by John Coates
Rising testosterone, it should be pointed out, does not start a bull market; usually a technological breakthrough or the opening up of new markets does that. But testosterone may be the catalyst that turns a rally into a bubble. It may by the same token be the chemical encouraging other expressions of overconfidence one sees towards the peak of a bubble, like oversized and ill-considered corporate takeovers, or the construction of record-breaking skyscrapers, such as the Empire State Building, commissioned at the end of the Roaring Twenties, or the Burj Dubai (renamed Burj Khalifa after it became insolvent), built during the recent housing bubble. Testosterone may be the molecule of irrational exuberance.
HIGH SEASON
In the weeks after Scott adds to his position, the stock market proves particularly volatile. His P&L now swings on a daily basis more than it ever has before. Up $4 million one day, down $3 million the next, up $7 million, down $5 million. Scott finds this volatility bracing, as it enables him to display to all that he can absorb these blasts and remain on his feet. On one especially bad day, when facing a loss of almost $8 million, he shows lesser mortals the full extent of his courage by adding another 1,000 contracts to his position, taking it up to the full limit agreed by Ash and the risk managers, 6,000 contracts – and this in addition to the large spread trade he has maintained for months now between stocks and bonds. He has jumped on this weakness in the market because tomorrow sees the release of statistics on the state of the housing industry. The market is worried about these numbers, because house prices have been dropping for months now, mortgage foreclosures have risen, and buyers of new homes have for the moment disappeared. Yet all this is music to Scott’s ears, as it makes it easier for him to add to his trade.
This is a crazy bet, executed in insane size, with a terrible risk–reward trade-off. Stocks are already too expensive by historic standards, but to add to this position when the housing market weakens is sheer folly. Cooler minds on the floor, like Martin and Gwen, hearing of Scott’s position, exchange knowing glances. A bull market, like a river in spate, carries almost all before it; and the few people on the floor who do not buy into the frenzy start to feel like outsiders. The atmosphere can be compared to that of an exciting party, bubbling with possibility and animated conversation, but when you listen to the talk you find you cannot keep up, or get a word in, or even see where the interest lies in the things being said; and then it finally dawns on you: you and a few others at the party are the only ones not coked to the gills. That is what it feels like in a bank during a bubble. The few people left unaffected by the narcotics whisper in coffee rooms and after hours about the insanity that could blow up their bank; but the rest of the crowd are beyond reach. No amount of statistics, no history of price–earning ratios, no reasonable chat can bring their faraway look down to earth. To them, the money being made holds out the promise of too many things only dreamed of: a penthouse on the Upper East Side, a private jet, even political clout – My God, I could be a player! – all this is right there for the taking. Such people are caught firmly in the delusional phase of the winner effect.
The next morning, however, brings a nasty wake-up call. The economic statistics show a worsening trend in the housing market, with sales down 3 per cent and prices nationwide sliding 2.5 per cent. Stocks promptly drop 1.5 per cent. But the fear does not last. The market smiles on Scott and turns an upward thumb. A weak housing market means without a shadow of a doubt that the Fed has finished raising interest rates for this business cycle. In fact it may now be forced to lower them, and the very possibility acts as a flame to a market already soaked in fuel.
Investors during bubbles seem to come equipped with special eyewear that permits them to view all economic news as bullish. Weak economic growth spells lower interest rates, so stocks and risky assets rally; strong economic growth means healthy balance sheets for both corporations and households, so stocks and risky assets rally. The dollar strengthens, and this means foreigners love US assets, so they rally; the dollar collapses, and this aids exporters and hence the economy, so assets rally. With this kind of spin no news dampens animal spirits for long, so by noon the stock market, celebrating the impending lower rates, has started to rally, and rally strongly. By the end of the day the S&P stands 3 per cent higher. Scott is mesmerised by his risk-management system, hooked electronically to the screens, for it calculates in real time the P&L on both his S&P contracts and his stock-to-bond spread trade; and towards the end of today not even he can remain calm as the number climbs to almost $15 million, bringing his year to date close to $32 million, more than he has made in his best full year.
The news transports Scott into another reality. Every one of his predictions has come true, every trade he puts on makes money. It takes a sober person not to be affected by relentless triumph of this magnitude, and Scott was never very sober to begin with. He, along with a few others, has today ascended into the realm of masters of the universe. There is nothing he cannot do. Rumours spread of his big win, and traders and salespeople timidly peek at the new hero. Scott breathes in the floor, hears its tumult and varying fortunes – the sound of the market itself, and all earthly glory. After acknowledging the adulation of his peers and the hints of a managing directorship that he takes as his due, he struts the main aisle of the trading floor, known appropriately in many banks as Peacock Walk, and heads out into a New York evening sparkling with opportunity.
In ancient Rome, when a general had achieved a great victory he was awarded a Triumph, a ceremonial parade through the centre of the city. But the ancients were clever; to prevent the general’s hubris from ruining him, they placed in his chariot a slave whose job it was to whisper in the general’s ear a reminder that he was not a god. ‘Remember this,’ the slave warned, ‘you are mortal.’ To bring home the point he would hold in the general’s line of vision a human skull, a memento mori, a vivid sign of his inevitable fate. But alas no such memento mori exists within the banks, so very little tethers a winning trader to earthly standards of prudence.
In the coming months, Scott’s P&L breaks new ground, amounting to almost $45 million, a figure which could well mount to $60 million by year end, putting him in line for an $8 million bonus. Despite his winning streak, Scott decides to close out his 6,000 stock index contracts. This decision does not stem from an uncharacteristic moment of prudence. Scott still believes in the trade, still thinks the bull market has miles to run, but he unwinds some of his risk for one very important reason. August is approaching, and that means it is time to move the carousing from Wall Street to the Hamptons, where Scott can play and party and brag with the other trading heroes. Despite a steady stream of statistics portraying a worsening economy, which Scott and others have managed to ignore, he leaves his spread position – stocks to bonds is a money machine, so let it keep printing – to be tended by assistants.
On the drive out on the expressway, as the sprawl of Queens and lower Long Island gives way to the pines and orange sand and the intensifying drone of cicadas, Scott sheds his workday concerns. High summer. The still point of the year. Scott basks in the knowledge that this is one of the last summers he needs a rental, the last time he shares. In the coming years he will own his own house on the beach, one of those half-timbered beauts from the 1920s about which there hangs an aura of almost otherworldly exclusivity.
SEVEN
Stress Response on Wall Street
Occasionally, it seems, when the world drifts unknowingly to the edge of an abyss, nature conspires to prolong a particularly glorious summer, as if to forestall the impending disaster, or to heighten the irony future historians will read into the prelude. Take, for example, the idyllic summer of 1914, coming at the end of the elegant and oblivious years, known nostalgically as the Edwardian Summer, leading up to the First World War. Or the New York autumn in 1929, when a heat wave lingered after vacationers had returned from the beach.
And so it was this September when Martin and Gwen and Scott and Logan, tanned and tone
d and ready for the final run to bonus time, straggled back to work, despite an Indian summer that would not relinquish its calm seas and golden days.
RISK ON, RISK OFF
For Logan, though, the summer break had not been quite as carefree as he had hoped. He was repeatedly called off the water by his wife waving his cell phone in the air, and would then have to spend an hour or two talking with the trading desk. For the market he trades, the market for mortgage-backed bonds, spent the month of August on a Coney Island-like rollercoaster ride as worries about the credit-worthiness of home-owners and mortgage lenders rose and fell with ever increasing intensity.
Mortgage-backed bonds consist of a large number of individual home mortgages that have been bundled together and issued as a single bond – securitised, as bankers call it – and sold to investors. They differ from Treasury bonds in a number of ways: if you buy a ten-year Treasury yielding 5 per cent, investing, say, $10,000 of your savings, you will get yearly interest payments of $500, and at the end of ten years you will get your $10,000 back. All of it. You have the US government’s promise on that (although recently a few people have questioned that promise). Mortgage bonds, on the other hand, are paid back by home-owners: you get yearly interest payments as home-owners make their mortgage payments, and in theory you get your money back at the end of ten years, if the mortgages underlying the bond mature at that date (most American mortgages mature in 30 years). You may get all your money back in ten years; or you may get very little of it back if the home-owners cannot pay back the money they have borrowed. For this reason, mortgage-backed bonds expose you to a greater risk of losing money than Treasuries, and consequently need to offer higher yields to entice investors to buy them. For much of this year they have had to offer about 6.10 per cent interest, a full 1.10 per cent higher than the 5 per cent on ten-year Treasuries. At this level they have tempted investors; and whenever mortgage bonds have yielded more than 1.10 per cent over Treasuries, investors have quickly stepped in to buy them.
During the spring and summer, however, the pattern changed: the mortgage market weakened, offering higher yields, yet the usual buyers failed to show up. Rumours circulated about home-owners getting into financial trouble and being unable to make their monthly payments; foreclosures on homes rose rapidly, and a couple of large mortgage lenders declared bankruptcy. Investors rightly began to fear they might not get back the money they had lent to home-owners. As a result yields on mortgage bonds have risen, and now offer a full 1.60 per cent more than Treasuries, making them more attractive than they have been in years.
August had provided some scary moments, but by mid-September the panic in the mortgage market has largely subsided. Traders ponder the higher yields on mortgage bonds, and find them attractive. Scott in particular thinks they are a steal at this price. When he and Logan are not tossing a tennis ball back and forth they are bouncing trade ideas off each other, and during one of these brainstorming sessions they decide to reload on credit risk. Logan opts for a spread trade by buying mortgage-backed bonds and shorting Treasuries as a hedge. He expects mortgages to increase in price relative to Treasuries, but – and this is the real attraction of the trade – while he waits for this to happen he is receiving 6.6 per cent interest on his mortgages but losing only 5 per cent on the Treasuries he is short. In other words, he is collecting interest almost for free. It is a very attractive position, so when investors and traders lose their fear of home-owners defaulting they rush into these spread trades, driving the price of mortgages up relative to Treasuries.
What happens on the mortgage desk happens on all desks across the trading floor that trade credit-sensitive securities. There too, traders buy corporate bonds, junk bonds, bonds of emerging market governments, and sell Treasuries against them. Scott for his part has re-established his long position in stocks. The trouble is, when crises erupt, all these trades have a nasty habit of blowing up together. Their performance waxes and wanes with the appetite for credit and risk in general. Lately, journalists have termed this seesaw in the financial markets ‘risk on, risk off’.
By the middle of September, it is risk on. After several years of a roaring bull market, enthusiasm is not easily dimmed by a few bad stats out of the housing market. In fact, for the past ten – no, twenty – years every scare in the market, every sell-off, has proved to be a buying opportunity, and that is how traders perceive this one. Old buying habits reassert themselves, and over the next few weeks the S&P 500 surges to an all-time high. Credit spreads once again contract, mortgage bonds rallying almost $3 relative to Treasuries.
Emboldened by the money they have made on stocks and mortgages, Scott and Logan now think about increasing their exposure to the credit markets, and look in particular at one segment of the mortgage market that has not recovered as much as the others. This is the market for sub-prime mortgage bonds. Mortgages are considered sub-prime if they are taken out by people who may have a hard time paying back the principal or indeed even making their monthly payments. For that reason these bonds have to offer considerably higher yields to investors. Instead of 6–7 per cent interest, they offer, depending on the risks of default on the underlying mortgages, a tantalising 10–15 per cent.
Scott cannot resist yields this high. He decides to sell his long position in stocks and buy some of these distressed bonds instead, thinking they represent better value. However, because they often prove illiquid to trade, meaning he cannot easily buy and sell them, he decides on buying an index called the ABX, which tracks the average price of a basket of sub-prime mortgages, just as the S&P 500 index tracks the average price of 500 stocks. The index he decides on was originally issued at a price of 100, but has now dropped to a bargain-basement price of 41, a loss of 59 per cent. Scott buys what he considers a modest amount of this index, $300 million. If the bonds drop to 37, which he thinks is a worst-case scenario, he could lose about $12 million, but he thinks it more likely the bonds will rally to 55–60 over the coming weeks.
Logan hates to be left behind on opportunities like this, so he too buys sub-prime mortgages, but only $100 million. He is already long mortgages through his spread trade; and in his capacity as a flow trader of mortgages he finds that he is continually buying them from clients, frequently more than he wants. Logan believes in the trade, but he does not take a bigger position, even though he has frequently done so, mainly because it is October and the fiscal year is drawing to a close. His P&L year to date shows him up a comfortable $29 million, putting him in line for a nice bonus – maybe $4 million. So why risk his P&L this late in the year? January is the time to start taking big risks again, because if they go wrong you have the rest of the year to make back the money. Late autumn, most traders agree, is the time to cruise to the finish line.
The next couple of weeks, moreover, may prove to be a particularly dangerous time to put on a large mortgage trade, and Logan knows it. There are scheduled for release a number of economic reports that the market has been anxiously awaiting: those showing US new home sales, the Case-Shiller house-price index, US GDP, and then the latest Fed meeting. All this information will shed light on a housing market many fear is hollowing out the American economy.
Unfortunately, in the coming week the traders’ fears turn out to be fully justified. The news is indeed bad. In fact it is worse than bad – it is horrendous. Sales of existing homes have dropped almost 8 per cent in one month, and the Case-Shiller index shows its largest drop ever, with house prices nationwide falling 8.5 per cent. The news shocks a market already reeling from record defaults on sub-prime mortgages. Scott and Logan start to lose money on their mortgage position almost from the day they put it on, and soon the ABX index is trading at 37, already reaching Scott’s worst-case scenario of a $12 million loss.
Logan is furious at himself for losing so much money at year end, and terrified by the way mortgages are trading. Through the sales force he sees nothing but selling, so he closes out his sub-prime position and concentrates on trying to
hedge all the mortgages clients keep selling him.
Scott, however, does not despair, because other markets appear much more sanguine about the economic statistics. Stocks and corporate bonds take the news in their stride, trading off a bit, but basically holding firm. Nervous traders, Scott included, interpret this solidity to mean that the worst of the news may now be over; the economy should start to improve. Such an interpretation is strengthened the next day, October 31, when the GDP report shows that the US economy continues to grow at a strong pace, despite the slowdown in housing. To top it all, the Fed lowers interest rates by a quarter point, and states in its press release that ‘economic growth was solid in the third quarter, and strains in financial markets have eased’. All this spells one thing to traders raised on the milk of optimism – the bull market is back. Stocks rally back to their highs, and Treasuries sell off as investors feel emboldened to venture from their safe haven. Mortgages do not participate in the rally, which is disconcerting, but given the strong growth in the economy and the Fed’s confidence, traders feel it is just a matter of time before this market too recovers its pluck. Relief is palpable across the trading floor.
Towards the end of the day, the excitement that has been building in the market transfers to Halloween celebrations and the evening ahead. Pumpkins are put out on one or two desks, a tombstone on another, and people look forward to trick-or-treating with their kids or heading out to costume parties, Manhattan at this time of year looking much like a film set for Night of the Living Dead. But just after the market closes, before the fun starts, something quite unexpected happens. Wall Street gets an early scare as an unscheduled announcement trickles across the news wire. An analyst at a Canadian investment bank has downgraded its assessment of Citibank’s future earnings, and in a strongly-worded statement cites Citi’s large inventory of bad mortgage loans. One analyst, one bank – Canadian at that. So what? Yet the news spooks the market in the after hours, and nags at it all through the night.