Photo: University of Chicago Booth School of Business
Prominent hedge fund manager Kyle Bass – whose big trade right now, known as the “widowmaker” in market circles, is betting against Japanese government bonds – gave a talk at the University of Chicago last week.During the talk, someone asked him about the Japan trade. People call it the “widowmaker” because everyone looks at Japan’s huge pile of public debt – the largest in the world as a percentage of GDP – and bets that it has to blow up. The problem for these traders, of course, is that it never does.
Bass relayed an interesting story about a conversation he had with a counterparty at “one of the biggest banks in the world.”
The gist of the story is that “27-year-old kids” have been selling default protection on Japanese government debt for insanely cheap – too cheap, thinks Bass – and that the banks are starting to realise that maybe they are underestimating the risk associated with a blowup in the Japanese bond market.
That’s the vibe Bass gets, anyways, from the conversation with his counterparty – they asked him to close out his trade.
“The AIG of the world is back,” says Bass.
Below is a partial transcription of Bass’s comments at the University of Chicago.
The AIG of the world is back. Here’s what I mean by that.
I have 27-year-old kids selling me one-year jump risk in Japan for less than one basis point. $5 billion worth at a time.
You know why? Because it’s outside of a 95 per cent VaR. It’s less than one year to maturity. So guess what the regulatory capital hit is for the bank? It rhymes with “hero.” Right?
And, if the bell tolls at the end of the year, the 27-year-old kid gets a bonus. And if he blows the bank to smithereens, ah. He got a paycheck all year.
We’re right back there. I mean, the brevity of financial memory is only about two years. I wouldn’t sell nuclear holocaust risk in Dallas for less than a basis point. You should be fired for thinking about selling something for less than 50 basis points, you know? And yet, this is happening again.
And it’s happening in huge size. You know, huge. We bought $0.5 trillion worth of these options.
Interestingly enough, recently, one of the biggest banks in the world called me and asked me if I would close my position. That was an interesting day for us. That happened to me in 2007, right before the mortgages cracked.
They said, “You know, we ran some new risk tests.”
And I said, “Really?”
And they said, “Yeah, you know, our new stress scenario is a little bit more punitive than the last one.”
And I said, “Well, what is it?”
And he says, “We don’t want to share our proprietary secrets of our bank with you.”
And I said, “OK, then I’m not closing it.”
And they said, “Whoa, whoa, whoa, whoa. Well, how about: in our old one, we had rates being stressed 50 basis points, and the new one has rates being stressed 400.”
And I said, “Ooh, yeah, 400. That would really hurt you on this trade, wouldn’t it?”
And they said, “Yeah, we’d like to close that one.”
And I said, “Well, I’d like to, but I’m not going to do that for you, so I’m sorry.”
But anyway, they are starting to realise. Why would they run a stress test like that? Who would have them run that stress test? This is happening.
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