion USD economy grew 8.5% from a year earlier in the first quarter of 2011.

Estonia’s Credit Rating Raised to A+ by Fitch on Economy, Public Finances - Bloomberg

"The government implemented austerity measures equal to 9 percent of GDP in 2009, preventing the budget shortfall from ballooning and keeping the country on course to adopt the euro. Estonia had the EU’s only budget surplus, 0.1 percent of GDP, and lowest public debt, 6.6 percent, last year."

Follow up on previous post "Stuck in the middle with you" part.
Bank of America's 8.5 billion USD settlement on Countrywide legacy mortgages with players like BlackRock, Pimco, New-York Fed and co, looking increasingly in jeopardy:

Primary Prosecutors of Mortgage Fraud? Pension Funds And Plaintiffs’ Lawyers - "Just when you think you’re caught up on all the troubles Bank of America is having with mortgage-related fraud, there’s another story. A group of bondholders calling themselves Walnut Place challenged the bank’s most recent settlement with bondholders for $8.5 billion."

Walnut Place, the nutcrackers:


Bond investors challenge $8.5bn BofA settlement - by Suzanne Kapner

“…The Walnut Place investors said that as many as two-thirds of the loans in two Countrywide trusts failed to meet underwriting guidelines, according to their own investigation. Extrapolating that failure rate to the 530 trusts covered by the bank’s settlement, the Walnut Place investors concluded that BofA could be liable to repurchase loans with unpaid principal balances of as much as $242bn.”

Bank of America stock currently 2.59% to 10.71 as I write this post.

July 19, 2011, we will get Q2 2011 Bank of America Corp Earnings Conference Call.
To be continued...

Liar's Poker winner à la Michael Lewis way: Goldman Sachs

Goldman Took Biggest Loan in Fed Program - Bloomberg

Blood in the Credit Markets - Game on - Greece, that Lehman feeling?

On the 26th of November I posted : European Sovereign Debt - There will be blood

Was it visionnary? Hardly so.

European politicians are running out of options. They can't keep kicking the can down the road, because the road has an end.

Greece Sovereign 5 year CDS is now trading upfront, following it's stratospheric rise to around 2190 bps (+435 bps on the day!), implying more than 80% cumulated probability of default:

2 years Greek yield hovering around 28.25%. It sounds like game over for Greece, at least that's what the market is telling us.

Ireland and Portugal 5 years Sovereign CDS widened by 34 and 25bps to 815 and 810 bps.

ITraxx Financial Senior at 171.5 bps and Itraxx Fin subordinated index was at 310 bps.
Itraxx Main Europe 5 year, representing 125 corporate investment grade names at its highest since January 10 at 112 bps.

Vix index which has been too complacent for too long, suddenly woke up today to move straight to around 24% before coming off slightly:

We need to monitor closely VIX, to see if it breaks above 30, which was the highest point reached on March 16th.

In relation to Greece, David Goldman has an interesting proposal to resolve the ongoing issue: "Europe Needs One Horrible Example"

An entertaining read to say the least!

In relation to US Banks CDS, still widening today:
S&P’s LCD group gave an update, surge in demand for default protection = Not the best sign.

"After a brief respite Tuesday, five-year protection costs for bank, broker and consumer financial companies rose another 4-6% today after widening a similar amount yesterday, with latest levels representing near or full retracement of net tightening moves across the sector over the first four months of the year, trade data show."

"Significant percentage moves wider in five-year CDS spreads since the end of May include Wells Fargo (up 31% to 107 bps), Merrill Lynch (up 29% to 182 bps), Bank of America (up 27% to 178 bps), Capital One Financial (up 25% to 125 bps), Morgan Stanley (up 23% to 176 bps), Citigroup (up 22% to 156 bps), American Express (up 17% to 85 bps) and Goldman Sachs (up 11% to 158 bps)."

I am sticking with my previous recommendations of avoiding US banks stocks.

It is still "Risk Off" mode for now.

The Hangover...Some guys can't handle credit...

Socrates: “All I know is that I know nothing.”



Another must read this week, the latest from the author of Liar's poker and the Big Short, Michael Lewis in Vanity Fair:

http://www.vanityfair.com/business/features/2010/10/greeks-bearing-bonds-201010

"The tsunami of cheap credit that rolled across the planet between 2002 and 2007 has just now created a new opportunity for travel: financial-disaster tourism. The credit wasn’t just money, it was temptation. It offered entire societies the chance to reveal aspects of their characters they could not normally afford to indulge. Entire countries were told, “The lights are out, you can do whatever you want to do and no one will ever know.” What they wanted to do with money in the dark varied. Americans wanted to own homes far larger than they could afford, and to allow the strong to exploit the weak. Icelanders wanted to stop fishing and become investment bankers, and to allow their alpha males to reveal a theretofore suppressed megalomania. The Germans wanted to be even more German; the Irish wanted to stop being Irish."

So true...I could not agree more with Michael Lewis.

Michael goes on:

"The resulting dumping of Greek bonds onto the market was, in the short term, no big deal, because the International Monetary Fund and the European Central Bank had between them agreed to lend Greece—a nation of about 11 million people, or two million fewer than Greater Los Angeles—up to $145 billion. In the short term Greece had been removed from the free financial markets and become a ward of other states.

That was the good news. The long-term picture was far bleaker. In addition to its roughly $400 billion (and growing) of outstanding government debt, the Greek number crunchers had just figured out that their government owed another $800 billion or more in pensions. Add it all up and you got about $1.2 trillion, or more than a quarter-million dollars for every working Greek. Against $1.2 trillion in debts, a $145 billion bailout was clearly more of a gesture than a solution. And those were just the official numbers; the truth is surely worse."

Some additional sobering facts about our dear European Greeks:

"In just the past decade the wage bill of the Greek public sector has doubled, in real terms—and that number doesn’t take into account the bribes collected by public officials. The average government job pays almost three times the average private-sector job. The national railroad has annual revenues of 100 million euros against an annual wage bill of 400 million, plus 300 million euros in other expenses. The average state railroad employee earns 65,000 euros a year."

Gee and we are lending some money to these guys? You've got to be kidding me...not.

At least the Greek banks were not as stupid as the other European and US ones in the subprime debacle:

"Virtually alone among Europe’s bankers, they did not buy U.S. subprime-backed bonds, or leverage themselves to the hilt, or pay themselves huge sums of money. The biggest problem the banks had was that they had lent roughly 30 billion euros to the Greek government—where it was stolen or squandered. In Greece the banks didn’t sink the country. The country sank the banks."

Wow...

Here is another interesting fact about Greek politics during election, another courtesy of Michael Lewis great article:

“The first thing a government does in an election year is to pull the tax collectors off the streets.”

Lies damn lies and statistics:

“At Salomon we used to call [the head of the Greek National Statistical Service] ‘the Magician,’ ” says Xafa, “because of his ability to magically make inflation, the deficit, and the debt disappear.”

"In 2000, after a flurry of statistical manipulation, Greece hit the targets. To lower the budget deficit the Greek government moved all sorts of expenses (pensions, defense expenditures) off the books. To lower Greek inflation the government did things like freeze prices for electricity and water and other government-supplied goods, and cut taxes on gas, alcohol, and tobacco. Greek-government statisticians did things like remove (high-priced) tomatoes from the consumer price index on the day inflation was measured. “We went to see the guy who created all these numbers,” a former Wall Street analyst of European economies told me. “We could not stop laughing. He explained how he took out the lemons and put in the oranges. There was a lot of massaging of the index.”

And after joining the Euro, this is what the Greeks did with the help of Goldman Sachs (the guys that created the wonderful Abacus transaction as well...):

"To remain in the euro zone, they were meant, in theory, to maintain budget deficits below 3 percent of G.D.P.; in practice, all they had to do was cook the books to show that they were hitting the targets. Here, in 2001, entered Goldman Sachs, which engaged in a series of apparently legal but nonetheless repellent deals designed to hide the Greek government’s true level of indebtedness. For these trades Goldman Sachs—which, in effect, handed Greece a $1 billion loan—carved out a reported $300 million in fees. The machine that enabled Greece to borrow and spend at will was analogous to the machine created to launder the credit of the American subprime borrower—and the role of the American investment banker in the machine was the same. The investment bankers also taught the Greek-government officials how to securitize future receipts from the national lottery, highway tolls, airport landing fees, and even funds granted to the country by the European Union. Any future stream of income that could be identified was sold for cash up front, and spent."

So, there you have it, the big question on everyone's mind is about the possibility of a Greek Default. Can it happen and will it happen? The only people that can let it happen are the Greeks themselves and looking at their outstanding records, I am pretty sure you can guess by now what the answer is...

Everyone wants to believe Greeks will not dare to default, because it is more a convenient truth and more reassuring to think they will act wisely and will not dare the unimaginable:



The head of the Greek National Statistical Service wasn't nickamed the Magician for nothing.
The Greeks got it so well for so long because, as per Stephen Macnik a researcher from the Barrow Neurological Institute in Phoenix, Arizona, said in an article from Wired Science:

"Tricks work only because magicians know, at an intuitive level, how we look at the world"

Read More http://www.wired.com/science/discoveries/magazine/17-05/ff_neuroscienceofmagic#ixzz0zBaihp2u

Stephen also adds:

"Even when we know we're going to be tricked, we still can't see it, which suggests that magicians are fooling the mind at a very deep level."

http://www.scientificamerican.com/article.cfm?id=the-neuroscience-of-illusion

As reminder, this is a clear picture on the evolution of the 5 year CDS price for Greeces since January 2010:



Greece unfunded liabilities problem is massive, more than 800% of GDP!



10 year Greek Bond Yields are creeping up closer to record level of May:



A default of Greece is therefore clearly in the pipeline.

James Mackintosh in his column from the FT says a Greek default is unlikely in the next two years assuming the government can cling on to power. Buying one to two year great bonds might therefore be very tempting for high yield seeking investors, but it is not for the faint-hearted.

http://www.ft.com/cms/s/0/2918d9fe-baef-11df-9e1d-00144feab49a,s01=1.html

For Ambrose Evans-Pritchard, in the Telegraph:

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/7990228/Ireland-breaks-up-Anglo-Irish-as-EMU-debt-jitters-return.html

"Political doubts are also surfacing in Greece. This week's cabinet shuffle by premier George Papandreou is a tilt to the populist wing of the PASOK party, hinting at austerity fatigue after the economy shrank 1.8pc in the second quarter. The EU debt agency Eurostat said Athens has not yet provided documents on the country's hidden debts."

Ambrose indicates also:

"A column by Fintan O'Toole in the Irish Times said the problem had become too big for Ireland after rescue costs escalated to €25bn, and possibly higher. "The choice is now stark: do we go on being "good Europeans" at the cost of destroying our own society or do we become "bad Europeans", lose the trust of our European partners, but save ourselves?"

"There comes a point of existential crisis when even the meekest of countries has to put its vital national interests (first). We are at that point now," he said, deeming it the job of the ECB to shore up Anglo Irish if it thinks default poses systemic risk."

The Irish are more disciplined than the Greeks in tackling their difficulties and are already taking drastic actions in respect to their crippled banking industry and seriously damaged economy. The major issue with the current crisis is the very large amount of damage inflicted to the household balance sheet in many countries.

The road to recovery will be unfortunately very long for many Europeans countries.

The final question is how long can the Greeks, the Irish, the Portuguese, the Spanish people endure the pain of the hangover?

Reminder of the US Hangover for US Households...in my next post, I will look at Household Balance sheet and forward implications...not a rosy picture to say the least...

The 4 Trillion dollar hangover...