There Are No Tail Risks, Only Failed Systems

Early on the foggy morning of January 10, 1940, German Majors Erich Hoenmanns and Helmuth Reinberger were flying in Hoenmann's Messerschmitt BF 108 along the Rhine. Hoenmanns was heading toward Cologne and offered Reinberger an alternate conveyance rather than having to take the train. Unfortunately for both, the fog had obscured the route as they were in the air and the airplane veered into both Holland and Belgium. Had that been the extent of their misfortune their story would be lost to history, but the aircraft suffered engine trouble and crashed near the Dutch border inside Belgium.

Arousing border guards who arrived by bicycle, the two German officers attempted to destroy the contents of Reinberger's yellow satchel. Contained within were major pieces of the German army's general attack plan for the Western Front. It was, after all, a period of high tension in the area and although Belgium was a neutral country, there was very much a sense it would not be able to remain as such.

After the Germans had attacked Poland in September 1939, contrary to enduring images of the Poles being utterly helpless against the German blitzkrieg onslaught, they needed some time to refit and rethink. The Poles had actually inflicted serious damage on the German forces, including destroying about a quarter of all the German aircraft that was deployed. And despite being badly outmanned and largely ill-equipped, the Polish anti-tank weapons proved deadly effective against the more lightly armored Panzers of the early war period.

In the months that followed the Polish invasion, the French and British, having finally declared war, opted for a defensive strategy that flowed from their experience of World War I. The French had built the famed Maginot Line, a system of fixed fortifications that was designed to give the defenders the upper hand in any fixed line conflagration. To the north, again with Belgium being neutral at the moment, the Western Allies assumed that the Germans would essentially follow the same strategy they had in 1914 - overrun the Low Countries and plunge into Northern France.

After the carnage in France during the Great War, the French, in particular, were very interested in keeping the Germans out as much as possible. So their defensive strategy required moving troops and equipment forward into Belgium to hold the Germans at the Merse and Dyle Rivers. The French expected to engage German Army Group B, believed to be the strongest, in Central Belgium to the north while holding southern approaches at the Maginot Line.

In between them lay the Ardennes Forest, an almost impenetrable obstacle that was believed fully unfit for large military formations. The French and some senior British planners were fully convinced that no tank group larger than a single battalion could successfully traverse the forest since its roads were not amenable to the large number of supply trucks that accompany bigger tank formations.

When Majors Reinberger and Hoenmann crashed in Belgium on January 10, the battle plans accompanying Reinberger largely confirmed the Allies' interpretations. Though most of the text contained specific instructions for Germany's 7th Air Division, of which Reinberger was its supply officer, it more than indicated that Germany's first moves would be nearly identical to the outset of WWI. More than anything, it convinced the Belgians that they were very vulnerable and that they should eschew their stated neutrality and begin to craft and adopt plans and contingencies to let the French and British forces move up.

Once the German's learned of the "Mechelen Incident", as it came to be called, it is believed that General Alfred Jodl, the overall German Chief of Military Operations, called off the attack. The Belgians were now alerted to the potential for hostilities, no less confirmed by the obvious approach of Germany's 6th Army. Though there is some contention the Mechelen Incident had no bearing on the overall strategy, there is more than a little evidence that Adolf Hitler directed the army's chief strategists to look for alternate plans. General Erich von Manstein had been putting forth a more risky and daring alternative for some time, planning on exploiting the gap in the Ardennes with fast moving Panzer divisions, fully aware of the difficulties faced in direct confrontations while in Poland. This plan, called Fall Gelb once adopted, completely broke with all perceptions of German strategy and military conventions.

On May 9, German Army Group B attacked into the Netherlands and Belgium, as suspected. This included paratroop incursions by the German 7th Air Division. It was, however, only a diversion while the main attack moved slowly through the Ardennes, featuring an immense group of 40,000 vehicles. Once the forest was traversed, with almost no opposition at all, a massive armor formation was in the rear of the main French and British defensive units now fighting in Belgium. The result was an almost complete encirclement, leading in relatively short order to the very hasty British evacuation at Dunkirk. The French were finished.

The history of World War II might have been far different had that plane never crashed in the fog that cold January morning in 1940. What if the Germans had gone through with their original strategy, as expected by the Allies? Perhaps France doesn't fall as quickly as the lighter Panzers would have been more vulnerable to the defensive formations at the Dyle River, just as they were in Poland. Being held up in France may have left the Germans unable to invade Russia, perhaps even keeping some of the most sinister aspects of Nazism depressed by necessity. That may be just wishful thinking, but there is a "butterfly effect" here that is undeniable. Wars, like all human systems, are complex beyond our comprehension. The smallest detail or "surprise" can produce innumerable and incalculable changes. That is particularly true where systems, in this case Allied defenses, are only robust in imagination, particularly when all outward appearance reinforces the illusion.

You get some of the same sense reading through a May 2013 Staff Report of the Federal Reserve Bank of New York. Examining potential "fire sales" in repo markets, the paper traces through the 2008 experience, including the first great "surprise" of that era - the events immediately preceding Bear Stearn's failure.

"On February 28, 2008, Peloton Partners, a London-based investment manager, revealed it had been getting margin calls and that creditors had begun demanding larger haircuts on mortgage-related collateral. Peloton announced that it was shutting down one fund (Peloton ABS Fund) and would shortly begin liquidating that fund's assets and closing a second fund (Peloton Multi-Strategy Fund) to further redemptions. The next day the Wall Street Journal reported that Peloton had had only limited success in selling assets on its own and that six of the funds' fourteen creditor banks had begun seizing collateral pledged by the funds."

It should be unsurprising that Peloton was a London-based fund, meaning eurodollars as the epicenter. Only a few days after Peloton, Thorneberg Mortgage also had collateral seized after the fund failed to meet a $270 million margin call. Because creditors were not interested in holding "toxic" collateral, these securities were "dumped" onto a market with few bids. This "fire sale" of securities, for only relatively small amounts, wreaked wide havoc, eventually to Bear Stearn's epic fate.

The chain of failure started with the marks on the Peloton and Thorneberg collateral. Because realized prices on actual sales were so much lower than anticipated, the entire system had to reset to reflect this "market" information. It led to a systemic haircut adjustment in the entire non-agency mortgage securities market.

It did not take long before it was not just small funds fighting for solvency. Only a week later on March 6, 2008, private equity firm Carlyle Group was forced into selling $5.7 billion in securities as creditors began reviewing haircuts and volatility expectations. That particular fund, as the FRBNY paper notes, was capitalized with $940 million in equity "augmented" by $21.8 billion of leverage (or 24 to 1). In other words, it did not take much creditor action to lead to a full unwind.

Of course, all of this snowballed into further margin calls, haircut adjustments and general dysfunction and almost total panic. The Carlyle sales were believed to be one of the most significant factors leading to Bear Stearn's failure. In the space of only a few weeks, the financial world was set afire and it continued well beyond where most thought possible - indeed most of the policymaker cadre was convinced their hurried retreat and "solution" to Bear's insolvency was the final act.

As a matter of the state of finance in 2013, there is more than a little consternation being very quietly expressed about "non-banks." In the aftermath of 2008, of course, the banking system has been done over in terms of risk management. The banks are very aware of how they are perceived and what they "can" do. While they are certainly engaging in other activities, demonstrated by the London Whale and the ongoing reclassification of prop trading into "client flow" and principal transactions, I highly doubt you will see the banks return to the "subprime" state that existed pre-crisis.

But that does not mean risk is being neglected. In fact, since 2008 non-bank financial firms have seen their assets swell by some 60%, from $779 billion to over $1.2 trillion, according to the Financial Times. These non-banks include business development companies (BDCs) and mortgage REIT's. BDC's are providing loans, in a tax-advantaged structure similar to REIT's, to smaller businesses. But they are not simply handing out riskier loans to these off-the-radar firms; BDC's are "boosting" returns by entering the CLO markets. They also park "money" in other specialist firms, mimicking the pyramid of risk that some of mortgage bubble CDO's and synthetic structures provided.

Since BDC's and mortgage REIT's can provide higher returns to investors dying from ZIRP and endless QE, they are only filling a role created by artificial distortion. The re-appearance of complexity and opacity goes with the territory - investors have very short memories when distortions are so very heavy handed. And because these non-banks are unable to fund themselves in the same manner and cost as regulated banks, they access funding through the regulated banks themselves. In other words, the regulated banks are borrowing at zero and lending, at a spread, to the BDC's and mortgage REIT's. Leverage is reborn in another package, once again taking the form of repos.

During the bond selloff in May, the mortgage bond market was particularly hard hit. While not receiving as much attention as US treasuries, outside of the impact mortgage rates are having on housing demand, the mortgage market was in a state of near-panic as taper talk heated up. On May 22, in trading leading up to the release of the FOMC minutes, Chairman Bernanke made comments around noon that were taken as if tapering were a given in the very near future. Mortgage bond prices routed as a result, with more than a few issues down more than a full point (that counts as near panic in the fixed income world).

The disaster in mortgage securities was somewhat incongruous to other fixed income markets, so it seemed as if something was amiss there. Once it spread, there was no stopping it. Even when the Fed minutes were finally released at about 2:10 pm, largely dissipating taper fears (for that moment) and contradicting Bernanke's earlier assertions, mortgage securities continued to be sold into the close.

The obvious candidate was mortgage REIT's. Since they are highly levered vehicles, the blast higher in rates, particularly on May 22, likely triggered more than a few margin calls on collateral. In the wake of the selloff, we have learned that FRBNY has been very quietly examining bank exposure to mortgage REIT's through repo channels. They do not seem to be taking a broader interest in the overall market distortions that provide impetus for these changes, however.

But if we really examine how these new financial structures are being integrated in the distorted system, we see that the problem runs far deeper than just specialty finance through non-banks. By nearly all accounts, and the current favor which certain asset markets roar with little concern of risk, "tail risk" and volatility are anachronistic. Before May 2013, that was true in the bond markets, including mortgage markets. Volatility has been suppressed, and there is no doubt that is coming from QE and the heavy hand of the Fed that continually buys up a high proportion of securities (which is much greater in MBS than UST).

The problem of low volatility is, in this instance, counterintuitive. Liquidity is not just a system with available "money" as true liquidity means depth - as in, when the selling starts there are enough bids to reasonably absorb that burst. But volatility that persists "too low" actually reduces the incentives for market participants to "trade", just as lower rates reduce the incentives for securities holders to lend collateral. Lower volatility in trading terms means dealers have to deploy greater size to reach their quotas, but that often runs counter to risk management systems. In other words, it is far more difficult to trade into a lower volatility market and stay within risk parameters. In that case, marginal market participants deploy resources elsewhere and depth erodes a little at a time - the market slowly and imperceptibly regresses.

All of these factors (mortgage REIT's, BDC's, low volatility and collateral strains) have a single genesis: the monetary policy of QE and ZIRP. As heartening as it may be to see FRBNY poking around the edges of mortgage REIT's, just as they steadily reconfigure banking "rules" for re-imaging regulated bank risk, it is actually confirmation that the Fed is deepening its commitment to its own Maginot Line and Dyle River plan. The problem is not non-banks, per se, it is the artificial intrusion into credit markets that create the conditions for non-banks to act and thrive as they have. It is the idea that artificially suppressing rates and volatilities are net positives, even though these alterations throughout finance more than suggest they are not.

Janet Yellen has conceded that the economy still needs "aid", but that is never balanced by a larger discussion as to why that might be. Admitting that monetary distortion is a net negative, as "costs" are revealed through these unconventional channels, would go a long way to explaining this "mystery." Subprime mortgages were not the cause of the 2008 crash; they were a symptom of systemic instability. Non-banks are already taking blame for 2013 skittishness, but they too are not the ultimate cause.