Select excerpts from Aaron Brown and Richard Dewey’s paper:
Toil and Trouble, Don’t Get Burned Shorting Bubbles (SSRN)
It was not a mystery that there was a bubble in subprime from 2005-2008. That did not mean shorting it was an easy trade. With the benefit of hindsight, we can learn about the risks of shorting frothy assets that may even be a bubble.
From the abstract:
Bubbles are among the most puzzling and controversial phenomena of financial markets. Although rare, their cumulative impact on both investor returns and the broader economy can be great. One particular question that has motivated research is why shrewd short sellers don’t prevent excessive price increases. The “limits to arbitrage” idea argues that correcting inefficient market prices is neither easy, cheap nor riskless. The “rational bubble” literature identifies situations in which being long the bubble is a better trade than being short, even if investors know for certain the bubble will pop.We examine the “short subprime” trade from 2005 to 2008 to evaluate these and other explanations. We argue that the short subprime trades had more risk than is commonly appreciated. We discuss how the opaque and illiquid nature of subprime mortgages deterred some investors from purchasing CDS contracts and note that other investors assessed the risk of counterparty failure, government intervention and unknown time horizon to be sufficient enough not to purchase CDS contracts.
Talking to investors who saw the bubble and passed on shorting it, instead opting for alternative strategies:
We interviewed and analyzed the internal research of several investors who evaluated the short subprime mortgage trade and decided not to purchase CDS contracts and present some of their reasoning below.
- The Basis Trade: Magnetar Capital in Chicago
Magnetar did not cooperate with the media, so their story has not been widely told. Magnetar reportedly employed a strategy whereby they purchased the riskiest equity tranche in many CDOs which often offered double-digit returns. They used this positive carry to pay for protection on the AAA tranches that most investors assumed were safe. Magnetar appreciated that the correlation between the safest AAA tranche and the lowest quality equity tranche would be close to one in a crisis due to the way these securities were constructed. - Picking-up-the pieces trade: Soros and Tepper
Soros
Perhaps the safest way to profit from the subprime mortgage meltdown was the time-honored method of picking up the pieces at the bottom. George Soros and his Chief Investment Officer Keith Anderson smelled opportunity and hired two ex-Salomon Brothersmortgage experts, Mason Haupt and Howie Rubin.
Tepper
David Tepper purchased shares of Citi and Bank of America near the bottom, helping his Appaloosa fund return 120% in 2009 on $12 billion in capital. - Convex-listed hedges correlated with a downturn: Talpins and Dalio
Ray Dalio at Bridgewater and Jeff Talpins at Element Capital are rumored to have purchased futures or options on government bonds that would rise in value if the Fed aggressively cut interest rates. Many on Wall Street believe that Element purchased Eurodollar options in 2007 that helped his firm generate returns of 26.4% in 2007 and 34.9% in 20083. Talpins has posted annualized returns north of 20%, without a single losing year in the decade that followed. And simply being long volatility in equity markets, fixed income or currency markets paid off nicely for many traders. The key to these trades is that they removed some of the unattractive aspects of the subprime trade, by using more liquid instruments, waiting for the crisis to materialize or constructing more nuanced expressions.
The collection of people that did these trades: George Soros, David Tepper and the team at PIMCO are investors with long-term track records. They made their money quietly, in sensible trades over several years, and were also able to put large amounts of capital to work.
The sobering difficulty of the short subprime trade:
Betting against subprime mortgages worked, but it was somewhat of a Goldilocks trade: it required default rates to get high enough to generate profits on your insurance, but low enough that the banking system survived to pay you and that the government didn’t help out borrowers at your expense.
Current backdrop:
As we write this analysis in the first quarter of 2021, financial market pundits are calling bubbles in everything from cryptocurrencies and TSLA to SPACs, high-end real estate and, most recently, stocks hyped on Reddit.
My takeaways:
- Shorting subprime looked like a hero trade but the path was painful and uncertain. You needed to weather the negative carry and margin calls on bilateral trades with banks for years. And you needed to bet against on institutions that were not bailed out.
- Taking a bubble on straight ahead looks like foolish risk reward, especially if the bubble is “rational”1 and has no clear correcting catalyst.
- Need to think about the risks and incentives of the system. For example, if you believe bonds are currently overpriced and shorting them, even with their low-yield and therefore relatively small negative carry, you cannot ignore the possibility that the rules can be tampered with in the name of the system. Just as banks were bailed out, it’s not impossible to imagine a yield curve control policy (YCC) similar to post-WWII would cap any upside on a short Treasury trade.
- The paper describes what you are up against eloquently:
The reality is that structuring good trades is often every bit as difficult as forecasting. This is particularly true if a trade is contingent on a crisis materializing, when pricing is less reliable, liquidity dries up and contractual obligations are sometimes not honored. In these instances, trade construction is everything. Even if an asset price bubble can be confidently identified ex-ante (no easy task), making money from the bubble is perhaps equally challenging…
This separates opinion havers from risk-takers. Getting the right odds on the right contingent payoff in the state of the world that matched that payoff. And then actually being able to collect. Having an opinion on markets is like have a business idea but no ability to execute.
Footnotes
- A helpful understanding of “rational” bubbles can be found on @Jesse_Livermore discussion of BTC on Infinite Loops:
A bubble, using our little framework, would be a situation where you have a price that is several multiples higher than intrinsic. It’s a large excessive, abusive, multiple of intrinsic value, where the cash flows are no longer really part of the equation anymore. There are two types of bubbles. There are what I would call “rational” bubbles, and I’m taking that term from Mohamed El-Erian in a different context, just to attribute credit. And there are “irrational” bubbles.
So let me go with an irrational bubble. Something like that is trading at some exorbitant, ungodly multiple of its intrinsic value and it’s possible to increase the supply. The owner can make the supply increase. That would be an irrational bubble because now you have a mechanism to bring the price back to intrinsic value, or to bring it back in that direction, which is going to be the dilution you’re going to experience. Alternatively, you could also have a bubble where you have an arbitrage, where let’s say you have the stock market trading at a hundred times earnings and you have treasury bonds at 10% yield. That’s an irrational bubble because you have a mechanism to force things back into a configuration that makes more economic sense.
With Bitcoin in this environment, you don’t have any of those things.