But February passed, and March passed, and April rolled in, and the gap between the price of CDX IG 9 and what the hedge fund traders thought it should be grew. And their bosses asked them questions, like: "Shouldn't this trade have converged by now?" "Have you missed something?" "How much longer do you want to tie up our risk-bearing capacity here?" "Isn't it time to liquidate--albeit at a loss?"
So the hedge fund traders began asking who their counterparty was. It seemed that they all had the same counterparty. And so they began calling their counterparty "the London Whale". They kept buying. And the London Whale kept selling. And so they had no opportunity to even begin to liquidate their positions and their mark-to-market losses grew, and the risk they had exposed their firms to grew.
So they got annoyed.
And they went public, hoping that they could induce the bosses of the London Whale to force him to unwind his possession, in which case they would profit immensely not just when the value of CDX IG 9 returned to its fundamental but by price pressure as the London Whale had to find people to transact with. And so we had 'London Whale' Rattles Debt Market, and similar stories
The London Whale was Bruno Iksil. He had been losing, and rolling double or nothing, and losing again for months. His boss, Ina Drew, took a look at his positions. They found they had a choice: they could hold the portfolio and thus go all-in, or they could fold. They could hold CDX IG 9 until maturity--make a fortune if a fewer-than-expected number of its 125 companies went bankrupt, and lose J.P. Morgan Chase entirely to bankruptcy if more did. Or they could take their $6 billion loss and go home. They could either take their losses, or sing "Luck, Be a Lady Tonight!" and bet J.P. Morgan Chase on a single crapshoot. After all, what could they do if the bet went wrong and they had to eat losses at maturity? J.P. Morgan Chase couldn't print money. So Drew stood Iksil down, and the hedge fund traders had their happy ending.
In late 2008, the Treasury bond went haywire. The interest rate on the Ten Year Nominal Treasury bond fell to 2.1% in the panic--clearly overpriced. In the late 1990s with the debt-to-annual-GDP ratio on the decline the Treasury bond had traded between 5% and 7%. In the 2000s with a weak economy the Treasury bond had traded between 4% and 5%. With the Federal debt exploding even faster than it had around 1990, it seemed to hedge fund traders very clear that the long-term fundamental value of the Ten-Year Treasury bond probably carried an interest rate of 7%, or more--and was at the very least more than 5%. So smart hedge fund traders shorted Treasuries, and waited for the Treasury Bond to return to its fundamental value.
And they ran into the widowmaker.
So they scrambled around, wondering: "Why did the interest rate on the Ten-Year Treasury peak at 4%? And why has it gone down since then? And why won't it go back to its 5%-7% fundamental." And they looked around. And they found Ben Bernanke:
The Washington Super-Whale.
He had printed-up reserve deposits, and used them to buy Treasury Bonds, and in so doing, they thought, had pushed the price of Treasuries up well beyond their fundamentals. Yet rather than easing off, taking his lumps, and letting the market "clear" he kept buying and buying and buying and buying, leaving the hedge fund traders with larger and larger and larger short positions in Treasuries that had to be carried at a loss. And every year that they carry those positions is a -2% times the size of the long leg negative entry in their cash flow.
Bruno Iksil, they thought, had been pulled up short by his boss Ina Drew's unwillingness to bet the firm and risk bankruptcy. Ben Bernanke, they thought, ought to have been pulled up short by his regard for financial stability--by his promise to keep inflation at its target, for the counterpart to J.P. Morgan Chase's bankruptcy and liquidation would be the national bankruptcy that is another episode of inflation like the 1970s. But Ben Bernanke wasn't pulled up short by the risk of inflation. He had no supervising CEO. And he dominated the Federal Open Market Committee.
But what Bernanke was doing, they thought, was as unprofessional as it would have been for Ina Drew to tell Bruno Iksil: "You turn out to have made a large directional bet that we can sell unhedged protection and profit? Let's see if you are right: let it ride!"
And so they went public with the Washington Super-Whale, as they had gone public with the London Whale. Perhaps somewhere out there was an equivalent of Jamie Dimon who could tell Bernanke that it was time to unwind the Federal Reserve's balance sheet now? Jeremy Stein, perhaps?
From my perspective, of course, the hedge fundies' analogy between the London Whale and the Washington Super-Whale is all wrong--the hedge fundies are thinking partial-equilibrium when they should be thinking general equilibrium. CDX IG 9 has a well-defined fundamental value: the payouts should each of the 125 companies go bankrupt times the chance that they will. What Bruno Iksil does does not affect that fundamental value. He can bet, and drive the price, but he cannot change the fundamental.
But the Washington Super-Whale is different.
by Brad DeLong | Read more:
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