Contagion Risks, Macroeconomic Entropy and Existential Vertigo
Thinking about the clusterfuck nature of financial markets.
Life is non-linear. The economy is a complex multi-factor equation meandering IRT. Everything compounds ad infinitum. Each crisis is bigger, weirder and wacker than the one that preceded it. In complex dynamic systems (like the economy, financial markets and even romance/love), risk is cumulative and exponential; it embodies scale invariance and outputs asymmetric, totally random ‘money shot’ moments. That is, increasing interdependence and symbiosis correlates with exponentially bigger booms, busts and ‘unknown unknowns.’ Exotic risks gestate and mutate, and then spontaneously flare up. Power laws underpin everything.
Today, systemic risk is seriously dangerous. Too-big-to-fail banks are bigger than ever, have a denser concentration of total assets vis-à-vis the financial system, and have much larger and dangerous derivatives books (just look at Deutsche Bank with its $50 trillion derivatives exposure).
To understand non-linearities and the risk of contagion, you can think of nodes in a network that become denser, more sensitive and more interdependent over time. Like, when Kim Kardashian petitions Jared Kushner who then pulls strings with the POTUS for a sit-down together, who then launches a global trade war targeting Canada and China, which then produces tit-for-tat retaliations and dicey path-dependencies that lead to mutual economic contraction. As in the film Syriana, ‘everything is integrated…everything is dangerously interconnected.’ The micro and macro converge — often violently. Entropy accelerates and unintended consequences result. Oh, fuck!
An even greater danger for markets is when incongruous types of contagion converge. This happens when market ructions (exogenous and endogenous perturbations) spillover into broader markets, then sudden losses give rise to systematic trading against a particular instrument, index or hedge fund.
When the position/trade/investment goes bust, credit losses spread to a wider network of fund counterparts which then come under suspicion and speculative assault. Soon a market-wide liquidity panic attack comes about, whereby all players want their dosh back fast — what Lord Keynes called ‘the fetish of liquidity.’ Shit goes critical in a flash.
This is exactly what happened during the Long Term Capital Management (LTCM) debacle in 1998. The month of August 1998 was a clusterfuck liquidity crunch involving broad classes of instruments and assets starting with Russia’s sovereign debt default. The subsequent month of September saw systematic targeting by speculators against the Russian ruble and LTCM, which spawned a broader contagion.
VIVISXN is a perceptive pupil of that event. It was an international monetary crisis that started in Thailand in June of 1997, spread to Indonesia and Korea, and then finally hit Russia by August. It was exactly like dominoes falling or an avalanche unleashing its kinetic fury. A perfect, polymorphic storm.
LTCM wasn’t a sovereign, although it was a hedge fund with the size, magnitude and gusto of a country in terms of assets under management (AUM) — a whopping $1.2 trillion.
There were 14 ‘big’ banks in the LTCM bailout fund. There were 19 smaller entities which ponied up a $1 billion dollar unsecured credit facility. Included were Treasury and Federal Reserve officials, government technocrats, the managers, partners, investors and stakeholders.
It was a $4 billion dollar all-cash deal, which was cobbled together within hours and just a modicum of due diligence. Systematic pressure on LTCM persisted until the fund basically crumbled like a stale cake. As global traders and investors attacked the fund’s positions, they neglected the fact that they were simultaneously the creditors of the fund. By busting up LTCM, they were essentially speculating against themselves. That’s when the Fed intervened and forced Wall Street to backstop the portfolio. Dangerous shit indeed.
If Long Term Capital had failed — and it was definitely in an advanced state of disrepair — $1.3 trillion dollars of derivatives would’ve militated against global Wall Street. In a paradoxical and circuitous way, Wall Street saved itself.
The existential vertigo of 2008 was an even more extreme iteration of 1998. We were days, if not hours, from the sequential, if not catastrophic collapse of every major bank in the world — an existential/civilizational risk to be sure. Of course, the 2008 panic had its roots in sub-prime mortgages (CDOs), but quickly spread to debt obligations of all varieties and vintages, especially money market funds and Euro bank commercial paper.
Consider the falling domino scenario again. What was the nature of the precipitous fall? We basically had a banking crisis. Except in 2008, Wall Street did not bail out a hedge fund; instead, the central banks bailed out Wall Street & Co.
But today, systemic risk is more pervasive — and more perilous — than ever. Each subsequent crisis is bigger and badder than the one before, don’t forget. The next crisis, which we should all be worried about, could well begin in the private bank debt market. The specific culprit is a kind of debt called ‘contingent convertible’ debt, or CoCos.
These bonds, underwritten by banks, start out like ordinary debt, but a bank in distress could convert them to equity in order to strengthen its capital ratios. The problem is that bondholders know this and start dumping the bonds before the bank can pull the trigger on the conversion. This can actually cause a bank run and trigger cross-asset defaults in other bonds/instruments. Far from adding buffers to bank capital structures, CoCos can make banks more unstable by igniting panics.
This is just one more example of economic complexity and it signals the notion that the next crisis will be more catastrophic than the last.
Also, automated trading algos, high-frequency players and ‘programmatic pimps’ could add liquidity when times are seemingly breezy, but then liquidity could suddenly vanish in times of market stress. And when the catalyst is triggered and a panic is born, complex contagion dynamics take on a life of their own.
These kinds of sudden, unforeseen convulsions can spontaneously occur and are entirely commensurate with the ideas of complexity theory. In complex dynamic systems such as financial markets, risk scales exponentially as a function of the system itself. The whole, we find out, is disproportionately riskier than the sum of the parts. It can crumble in a nanosecond without warning…or can ‘melt up‘ in lightning-like fashion delivering astonishing, ultra rare returns.
Increasing network density (i.e., market scale) correlates with exponentially larger market collapses. ‘The bigger they are, the larger the liquidity crunch’ — and contagion — in the future.
The ability of central banks to deal with a new crisis is highly constrained by low interest rates, moral hazard, bloated balance sheets, wild geopolitics, and jittery, footloose global investors which are paving the way for ‘self-fulfilling’ prophecies.
For now, it is somewhat clear which hazards could cause downside dislocations. The catalysts include: Turkey, trade wars, Argentina, Chinese banks, Russian adventurism, risk-infested derivatives books, Trumpanomics, a strengthening US dollar and emerging market debt. Market ‘micro-structures’ are also super fragile and there is the random inconvenience of algo-induced arrhythmia. Oh, and possibly more calamitous natural events like violent volcanism, erratic asteroids, and freakish earthquakes. And don’t forget populist politics which is poisoning Italy’s fixed-income well and spreading to Spain…Hostile aliens might be invisibly prowling in the ether, too.
Markets are in a very precarious position and volatility has returned with a vengeance. Regardless of which direction markets go from here, yesterday’s events are gestating, mutating and morphing beneath the surface today; the threat of contagion is a scary reminder of the hidden linkages in the modern macro economy.
We are currently insulating our positions and adding extra hedges. A storm is brewing. Be happy May is over!
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