Markets are Broken; Welcome To The Brave New World Of Volatility Squared

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December 28, 2011 2:21pm NASDAQ:EUFN NYSE:VGK

Shah Gilani: I’ve said it before, and I’ll say it again. The markets are broken. It’s not that they’re not functioning on a daily basis, pricing risk and assets and performing their price discovery duties. They are doing that – or at least trying to.

Those are the little, daily things that markets do, and there are things there that are broken. (I’ll get to those things another time.) Think of those little things as the “hows” or the “mechanics” of buying and selling.

Think of the big things as the “whys” or the “psychology of investing.”

Those are the things that are broken.

Until they are fixed, or “things” change, drastically, we are in for some really wild swings in the months, quarters, and years ahead.

I’m going to point out all of these big things to you, over time. But right now, I’m going to point to just two.

1) No More Buy-and-Hold Believers

First, there are two types of players in markets, investors and traders.

It used to be that investors dwarfed traders – by a huge margin.

Investors were the meat and potatoes and the vegetables, and traders were the gravy that made sure investors’ plates were liquid enough so that they didn’t choke when swallowing their meals.

But that’s all changed.

There aren’t that many truly long-term investors any more. It’s too dangerous to be an investor in the traditional sense. That’s why most investors, at least those that call themselves investors, are really all traders now.

I don’t mean traders in the high frequency sense, or even in the day trading sense. I mean they are traders because they invest for the future but can’t see beyond a few quarters, if that, so they have to get out of positions.

These traditional investors almost always have stop-loss orders down, or at least have stop-loss levels in mind as part of their investment “plans.” A lot of them now use profit targets, too.

That hardly ever happened traditionally. Investors invested. They were buy-and-hold believers in a brighter future where, over time, assets appreciated, and they stuck with them.

Not any more.

You can’t do that unless you have nerves of steel, tons of capital, and a generational approach to holding your positions. Even then, I say, good luck with that.

So, from the perspective of psychology, if it’s not safe to be an investor, but being in the markets is still a tremendous wealth-generating endeavor, trading will remain the tail wagging the old dog.

For me, that’s all well and good. I’m a trader. I always have been. Sure, I used to have a bunch of long-term investments that I expected to always weather short-term trading and fluctuating economic cycles. But those all ended up being a 50/50 proposition. Meaning I lost on about half of those investments and made money on the other half. I’m talking about maybe eight positions that I’d keep on the books for years.

Not any more. Why? Now I use that capital to trade bigger positions, because holding a diversified (I’m not including the few mutual funds that I used to own, that I jettisoned a long time ago) portfolio, even a well constructed, concentrated one, didn’t work out.

My point is, think about how you look at the markets. Ask yourself if you are an investor or a trader. Ask yourself how much time you have, how much capital you have, and what kind of constitution you have… and do the math yourself.

2) Credit Default Swaps

The other thing that’s broken that’s really huge – as in hundreds of trillions of dollars worth of huge – is the credit default swaps market.

Credit default swaps are nothing more than over-the-counter (there’s no real exchange, these are essentially bilateral contracts) insurance policies on pools of underlying assets.

Greek sovereign debt is exactly where I want to go with this. If you are an investor (then you’re probably being dishonest) or a trader (more likely) who bought Greek government bonds (hopefully you’re not Jon Corzine), chances are, you’re loving the yield but scared as all get-out about the risk.

Say you’re a big trader, say you’re one of the hundreds of European banks (NASDAQ:EUFN) that bought Greek bonds, maybe you’re even the European Central Bank (ECB), and you’ve been buying Greek bonds to prop up that market.

Chances are, you would also be buying some insurance against a default on your extensive holdings.

Chances are you didn’t buy your insurance from Allstate (AIG, maybe). No, you didn’t because insurance companies (AIG is another story) don’t sell insurance on sovereign debts.

But other banks do sell that insurance, hedge funds sell that insurance. You can buy insurance in the form of credit default swaps.

Now you can sleep at night, right?

No. You just woke up to the worst nightmare you’ve ever had. Only it’s not a dream.

I’m not going to complicate this (although it is complicated). The short version is that the insurance you bought and paid for isn’t worth the paper it’s written on.

The last deal proposed to bail out Greece called for creditors (buyers) who hold Greece’s debts to take a 50% haircut. And they were being asked to do that “voluntarily” as in, “please” do it. That means they were being asked to swap the bonds they held, which they expected to get 100 cents on the dollar for (eventually) and replace them with new bonds that they would only get paid 50 cents on the dollar for, when they mature.

Investors, make that traders (think “banks”), would lose half their money. But, they weren’t all that worried because they had insurance. They had bought all these CDS deals.

They were going to be made whole when they got paid off on the insurance they bought.
Well, wouldn’t you know it. That ain’t gonna happen now.

The ISDA, the association that makes the rules that all the CDS players abide by, has said that technically, because Greek holders were voluntarily asked to haircut their holdings by 50%, that’s not a default, and the insurance is no good. You can’t collect.

Two things are extraordinarily frightening here.

What is really going to happen to the balance sheets of all those banks that bought CDS insurance and marked their books like they were all good and comfy because they had insurance? What accounting horror stories are buried deep in the bowels of banks’ books? How much capital will they really need if they have been fake-marking their exposure because they said they were “insured” and would be made whole?

Second, what’s the value of CDS insurance now on any underlying holdings of any bonds or debts (think Italy!) if it’s here today, gone tomorrow?

If I’m an investor (sorry) or a trader, and I want to buy Italian bonds but don’t want the risk, just the other day I would have bought CDS on my Italian bonds.

Today, I don’t trust the sanctity of my bilateral insurance contract, so I won’t waste my money buying any more CDS.

What I will do is demand a heck of a lot more interest from Italy to buy their bonds, since I’m at open risk of their defaulting.

Let’s see, what will it take for Italy to sell its bonds now?

Oh, this is not going to be good for Europe (NYSEARCA:VGK) …

Markets are broken. Welcome to the brave new world of volatility squared.

Written By Shah Gilani From Money Morning

Shah Gilani is the editor of the highly successful trading research service, The Capital Wave Forecast, and a contributing editor to both Money Morning and The Money Map Report.  He is considered one of the world’s foremost experts on the credit  crisis. His published open letters to the White House, Congress and U.S.  Treasury secretaries have outlined detailed alternative policy options  that have been lauded by academics and legislators.

His experience and knowledge uniquely qualify him as an expert.  Gilani ran his first hedge fund in 1982 from his seat on the floor of  the Chicago Board of Options Exchange. When the OEX  (options on the Standard & Poor’s 100) began trading on March 11,  1983, Gilani was working in the pit as a market maker, and along with  other traders popularized what later became known as the VIX (volatility  index). He left Chicago to run the futures and options division of the  British banking giant Lloyds TSB. Gilani went on to  originate and run a packaged fixed-income trading desk for Roosevelt  & Cross Inc., an old line New York boutique bond firm, and  established that company’s listed and OTC trading desks. Gilani started  another hedge fund in 1999, which he ran until 2003, when he retired to  develop land holdings with partners.

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