But time passes and the herd thunders on.
First, our boilerplate introduction to Mr. Bassman:
...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." is a technical term only used by market professionals for those situations where one has decided to go full Alinsky rule #5:
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....
#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.
In 2006 he built the RateLab, a full spectrum US Rates Trading Desk Strategy Group. Here he worked with investors to advise and optimize their risk exposure. As a key member of the client trading business, he facilitated activity by providing liquidity to both the firm’s clients and market makers.
After a (too) brief sabbatical, in 2011 Mr. Bassman joined Credit Suisse's Global Rates business where he identified and integrated investment and hedging opportunities for sophisticated investors.
Most recently, Mr. Bassman was an Executive Vice President and Portfolio Manager at PIMCO - a leading global investment management firm. Here he managed investments for the Liquid Alternative products group as well as advised on portfolio strategy across asset classes for the firm's franchise businesses.From The Convexity Maven, May 30:
Mr. Bassman splits his time between Laguna Beach, California and New York City. He has a B.A. in management science from the University of California, San Diego and an MBA in finance and marketing from the University of Chicago....
A devout man was alone in his home when the flood warnings arrived.A police car drove up with an offer to take the man to a dry shelter; he declined saying that G-d would save him.
Soon the waters rose,and he ran up the stairs. Looking out the second story window he saw a Coast Guard skiff pull up with the offer to take him to an upstream dock; he declined saying that G-d would save him.
With the waters cresting, the man climbed to the roof of his house. Wet to his waist, a Navy helicopter hovered overhead dangling arope and the airman yelled at him to grab a hold; he declined saying that G-d would save him.
The man drownsand was soon elevated to heaven.Upon meeting G-d he asked why such a devout man as he was not saved?G-d replied: I sent you a car, a boat, and a helicopter—wasn't that enoughAlso from Mr. Bassman via CI:
My January 29, 2018 commentary titled "It's Never Different This Time" highlighted that the projected reduction in G-7 Central Bank balance sheets in Q1-2019 should be a concern since the infusion of liquidity seemed to be well correlated to calming and elevating financial markets.
A year later,in my February 6, 2019 commentary titled"Wall Street Jenga", I noted that December’s initial Yield Curve inversion flashed a signal for a market or economic disruption in Q2-2020 (Eighteen months ahead)
I also offered a special notice that I was keeping an eye on the spread between the -agaric line-Federal Funds rate and the -kratom line-5-year forward 5-year swap rate (5yr-5yr). While there are many Yield Curve combinations, I like this one since the 5yr-5yr rate is a bit more insightful than the spot Curve and is also a half-step removed from the impact of Quantitative Easing/Tightening (QE/QT). This week, these two rates finally inverted on a closing basis.
The best and the brightest are bleating how "it is different this time": Puff! I will state for the record that the basic human impulses of Fear, Greed, and Ego (Hubris) have not changed too much since (wo)mankind resided in caves. Moreover, I will NOT be the next headline seeking pundit calling for a crash; rather I am just saying that important risk vectors are now in disequilibrium, and these cannot be excused by QE, Trump, or the proximity of MMT.
Let’s keep our heads clear, it is not time to panic. The S&P 500 is not rich; rather it is on the high side of fair relative to interest rates.Additionally, low Sovereign rates in conjunction with the demographic demand for coupon(retired Boomers need income) will allow most maturing debt to be rolled over
Truth be told, I cannot point to where the surprise will germinate;such is the definition of a surprise.That said, well-heeled investment professionals are effectively willing to purchase five-year bonds to be issued in 2024 (five years hence) at a rate below today’s risk-free overnight rate. This is different than a low print on the VIX, which is a derivative of a derivative;these are two of the most heavily trafficked interest rates in the unfettered US Dollar market.
Unless this was a ‘quick kiss’ during the holiday shortened Hamptons summer kick-off, I am starting to prepare for a macro-political or -economic disturbance. What am I doing?I am not explicitly reducing risk exposure, per se, rather I am adjusting themanner in which I touch it.I am covering(embedded) out-of-the-money option shorts and seeking ways to be long convexity –unbalanced risk in my favor
Volatility is still relatively cheap; a six-month out-of-the-money call option on SPY has an Implied Volatility of about 13%. So instead of being outright long equities, I might buy the K = 295 call at ~5 points with a break-even of 300 (SPX = 3000). Yes, I will miss a small rally; but if the trade war is resolved I will participate in a break out to new highs.
I love mid-grade Credit/MBS/Muni Closed-end Funds and Mortgage REITs. These assets have taken a beating from the Yield Curve flattening. There may still be some dividend trims as cheap legacy funding debt is renewed at higher rates, but that is already priced in. Notice that many Muni CEFs trade at a 10% discount to NAV and some REIT’s trade at a discount to Book Value. If the Curve signal is real, FED rate cuts next year will jump the dividend payout.And if I am wrong, well, I can lick my wounds while clipping a 9% coupon.To be clear, this is a levered investment;but it is linear, not convex risk....MORE
Convexity Maven: "Wall Street Jenga"
And one we missed, "Lost Horizon", May 1 (eight page PDF)
