Thursday, February 6, 2020

Convexity Maven: "“Pigs Can Fly...”

Mr. Bassman knows stuff.*
From Harley Bassman, The Convexity Maven, January 28:
The full quotation is: “Pigs can fly if shot out of a large enough cannon, but they eventually return to Earth as bacon.
”Thus, I will summarize my thoughts on Quantitative Easing (QE2 to QE~), and the inventible [sic] engagement of Modern Monetary Theory (MMT): Yikes !!

QE1 was a legitimate and necessary policy. For better or worse we live in a financially based economy where leverage (borrowing) is at its core. As such, when the monetary plumbing became clogged, the financial Plumber in Chief (the Federal Reserve~FED) had to plunge the system.

Subsequently, the FED and the Federal Government should have followed its 1989 playbook from the Savings and Loan financial crisis. Irreconcilably bad institutions should have been closed, and the senior villains should have been prosecuted. Even if convictions could not be assured, public trials should have occurred as both good policy and politics. Monetary settlements from highly compensated CEOs only evidenced that they could game the system twice.

Recall that Al Capone was ultimately convicted for tax evasion, not bootlegging, bribery and murder. So too do Wall Street managers fear the SEC’s catch-all crime of “failure to supervise”. This statute is so broad that a first-year legal associate could convict a ham sandwich; and you wonder why our politics have become so acrimonious?

But enough bloviating, let’s return to the matter at hand. I will stipulate that a fiat currency cannot be created at a faster rate than the growth of the economy without inflation. Over 5000 years of collective civilization, we have no record of the Sovereign printing the coin of the realm at such a pace without the currency becoming devalued. If such were the case, surely there would be legends of how poverty was eliminated with the wave of the hand.

It has been my stated opinion that the US Treasury ten-year rate will not exceed 3.50% until at least 2023. It is here that the -baltic line- Labor Force Growth Rate rises significantly and should begin to pull up the -carnelian line-of interest rates....
... While this is not news to frequent readers, what should be highlighted is that the year 2020 marks the mid-point of when the Baby Boomers reach the age of 65. As such, the speed of their exit from the work force diminishes relative to the increase of Millennials finally leaving Mom’s basement to find a job.

The point here is that this baked-in-the-cake demographic inflection point is no longer in the distant future, but rather within the reasonable investment horizon.And indeed,one should be quite fearful of owning financial assets come the day interest rates rise above ~4.00%; but don’t fret yet, there is time to prepare.

Since the start of the Great Financial Crisis (GFC), stocks and bonds have moved in opposite directions; when stocks trade down, bond prices rise (to a lower interest rate), effectively offering hedge value for a diversified portfolio.

The –buttercup line- correlation has been a boon for quantitative investment managers, especially those who employ leverage via a ‘risk parity’ strategy. Here, one might use $100 of capital to buy $130 of bonds and $70 of stocks. Such a portfolio has delivered superior returns with a lower volatility; truly an Investment Nirvana....

*Our boilerplate introduction to Mr. Bassman. First off he defines convexity:
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change).

Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
"Pish. Posh." is a technical term only used by market professionals for those situations where one has decided to go full Alinsky rule #5:
#5 Ridicule is man’s most potent weapon. It’s hard to counterattack ridicule, and it infuriates the opposition, which then reacts to your advantage...
The Convexity Maven is nothing if not a professional. Here is part of his mini-bio at MacroVoices:
Harley S. Bassman
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty-six-year career at Merrill Lynch.  In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions.  In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities.  Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS - Beneficial Interests in GNMA Servicing.  Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992.  As managing and hedging prepayment risk became a priority focus for the financial markets, Mr. Bassman created PRESERV, Merrill's trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights.  Later, Mr. Bassman managed Merrill's initial venture into off-balance sheet mortgage trading.
In 1994, Mr. Bassman assumed responsibility for OTC bond options.

Within a year, Merrill was the leader in this product sector.  A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index.  Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.

From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.

Mr. Bassman became the manager of North American MBS and Structured Finance trading in 2001.  During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self-contained Sub-Prime mortgage conduit.  He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform....
And so much more, all those cutesy Merrill acronyms can be blamed on him and his team.