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To understand the risk of contagion, you can think of the marlin in Hemingway’s Old Man and the Sea. The marlin started out as a prize catch lashed to the side of the fisherman Santiago’s boat.
But, once there was blood in the water, every shark within miles descended on the marlin and devoured it. By the time Santiago got to shore, there was nothing left of the marlin but the bill, the tail and some bones.
In this metaphor, the marlin is XIV. During regular trading hours last Monday, there was not much blood in the water. But, once traders saw the damage to VIX, they smelled blood in terms of the value of XIV.
At that point, markets (the sharks) no longer traded XIV in relation to other instruments. Instead markets systematically traded against XIV in an effort to force every holder, sponsor and guarantor to suffer a total loss. They were out to break it.
Markets intended to pressure the price of XIV until there was a suspension of redemption, a collapse to zero, or ultimately noteholder litigation.
I apologize if this sounds a bit technical. The bottom line is, the damage seems to have been contained.
But, what if the XIV ETN holdings had been concentrated at just one or two hedge funds? What if those holders themselves were highly leveraged and were losing money on stocks and XIV at the same time? What if rumors had leaked out into the marketplace about “hedge funds in distress?”
An even greater danger for markets is when these two kinds of contagion converge. This happens when market losses spillover into broader markets, then those losses give rise to systematic trading against a particular instrument or hedge fund.
When the targeted instrument or fund is driven under, credit losses spread to a wider group of fund counterparts who then fall under suspicion themselves. Soon a market-wide liquidity panic emerges in which, “everybody wants his money back.”
This is exactly what happened during the Russia-Long Term Capital Management (LTCM) crisis in 1998. The month of August 1998 was a liquidity crisis involving broad classes of instruments. But, the month of September was systematically aimed at LTCM.
I was right in the middle of that crash. It was an international monetary crisis that started in Thailand in June of 1997, spread to Indonesia and Korea, and then finally Russia by August of ’98. It was exactly like dominoes falling.
LTCM wasn’t a country, although it was a hedge fund big as a country in terms of its financial footings.
I was the general counsel of that firm. I negotiated that bailout. The importance of that role is that I had a front-row seat.
I’m in the conference room, in the deal room, at a big New York law firm. There were hundreds of lawyers. There were 14 banks in the LTCM bailout fund. There were 19 other banks in a one billion dollar unsecured credit facility. Included were Treasury officials, …read more
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