| Programming note: Money Stuff will be off tomorrow, back on Thursday. Mortgages The traditional banking system goes like this: - You put your money in a bank account. It pays a little interest. You can take your money out any time.
- The bank lends your money to your neighbors to buy houses. They pay interest. Their loans are due in 30 years.
This largely works—most depositors don't want their money back at the same time, the mortgages pay higher interest than the deposits, etc.—though the problems are well known. The modern banking system goes like this: - You put your money in a money market fund. It pays a little interest. You can take your money out any time.
- The money market fund lends your money to a big dealer bank in the repo market, collateralized by Treasury bonds or mortgage-backed securities. It can take its money back any time.
- The dealer bank lends the money in the repo market to a mortgage real estate investment trust, collateralized by the REIT's mortgage-backed securities. It can take its money back on fairly short notice, or issue margin calls if the mortgage-backed securities lose value.
- The mortgage REIT uses the money to buy mortgage bonds from mortgage lenders. It can't generally get its money back, but it can sell the bonds if it needs to raise money.
- The lenders use the money to make mortgage loans to your neighbors to buy houses. They pay interest. Their loans are due in 30 years.
I am omitting some steps there—government-sponsored enterprise guarantees, warehouse lenders to non-bank originators, etc.—and of course that is not the only way that the modern system works; sometimes it works exactly like the old system. (There are still bank deposits, certainly, and there are even still mortgages made by banks and held on their balance sheets.) It's not even the main way that the modern system works, for mortgages: "The mortgage Reits entered the coronavirus crisis owning an estimated $500bn of bonds backed by property loans," out of a total of about $16 trillion of U.S. mortgages. Still $500 billion is a lot! And what is striking about that system, compared to the old system, is just how many steps it has. Anyone doing the investing at the top of the chain doesn't really know what is going on with their money at the bottom of the chain. And anyone anywhere in the chain can decide to take their money back—because their opinions have changed, or because they worry about the people above them in the chain asking for their money back—which will lead to cascades lower down. There are a lot of tight linkages, and if any of them go wrong then the whole system seizes up. And so one thing that is happening now is ... everything? All at once? Like, pick a step of that process and it is seizing up. The Fed has stepped in to guarantee money market funds, out of worries that their investors will run on them. The Fed has stepped in to support repo markets, out of worries that investors will run on them. The dealers are pretty much running on the mortgage REITs: Real estate investments trusts that specialise in buying mortgage-backed securities are playing a prominent role in the current market turmoil, dumping their holdings in response to margin calls by their banks. … Shares in Annaly Capital and AGNC Investment, the two largest mortgage Reits, have been cut in half in recent weeks. A smaller peer, AG Mortgage, fell 38 per cent on Monday after saying "it does not expect to be in a position to fund the anticipated volume of future margin calls under its financing arrangements in the near term". The mortgage Reits fund themselves by pledging bonds in return for cash in the short-term funding, or "repo", markets, and have assets valued at as much as 10 times their common equity. … The falling value of their mortgage bonds, driven down by the rush for cash and worries about defaults as the coronavirus leaves homeowners unemployed, has pushed the Reits past their leverage limits, forcing them to sell bonds into an already weak market. The mortgage REITs are dumping mortgage bonds, driving down their prices, as the Fed steps in to shore them up: Holders of mortgage-backed securities are fielding redemption requests from clients, margin calls from jittery counterparties and drops in their valuations, forcing the funds to solicit offers on billions in assets in emergency sales over the weekend. If such sales accelerate, bond prices could fall and put pressure on other investors to mark down or sell their holdings too. … The Fed, in a surprise announcement early Monday, said it's buying unlimited amounts of Treasury bonds and mortgage securities to keep borrowing costs low. … But that effort has limits. For example, the central bank is focusing on securities consisting of so-called agency home loans and commercial mortgages that were created with help from the federal government. And the originators have stopped originating mortgages because everything is nuts: Flagstar Bancorp, one of the nation's biggest lenders to mortgage providers, said Friday it stopped funding most new home loans without government backing. Other so-called warehouse lenders are tightening terms of financing to mortgage providers, either raising costs or refusing to support certain types of home loans. One prominent mortgage funder, Angel Oak Mortgage Solutions, said Monday it's even pausing all loan activity for two weeks. It blamed an "inability to appropriately evaluate credit risk." One thing to say about this is that it doesn't exactly seem to be a cascade. It's not like money-market-fund withdrawals led to repo-market seizures which led to mortgage REIT margin calls which led to reduced mortgage originations. It's more like exogenous bad economic news happened, and everyone everywhere in the chain noticed it simultaneously, and they all freaked out at the same time in the same direction. A failure at any link could be bad for the system; now, every link is failing. Another thing to say about it is that the money goes in at the top and the evaluation of economic opportunities happens at the bottom. If you are worried about technical failings of the system, you might try to improve its liquidity by pouring money into the top of the funnel. And so the Fed is supporting money market funds and repo and mortgage bonds and so forth. Which should help. But the explanation of this crisis in the mortgage market is not a lack of cash in the repo market; the explanation is that the economy is entering a recession and people may not be able to pay their mortgages, and mortgage lenders (and all the people further up the chain who lend them money) don't want to make loans that won't get paid back. People worry about a lack of liquidity in the bond markets—they worry that if they want to sell assets, no one will be there to buy—and they put that worry in terms of market structure and funding availability and regulation. But liquidity is bad at the bottom of the chain too, and that is explicitly for the good old-fashioned simple reason that no one wants to buy stuff when they don't know what it's worth. Angel Oak will stop making mortgages due to an "inability to appropriately evaluate credit risk": No one has any idea if anyone will be able to pay back a mortgage, so why make mortgages? Similarly: Also retreating: A new generation of sophisticated home flippers, who use data and debt to buy and sell homes in quick order. Zillow said Monday it has stopped purchasing homes, following rivals SoftBank-backed Opendoor and Redfin Corp. "No one can say what a fair price is right now, so we're not making any instant offers," Redfin's Chief Executive Officer Glenn Kelman said last week. "No one can say what a fair price is right now" is a pretty good reason to stop buying stuff, and it is hard to solve with cash infusions. Gamma flip A good basic story is that if people think that a stock should be worth a lot, they will buy it, and so it will be worth a lot. If they think it should not be worth a lot, they will sell it, so it will not be worth a lot. At least in the short term, market perceptions tend to become reality, or at least to amplify existing reality. A similar basic story, imperfect but useful, is that if people think the market will be volatile, they will buy volatility, and so the market will be volatile. For a long time now people have more or less thought that the market would not be volatile, so they sold volatility, and so the market was not volatile. Now, however, they think that the market will be very volatile, so they are buying volatility, and so the market is very volatile. I mean the market is very volatile mostly for other reasons, but the volatility buying doesn't help. Here is Bloomberg's Luke Kawa with the Greek letters: Dealers were long the guardians of the Goldilocks markets that befitted an economy that was lumbering along, serving to moderate price action when it got too hot or too cold. Until recently, stated in the simplest terms, there were way more people looking to sell options than buy them, and dealers took their business. Among the would-be sellers were institutions embracing a variety of fancy tactics, among them one known as call overwriting, in which someone who is long a stock sells an option on it to collect a fee and boost her return. These strategies are big enough to have implications for intraday price action in major equity indexes like the S&P 500. Consider a pension fund engaged in a call-writing strategy. The dealer on the other side of the trade -- the call's buyer -- normally goes short the underlying stock, so that if the option's value declines, the loss is hedged. In Greek parlance, that's known as staying "delta neutral." To remain delta neutral, a dealer covers some of this short (buys the stock) when the stock falls, and shorts more when the stock advances. Therefore, dynamically managing of this "long gamma" position has the effect of tamping down realized volatility. People—end users, real investors—think the market will not be volatile, so they figure they can risklessly collect some extra cash by selling call options. (This is a bet against volatility: If the market goes down 50%, call overwriting will seem like a bad strategy because you still own the stock; if it goes up 50%, call overwriting will look bad because you give up the gains; if it goes up 2% call overwriting will look great because you increase your returns.) Selling call options (or put options for that matter) is "selling volatility"; the people buying the volatility are dealers. The dealers—unlike the end users—are not trying to make a big directional bet; they are intermediaries; they are in the business of manufacturing financial products and delivering them to their clients. The product that they have sold to their clients, in this case, is calm. (The clients are selling volatility, so they're buying the absence of volatility). So the dealers go out and manufacture calm for their clients.[1] They do this by buying stocks when they go down and selling them when they go up, which has the effect of making them go down less when they're down and go up less when they're up. Kawa again: This is what happens in a tranquil market. In a haywire one, it flips on its head. At times like now, options lose their allure as quick bets to enhance yield, and revert to their fundamental role as market hedges. With institutions banging down the door to purchase protection, dealer activity radically changes. If investors are buying puts hand over fist, that means dealers are forced to sell stock to offset their exposure when markets fall. JPMorgan strategist Marko Kolanovic described how this flip in dealer positioning contributes to an extreme see-saw in price action that sees stocks collapse one day only to zoom higher the next. First, equities retreat as investors react to negative news on the outlook for the global economy and potential for corporate credit stress by fleeing risk assets. This prompts dealers to short more, driving the price of shares down too far. Then, prices overcorrect as this dynamic reverse itself 24 hours later, he said. People—end users—now think the market will be volatile, so they figure they should spend some money to protect themselves from the volatility. They buy put options—volatility—from dealers. The dealers are not trying to make a big directional bet; they have sold volatility and have to deliver it to their clients, so they go out and manufacture that volatility by buying stocks when they go up and selling them when they go down, which has the effect of making stocks go down more when they're down and go up more when they're up. Mostly down these days. This is a story about stock (and stock-index) options but it has the same basic form as a lot of other trades. In calm markets, people make bets on calm markets that tend to have the effect of further calming the markets. When markets become wild, people unwind those bets and start betting on wild markets, which tends to have the effect of further aggravating the markets. Insider trading (1) I wrote the other day about allegations that Senator Richard Burr had dumped a bunch of stock last month after receiving classified briefings about the spread of the coronavirus. The shares he sold included hotel stocks like Wyndham Hotels and Resorts Inc. "The highly classified briefings Burr got were presumably not about Wyndham Hotels and Resorts," I wrote, but the accusation is that Burr misused governmental information for his own profit. I wrote a whole long thing about how this demonstrates that insider trading is not about fairness to counterparties but about misuse of information. "The people who are mad at Burr are not mad because they recently purchased Wyndham stock," I wrote. "The point," I wrote, "is not that he (maybe) cheated his counterparties, the buyers of Wyndham stock; it's that he (maybe) cheated his employer, the American people." But, I don't know, also the buyers of Wyndham stock: Alan Jacobson, a shareholder in Wyndham Hotels and Resorts, sued Burr in federal court on Monday, alleging that the senator used private information to motivate a mass liquidation of his assets. It is illegal for senators to use nonpublic information in conducting securities exchanges. ... "Had Plaintiff and the market known of the material nonpublic information in Senator Burr's possession regarding COVID-19, and on which Senator Burr traded, Wyndham's stock price on February 13, 2020 would have been substantially lower," the suit continued. "Senator Burr and his wife sold up to $150,000 of Wyndham stock on that date, and therefore he and his wife pocketed up to $150,000 in illegal insider trading proceeds at Plaintiff's expense." Jacobson argued he had suffered harm because he kept his shares while they were trading at artificially inflated prices due to the lack of public knowledge on the coming economic devastation from coronavirus. Not even a buyer—a holder of Wyndham stock—but whatever. One point here is really that anyone can sue anyone for anything. Insider trading (2) Here is "Political Connections and the Informativeness of Insider Trades," by Alan Jagolinzer, David Larcker, Gaizka Ormazabal and Daniel Taylor, forthcoming in the Journal of Finance, about the last financial crisis: We analyze the trading of corporate insiders at leading financial institutions during the 2007 to 2009 financial crisis. We find strong evidence of a relation between political connections and informed trading during the period in which TARP funds were disbursed, and that the relation is most pronounced among corporate insiders with recent direct connections. Notably, we find evidence of abnormal trading by politically connected insiders 30 days in advance of TARP infusions, and that these trades anticipate the market reaction to the infusion. The authors track trading by officers and directors of publicly traded financial institutions, and "identify political connections based on whether a board member has current or previous work experience at the Federal Reserve, Treasury Department, Congress, or a bank regulator." And: Evidence of elevated trading among politically connected insiders prior to TARP infusions, and that these trades predict the market reaction to the infusion, would suggest insiders are trading based on superior information about TARP infusions. Measuring trading by corporate insiders over the 30 days prior to the announcement of their firm's TARP infusion, we find that insiders are net buyers (sellers) before 34.8% (20.3%) of infusions in our sample. We find a pronounced increase in the trading activity of politically connected insiders 30 days prior to the announcement, and that these trades predict the market reaction to the infusion. Notably, similar results do not obtain among insiders without political connections: insiders without political connections do not appear to time their trades to coincide with TARP infusions. Insider trading (3) It is, surprisingly, a theme these days: Changes forced by the pandemic could result in more people having access to material nonpublic information that might have even greater value than it would under normal circumstances, the co-directors of the Securities and Exchange Commission's enforcement unit said in a statement Monday. "Those with such access -- including, for example, directors, officers, employees, and consultants and other outside professionals -- should be mindful of their obligations to keep this information confidential and to comply with the prohibitions on illegal securities trading," Stephanie Avakian and Steven Peikin said in the statement. Here's the statement. I guess it is true, as they say, that "corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances." A lot of companies are going to negotiate bailouts or be acquired, and you should buy their stock before that is announced; a lot of other companies are going to go bankrupt and you should sell their stock before that is announced. And that information is going to be shared in a lot of conference calls in living rooms, etc., with maybe less-than-ideal information security. A lot of corporate insiders' spouses will be getting more inside information than they usually do. On the other hand the SEC is pretty good at catching spouses who insider trade? And one thing that is not going to happen is that people are not going to be sharing inside information with their friends at bars or restaurants or the clock at Grand Central or, crucially, on golf courses. Only the most blatant insider traders trade on their own, or their spouse's, companies or deals; most of the hard cases to catch are the ones driven by social networks, people tipping friends of friends in casual conversations on the golf course. Social distancing might shut down a lot of social insider trading. Good ICO Do you think that, as the economy slides into a new Great Depression, the fun scams will all dry up? Will con artists stop doing extravagant cryptocurrency scams and spend their time, like, taking desperate people's money with false promises of coronavirus cures or toilet paper? I don't know, but if we have reached the end of the golden age of crypto scams, at least it ended on a high note. Last Friday the U.S. Securities and Exchange Commission brought a case against Meta 1 Coin: The SEC's complaint alleges that Florida residents Robert Dunlap and Nicole Bowdler worked with former Washington state senator David Schmidt to market and sell a purported digital asset called the "Meta 1 Coin" in an unregistered securities offering conducted through the Meta 1 Coin Trust. The complaint alleges that the defendants made numerous false and misleading statements to potential and actual investors, including claims that the Meta 1 Coin was backed by a $1 billion art collection or $2 billion of gold, and that an accounting firm was auditing the gold assets. The defendants also allegedly told investors that the Meta 1 Coin was risk-free, would never lose value and could return up to 224,923%. According to the complaint, the defendants never distributed the Meta 1 Coins and instead used investor funds to pay personal expenses and funnel proceeds to two others, Pramana Capital Inc. and Peter K. Shamoun. The complaint alleges that some of the investor funds were used to buy luxury automobiles, including a $215,000 Ferrari. In all, the complaint alleges the defendants raised more than $4.3 million from more than 150 investors in and outside the U.S. Sure, right, lies, gold, Ferraris, all pretty normal. But the complaint is full of lovely details. For instance this is an alleged crypto scam with a side of "sovereign citizen": By putting Meta 1 on the blockchain, or whatever (there was no actual blockchain), its promoters claimed to be above the law: By at least August 2018, Dunlap had created Meta1's website, https://meta1.io. The website described Meta1 and claimed that it was not bound by any laws. Specifically, the website noted that Meta1 is "a Private trust operating in a 'Private Jurisdiction'. Meaning [sic] META 1 Coin is not within a State or Federal jurisdiction and not accepting contracts from any such parties. The various federal agencies and their attempts of defaming and stopping the advent of digital assets have no legal bearing on META 1 allowing META 1 to operate without the interference of such agencies." To the point that, when the SEC started to ask questions: Each Defendant returned the subpoena to the SEC with the word "Fraudulent" marked on every page. Schmidt refused to produce documents to the SEC, and refused to testify. Dunlap refused to produce documents. He appeared for testimony, but refused to answer several important questions, such as whether he drafted the Whitepaper, claiming at various times the questions were ridiculous, the answers were none of the SEC's business, and he "[has] no contract with the SEC." Meanwhile the actual promotion of the coin involved going on psychic YouTube: On September 5, 2018, Dunlap and Bowdler appeared together to promote the Coin on an Internet talk show called "Crypto Visions, Evolutionary Journeys" ("Crypto Visions"), which was hosted by a self-proclaimed psychic and is accessible on YouTube. The show's host claimed that "Spirit Guides" empower her to recommend specific cryptocurrencies. On this show, Dunlap falsely claimed that Meta1: (1) owns $1 billion worth of art that Dunlap purchased with his own money, insures the art with a $1 billion surety bond, and keeps the art in a vault; (2) owns a forensics laboratory in Sedona, which Dunlap uses to authenticate all of the art that Meta1 acquires, and that Dunlap developed an authentication process; (3) is "operating outside the jurisdiction of the state and federal government, and so we're very, very let's say astute, regarding asset protection"; (4) owns its own exchange and "all aspects of source code"; (5) is acquiring its own offshore bank; (6) acquired a company which will enable Meta1 to offer a "non-bank credit card"; (7) developed a "smart contract" which ensures that the Coin cannot be sold for less than asset value; and (8) has a goal of "get[ting] the asset value to . . . several trillion dollars." Bowdler contributed to the deception, telling the Crypto Visions audience that "the Coin has been specifically architected out of the angelic realm" and that it is "really exciting when people find out what we're doing with the art." Bowdler told the audience that she channeled "the Archangel Metatron," who told her that: (a) of all the cryptocurrencies being issued, only 15-20 would be left standing; and (b) the Coin would be one of them. Bowdler also told the audience that Metatron and Abraham Lincoln revealed to her what would happen in the world's financial and economic structure over the next 20 years. Because the audience shared her "metaphysical beliefs," Bowdler knew her statements would influence them to invest in the Coin. I like that last sentence. Traditionally there is some requirement of materiality in fraud; traditionally you get in trouble for lying about things that a reasonable investor would find important in making an investment decision. I do not think a reasonable investor would be much persuaded by claims of Abraham Lincoln's ghostly endorsement. (Rather the reverse!) But, the SEC's point here seems to be, Meta 1's actual investors were. Somehow. These people raised $4.3 million with this. Things happen Fed's Historic Step Into Credit Market May Cure ETF Dislocations. 'Great liquidity crisis' grips system as banks step back. Dealmakers Are Getting Creative After Virus Upended M&A Market. Bond Downgrades Begin Amid Coronavirus Slowdown. JPMorgan Plans Firm-Wide Hiring Freeze Amid Virus Uncertainty. Bank of America allows trading from home after staff backlash. Citadel turns 2020 profit after spotting virus risk early. DE Shaw quant fund takes hit from markets gone haywire. Bill Ackman Makes $2.5 Billion 'Recovery Bet' Amid Coronavirus Tumble. Companies Race for Cash in Coronavirus Crisis. PG&E to Plead Guilty to Involuntary Manslaughter Charges in Deadly California Wildfire. The Very Specific Reason We Shouldn't Bail Out the Cruise Industry. A street food vendor's tip led archaeologists to find an ancient Maya capital in a cattle rancher's yard. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] This is … not a technical explanation. Really the dealer *does* have an unhedged long volatility position in the standard case (sell option, delta-hedge); selling an option and hedging only the delta *is* a bet on volatility. Still it also has the effect of dampening volatility; the explanation in the text is in the right spirit. | 
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