Love Jim Cramer or hate him, he is right in at least one regard: there is a market for everything. What Cramer means is whether you are considering exposure to an item as straightforward as people’s love of Coca Cola or as arcane as the ability of Midwestern businessmen to travel more efficiently on weekdays in the winter, you can find it. However, one can buy shares directly in Coca Cola, but not in Midwestern business man’s travel time. The rub is the exposure shows up in places we often wouldn’t expect via the interplay of events that we didn’t consider to be related. And just as it may be tricky to find a desired exposure, the corollary is we are often unaware of what arcane exposures we actually have.
Consider a truck driver in Oklahoma. He may be unaware that for the past several weeks he has had an exposure to the reputation of the global investment bank Credit Suisse.
The story starts in the fall of 2011 with the spike in concern over Iran’s nuclear program and what Israel or even the US might do as a pre-emptive measure. Iran threatened to close the Strait of Hormuz in response to any attack, and as the rhetoric increased investors sought to position themselves in the event oil flows were disrupted and prices spiked.
Oil futures prices rose as a result. In the three months ended November 30, 2011 oil had a beta of 1.1 to the S&P 500, meaning it rose 10% more than (the 20% rise in) the stock market over the same period. However, over the previous three years, the beta of oil to the S&P was only 0.9, meaning it would have been expected to have risen 10% less than the market in that period. This outperformance occurred even while oil was facing headwinds that US stocks were not: political incentive to lower gas prices in an election year, talk of releasing the strategic petroleum reserve, Saudi Arabia promising to increase output, and real evidence of slowing demand from China as evidenced by only their third (and by far their largest) monthly trade deficit in a decade.
Oil’s outperformance made it a more expensive place to buy protection. Worse still, for those looking to hedge a Middle Eastern event, the oil futures roll, what it would cost to stay long oil futures, had doubled in price, from 25bps a month to 50bps. So now a hedger must not only pay an elevated base price for insurance, their monthly premiums had doubled.
As would be expected oil hedgers looked to cheaper forms of insurance. An obvious source would be buying the volatility of the stock market, as an oil supply shock would raise fear in the market, and volatility would increase. As evidence that oil hedgers moved in to the equity volatility market we can look to the performance of TVIX, a double levered volatility ETN. Starting in mid-December, about the time oil was reaching a new higher plateau v stocks, interest in the TVIX started ratcheting up. Shares outstanding had been in the 2.5mm range for more than a year, but now rose sharply from 2.5mm to 5mm. In January they exploded to 25mm shares, and then to 40mm in mid-February when the manager of the ETN, Credit Suisse decided to halt all new share creations.
Why would Credit Suisse do this? The more shares outstanding, the more money the bank would make. However the larger an ETN of this nature gets, the more chance the investors in that ETN have of losing money as the ETN managers (CS) must buy the underlying assets at prices inflated by the manager’s own outsized orders. Perhaps pre-2008 CS would have seen no problem in customers having an increased chance of losing money as the bank was raking it in. But post Fabulous Fab, banks are presumably more caring of what could happen to their reputations if investors are harmed, if not actually being more caring about the investors.
ETN creations allow investors to own the ETN as its net asset value (NAV). The suspension of creations meant that buyers of the TVIX no longer had the option to buy at its NAV and sellers could charge whatever the market would bear. Thus the TVIX was no longer tethered to its underlying assets. The result was a classic short-squeeze. On the first day creations were suspended TVIX went to 10% premium to its NAV—a very large amount give that the day CS resumed creations the premium would go to zero. Then the TVIX took on a life of its own as the premium went to 18% two days later. Then 25%. As the premium grew larger the shares outstanding of the VXX, an unlevered version of the TVIX went from 20mm to 113mm in the month after the TVIX suspension. As a result of all this, VIX futures, volatility contracts that underlie both the TVIX and VXX went from a 1pt premium in the front month and 2pts in the 2nd month to 5 and 8 respectively, in effect adding 25% to the cost of buying volatility even as actual market volatility was declining. By mid-March the TVIX stood at an astounding 90% premium to its NAV. A premium that would collapse the day CS resumed creations.
It is telling what didn’t move during this frenzy: S&P 500 options. These options are another way of gaining exposure to volatility and thus a viable alternative to the TVIX, VXX and Vix futures (and oil futures). But using S&P 500 options to get long volatility is far more complex and time consuming than using the ETNs and Vix futures. It was apparent that those buying all this volatility were not professional equity volatility traders or they would have used the more complex but far less expensive instruments. It was oil investors looking to ‘be long’ an oil price spike.
The more expensive TVIX and its cousins became, the more expensive oil became, as even at its elevated price oil was becoming a relatively cheaper hedge than volatility. CS’s suspension in creations caused the price of volatility to oil hedgers to spike ultimately causing oil to become more expensive. This is not to blame CS—had they not created the TVIX (a simple way for traders to hedge a middle east event) in the first place oil would have been higher to start. This is just to illustrate that truckers in Oklahoma now had an exposure to CS’s concern for its reputation.
Relief may be in sight. Thursday saw a dramatic sell off in the TVIX, from its 90% premium to a 45% premium, the first drop since creations were suspended. And (not coincidentally) CS announced after the close Thursday that creations in the TVIX would resume. With the resumption of creations the rest of the premium vanished Friday bringing the TVIX drop to 50% in two days. (Separately market pros are left to wonder who was on the giving and receiving ends of the leak early Thursday that CS would resume creations as those who started selling the TVIX Thursday made a small fortune by Friday afternoon.)
With the release of the TVIX pressure, Vix futures fell dramatically and are now much closer to their normal premium, standing at 2.5pts and 5.5 pts respectively. This should in turn reduce the upward pressure on oil as hedges are far cheaper than they were a few days ago. And gasoline consumers can thank CS for allowing TVIX creations to resume. And it is likely no coincidence that Thursday, the day TVIX premium finally started to contract, oil underperformed equities by the largest percentage it had in 3 months.