Podcast Summary
A Real Estate Manager's 360-Degree Perspective on Investment Opportunities: Principal Asset Management uses a comprehensive approach to real estate investment, combining local insights and global expertise to identify promising opportunities. Recent episodes on Odd Lots have highlighted the relevance of Korean structured products, with an upcoming episode providing insights on their current state.
Principal Asset Management, as a real estate manager, leverages a 360-degree perspective to deliver local insights and global expertise across various investment classes, including public and private equity and debt. Their teams use this combined knowledge to identify the most promising investment opportunities. Recently, several episodes on the Odd Lots podcast have become particularly relevant due to current events. One such episode, featuring Ben Eifert of QVR Advisors, discussed Korean structured products popular with retail investors, which were based on the premise of a massive stock market crash not occurring. With the market crash that has since occurred, listeners have been asking for updates on these structured products. In this follow-up episode, Ben will provide insights on the current state of these instruments and the overall options market. Listeners are encouraged to revisit the initial interview for a refresher on the Korean structured products before diving into this discussion.
Reverse convertible and auto callable notes: Popular fixed income products for retail investors in low-interest-rate market: Investors seeking fixed income from equity market face potential substantial losses with reverse convertible and auto callable notes due to market downturns, with many notes terminated recently, primarily affecting Euro stocks and some Asian agencies.
In the current low-interest-rate market environment of the last decade, popular financial products for retail investors seeking fixed income from the equity market involve selling optionality through reverse convertible, auto callable notes. These notes offer annual coupons, but if underlying equity indices experience significant downturns, investors can face substantial losses. For instance, if an investor puts in $100 and the market drops 40%, they could lose 40% of their investment. These notes can be linked to multiple equity indices and have callable features. With the recent market sell-off, many of these notes have reached the trigger points for termination, primarily affecting Euro stocks and some Asian agencies, despite the S&P 500 being down significantly as well. Banks track the overall market landscape, and it's been reported that a considerable percentage of the outstanding stock of these notes has terminated.
Banks face rising risks from structured notes linked to stock indices: Banks' hedging strategies for structured notes linked to stock indices are becoming less effective due to market volatility, increasing the risk of large losses as more notes approach maturity
The recent market volatility and potential knockout of structured notes linked to stock indices like the S&P 500 pose significant risks for banks that have issued these products. Retail investors holding these notes have seen large mark-to-market losses, and as more notes approach the knockout point, the risk for banks increases. The banks' initial hedging strategy involves selling deep out-of-the-money call options on the underlying indices. However, as markets decline, the banks' hedged portfolios become longer in volatility from their perspective due to the unique characteristics of barrier options. This means that as the market continues to fall towards the barrier, the banks' net position collapses rapidly when the notes terminate. The current market volatility, with the S&P 500 still down significantly, has led to a significant increase in volatility for these banks, making risk management a critical concern.
Banks' derivatives performed well during recent crisis due to post-2008 regulations: Post-2008 regulations enforced risk management measures, reduced tail risk, and encouraged banks to transfer risk, resulting in hedge funds and asset managers bearing losses during recent crisis while banks remained well-hedged and experienced manageable losses in derivatives portfolios.
The recent market crisis resulted in banks' derivatives portfolios performing well, unlike the 2008 credit crisis where banks suffered significant losses. The reason for this is the post-2008 regulatory environment, which enforced strict risk management measures, reduced tail risk, and encouraged banks to transfer risk to hedge funds and asset managers. During the recent crisis, these hedge funds and asset managers experienced substantial losses instead of the banks. Additionally, banks were well-hedged due to the fast pace of the crisis, and their auto call portfolios, while risky, were manageable. Overall, the banking industry's risk management strategies have proven effective in mitigating losses in derivatives portfolios during the recent market downturn.
Banks' risk exposure shifted to hedge funds through complex financial instruments: Banks facilitate complex financial trades with hedge funds, leaving them with massive exposure to tail risks, making it hard to offload this risk due to a lack of liquidity and unique nature of each trade.
Banks have reduced their risk exposure since the financial crisis, but the risk has shifted to hedge funds and other investors through complex financial instruments like alternative risk transfer trades, specifically capped variant swaps. These swaps allow organizations to sell variance, or volatility, with a cap on potential losses. Banks facilitate these trades by buying capped variance swaps from clients and selling uncapped variance in the interdealer market. However, these positions leave banks with massive exposure to tail risks, or market crashes. In the past, banks might have kept these positions for the carry trade, but now they must manage this risk due to regulatory requirements. The lack of a liquid market for capped variance swaps and the unique nature of each trade makes it difficult for banks to offload this risk, leaving them vulnerable to significant losses during market downturns.
Hedge funds and asset managers sold uncapped variance and bought capped variance for consistent monthly returns until the financial crisis in March 2020: During the financial crisis, the sudden increase in volatility led to substantial losses for hedge funds and asset managers from variance swaps and other complex financial products, highlighting the importance of understanding and managing risks in volatile markets.
Before the financial crisis in March 2020, many hedge funds and asset managers engaged in alternative risk transfer deals involving variance swaps, where they sold uncapped variance and bought capped variance to make a consistent return. These trades were popular due to their ability to generate profits every month as long as volatility did not increase by more than 2.5 times within a month. However, during the crisis, volatility increased significantly, and the losses from these trades were substantial, wiping out entire portfolios. It's important to note that these types of trades, along with others related to gap risk and esoteric implied risk factors, had produced consistent returns for many years, making many people very wealthy. However, the suddenness and speed of the volatility increase during the crisis were unprecedented and obliterated many positions. Tracking these complex financial products can be challenging, as they are not publicly quoted and are often traded over-the-counter in the interdealer market. It requires specialized knowledge and resources to monitor their pricing and risk. The complexity and interconnectedness of these financial instruments can make it difficult for even experienced market participants to fully understand and manage their risks.
Assessing risks in complex financial markets: Understanding complex financial markets and staying informed about market trends is crucial for investors to assess risks and potential daisy chain effects. The migration of risk from banks to the buy side has been successful in reducing systemic risk, but may lead to increased risk if left unchecked.
Understanding the size and state of complex financial markets, such as the Korean structured note markets, requires access to detailed research reports from large banks and close monitoring of market participants. This information is essential for derivatives investors to assess risks and potential daisy chain effects. The migration of risk from the banking system to the buy side, as seen in recent market volatility, is a complex issue with valid arguments on both sides for regulators. From a systemic risk perspective, this outcome has been a success, as banks have shown resilience during market shocks. However, some investors, particularly hedge funds, have faced losses on volatility products. Regulators may view this as a desired goal, as it reduces their burden of managing systemic risk within the banking sector. Yet, critics argue that this shift could lead to increased risk in the financial system if left unchecked. Overall, staying informed about market trends and understanding the risks involved is crucial for all market participants.
Market dislocations caused by economic crisis and bank risk aversion: Central banks respond with aggressive measures to encourage lending and stabilize markets, while regulators seek balance between control and risk-taking.
The current economic crisis caused by the coronavirus pandemic has led to significant market dislocations, which are not fundamentally driven but rather a result of banks stepping back from risk-taking and market intermediation. Central banks have responded with aggressive measures, including buying investment-grade debt and rolling back capital restrictions, to encourage banks to lend and stabilize markets. Regulators are recognizing that overly restrictive regulations may cause liquidity problems under stress, and the challenge now is to find a balance between maintaining control over systemic risk and allowing banks to effectively intermediate financial markets and take calculated risks. The recent volatility in financial markets, as measured by the VIX index, has come down significantly but remains a reminder of the uncertain times we are living in.
Private markets could face significant challenges in the coming months: The private markets, particularly private credit and overleveraged private equity, may still face significant challenges and potential declines in asset prices despite the Fed's efforts to restore functionality to fixed income markets.
While the public markets may have seen the worst of the volatility and disorderly market behavior, the private markets, particularly private credit and overleveraged private equity, could still face significant challenges in the coming months. The worst may not be over for these markets, and bodies are expected to start floating to the surface within the next 3-6 months. Despite the Fed's efforts to restore functionality to fixed income markets, private assets held at inflated valuations and sensitive to the performance of small cap businesses could see significant declines. Ben Eifert, a market strategist, believes that this is where the focus should be for those looking for continued market disruptions. While the public markets have seen a significant amount of liquidation and cleaning up of risky positions, the private markets, which are not mark-to-market, could still face a reckoning. The economic shock from the current crisis is expected to take a long time to work through the system, and asset price levels could potentially be significantly lower even after the public markets have stabilized.
Understanding the Complex Dynamics of the Financial Landscape: The financial crisis of 2008 led to a shift in risk from banks to investors, with both benefits and risks. As regulations change, it's important to remember the core purpose of banks and consider potential economic shocks and their impact on seemingly safe assets.
The financial crisis of 2008 led to a shift in risk from banks to hedge funds and other investors, and the question of whether this was the right move is still up for debate. Ben's discussion highlighted the feedback loops in the market and the exacerbated effects of hedging, but also mentioned the financial stability that comes with risk being moved to the buy side. As we consider the potential rollback of Dodd-Frank regulations, it's important to remember the core purpose of a bank as a place to hold money and consider the potential risks that still exist in the economy, particularly as the health and real economic crises continue. The crisis began as an exogenous shock, and the impact on seemingly safe assets is a concern as the crisis drags on. While it's too early to declare victory in the aftermath of the financial crisis, it's clear that understanding the complex dynamics at play is crucial for navigating the financial landscape.
Uncertainty in the world of private credit and debt-heavy assets: Banks given leeway to reduce reserves against private assets, but potential risks for losses if assets perform poorly, future of these assets and financial system uncertain, follow Ben Eiffert for insights, check out 'Money Stuff' podcast for analysis
The world of private credit, private equity, and other debt-heavy assets, which have so far escaped the washout seen in publicly traded instruments during economic downturns, is facing significant uncertainty. Banks, which hold a lot of these assets, are being given more leeway by regulators to reduce their reserves against certain assets to improve market liquidity. However, this could backfire if something were to happen to these assets, potentially leading to losses for the banks. The unprecedented economic downturn raises many questions about the future of these assets and the financial system as a whole. We can expect this topic to be a source of discussion for years to come. The hosts, Tracy Alloway and Joe Weisenthal, recommend following their guest, Ben Eiffert, for high-value insights on the topic. Listeners can also check out the new Bloomberg podcast, "Money Stuff," for in-depth analysis of Wall Street finance and related topics.
