The Big Short – A Great Book, A Difficult Strategy
Guest post by Peter Tchir.
I liked the book. It was a good read. It is also a compelling strategy. Find something that costs next to nothing to put on with huge potential gains. The big short was the ultimate elephant hunting or lottery ticket.
The beauty of the big short is that some investors found some obvious flaws in a market. They thought the deals themselves had problems and the structure of the more complex deals was also done incorrectly. They went against the grain, they used logic and intelligence to find an opportunity, and in turn crushed it. It really is a great story and is incredibly compelling.
The problem is that things mostly trade rich, because they don’t have much value. CDS, contrary to popular opinion, doesn’t typically have big payouts. It often trades tight because most companies don’t run into trouble.
It is exciting to spot trouble, huge amounts of money can be made getting short, but it isn’t easy. More often than not, companies wiggle out of trouble and it is easy to be bled to death on carry. I like being short, it can be a great strategy, but it isn’t easy.
That to me is one of the biggest problems in the market. Investors, many of whom have underperformed, and are all looking for the big kill to make up the year. Everyone is looking for that one trade that will result in stellar returns, and as far as I can tell, most have come to the conclusion that being short is that trade. As volatility (VIX) has collapsed and stocks have marched higher, many have continued to look at CDS and the credit markets as an ideal short. “It doesn’t cost much” and “can have a huge payoff” is the rationale. To a large extent that is true, but so far it hasn’t worked.
Being Short Europe Hasn’t Worked Well
MAIN is the European investment grade CDS index. Many were short hoping sovereign problems would lead to widespread credit panic. Yet it hasn’t. In fact most sales of protection this year are in the money. It has by and large been a better strategy to sell protection, and the only trades that have worked were basically ones done at the height of LTRO2 frenzy and the whale trade.
Carry on that trade will be worth about 25 bps over the course of the year. The roll down also mitigates the cost of being wrong. For all the hype about Europe, being short generic investment grade credit, while exciting at times, hasn’t been a consistent money making strategy and looks nothing like the “big short” returns people have been hoping for.
Even Being Short Spanish Debt Hasn’t Been Great
Had you chosen to be short Spain, you would think you would have great returns. Spain has defined the struggle for Europe this year. Short Spain has had more periods where you could have made money than shorting Main, but even the 5 year Spanish bond has been surprisingly resilient. Had you gotten short at the highs (102) and covered near the lows (88) you would have had a very nice return. Not a “big short” type return, but a good one nonetheless. But that highlights another key part of the “big short” that no one likes to talk about. Conviction.
Paulson In Particular Was Convinced His Trade Was Right
I don’t know exactly what went on in his mind during 2007 and 2008, but my experience with him as a trading counterparty (I was a CDS index market maker during that fun time) and his monthly returns give some insight. His returns were NOT steady. I don’t have the exact numbers in front of me, and am going by recollection, but he had some pretty bad months. There was at least one month where he was down 5% on the big short trade and at least one or two other months with decent sized losses. Losses that many managers today wouldn’t stomach.
The trade worked because he stuck with it. He didn’t care about his monthly returns. He had a view and turned out to be correct. The fund management business has changed so much since then, that I don’t think many managers will tolerate swings like that, so rather than making the “big short” they make some “small shorts” and then get topped and turned enough that they don’t even keep all of those gains.
The “big short” required a level of conviction that most funds just don’t have the luxury of having now, or don’t think they have the luxury of having.
If The Big Short is so Easy, Who Killed it on Greece in 2011?
Greece, in a period of less than 2 years did almost as poorly as sub-prime. These bonds were issued in March 2010. They traded at par. By the end of 2011, they were trading at 22. Greek 5 year CDS went from 250 bps to over 70 points up front during that time. Again, not quite “big short” type numbers, but where were all the killer years?
This was almost a repeat of the big short, yet, where are the 200% returns from that year? No one seemed to truly believe that Greece would go? Very few people rode it all the way down? For all the talk of the big short, we had a great opportunity and yet most missed it.
Where Does That Leave Us?
Over the past two weeks I have vacillated between being long and short. For a period of time I had remained steadfast in my conviction that Spain, Italy, Banks, JPM, CDS, and high yield were all going tighter. I even liked the S&P 500. Since then I have flip flopped. My timing hasn’t been bad, and I got back to being long, in large part, because the market felt too bearish.
But I think it isn’t that the market is overly bearish, but that the market is set up to kill it on a bearish trade. I’m having a horrible time expressing my thoughts, but it seems to me that most people would benefit from a big move down. That everyone sees upside as limited and downside as unlimited. That there is a “big short” trade in the market. That is why I have had so much trouble reconciling very bits of data and various conversations.
It isn’t that everyone is bearish, but people have far more lottery ticket type short trades on. That is why I don’t think we see it any time soon. So I remain long. I am small, and will change the view is something new happens, but I think we continue to grind higher, probably on low volumes, with limited volatility.
The entire market seems sure that volatility and volumes will pick up in September. They probably will, but this August was extremely slow even for August. Is that the “new normal”? That volatility and volumes will remain low? That algos have less opportunity to trade, causing less volatility? That central bankers charm the markets with words to prop it up just enough, and they do it so frequently that bears struggle to gain momentum?
The consensus has a way of typically failing, and if everyone, and I mean everyone, is convinced volumes and volatility will pick up in September, then we may not see that. And if we don’t get that, the “big short” will be a horrible strategy and will slowly bleed people out of positions.
I think there are a lot of “tourists” in the CDS market, all with visions of 2007 Paulson-like returns, and I think they will be disappointed and they need to be sucked out before we can see a more meaningful sell-off (and I too still own some puts, that I’m thinking I should maybe just punt out while I haven’t lost much on them).