More on the literal Bernanke put | FT Alphaville

More on the literal Bernanke put

Central banks using options as a monetary policy tool — crazy, right?

But there’s history here. The Bank of Spain reportedly sold put options on the peseta to fight devaluation pressures back in the ERM crisis days of 1993, though it denied this emphatically at the time.

And in late 2008, struggling with the subprime-sparked financial crisis, US Treasury secretary Timothy Geithner floated the idea of “issuing derivatives correlated with the performance of an existing index of mortgage-related credit.” And specifically, selling put options on the infamous ABX, which consists of baskets of CDS tied to subprime mortgages and to which a number of bank portfolios were tied. Doing so, the Treasury said, would allow “institutions to hedge their exposure to aggregate risk.”

And of course, back in 2003, the Federal Reserve talked of using derivatives as a way to influence yields on long-term US Treasuries, one of the original goals of quantitative easing. That idea is currently the talk of the (admittedly conspiratorial) blogosphere — especially the idea that the US central bank could be selling put options on USTs at strike prices matching their yield target. The literal Bernanke put.

What are we talking about here exactly?

The basic idea here is that the Fed, by selling those puts, comforts a US Treasury market increasingly nervous about rising interest rates, the end of QE2, US debt dynamics or whatever. These are American-style put options conferring the right, but not the obligation, to sell a given quantity of the underlying asset at a certain price. So they act almost like portfolio insurance in this particular case.

According to Eric deCarbonnel at MarketSkeptics, put options on US Treasuries are incredibly cheap at the moment and financial advisers are recommending them to their clients as a hedge. At the same time, he argues, these cheap put options make USTs look safe to investors — driving down yields.

Meanwhile, he says, the Fed is creating a new class of investors — those who buy US Treasuries and speculatively bet against them with put options. This, says deCarbonnel, is one of the lesser-known nuances of Nassim ‘Black Swan’ Taleb’s well-known shorting of US Treasuries strategy.

The central bank of volatility?

Even without selling specific put options — and remember it’s just conjecture at this point — we know the US central bank has been selling volatility through its existing unconventional monetary policy. It’s the original Bernanke put — not the literal (US Treasury) one. As Artemis Capital Management has described it, you effectively put a floor underneath equity prices that works similarly to an equity put option.

Here’s some more detail from Artemis:

In theory the Federal Reserve is now the largest volatility trader in the world because current monetary policy is akin to shorting massive amounts of volatility and assuming tail risk. The current regime of monetary and fiscal stimulus is similar to writing a naked put on the entire financial system with margin backed by the US debt. The premium received from the sale of the naked put is financed via demand for our debt and redistributed to the investor class to re-flate underlying asset prices and depress volatility. The theory is that the reinvestment of this premium by investors into underling risk assets ensures the Fed’s naked put is never exercised. In effect, the Federal Reserve is constantly shorting vega on a systematic level. This stimulus regime socializes “tail risk” to generate short-term prosperity. If asset prices drop the Fed is forced to sell more volatility to artificially support prices.

What should be clear is the trade only works so long as asset prices don’t fall too far and so long as the Fed enjoys an essentially unending (US Treasury) bankroll. If something goes wrong, well… Just remember this is effectively a naked (read: unlimited) put on low volatility. The Fed is ‘massively’ short volatility.

That, incidentally, is also the trade that buried Long-Term Capital Management back in 1998. As Pablo Triana has recounted, LTCM believed that shorting (implied) volatility at 22 per cent was a bargain because historical (realised) volatility had been around 15 per cent. Once long-dated implied equity volatility did rise to huge levels (mostly on new supply/demand dynamics) LTCM was killed.

Kind of fitting, then, that the term ‘Bernanke put’  is a play on the ‘Greenspan put’ first coined in the 1990s in reference to the Alan Greenspan-headed central bank’s response to the LTCM crisis.

From selling volatility to selling options?

If selling volatility can be associated with the blow-up of LTCM, then selling put options can be likened to the collapse of AIG — and indeed, some bloggers have already made this analogy. AIG underwrote CDS on mortgage products, enabling banks to load up on junky bonds safe in the knowledge of their portfolio ‘insurance’. Once the tide turned, however, AIG was caught on the wrong side with almost no limit to its potential downside. And, as we all know now, in late 2008 it had to be bailed-out by the Fed.

It was a thought not missed back in 2003, when the Fed’s Dino Kos mulled over the measure — noting that “a successful program would be one in which any options sold would never be exercised.”

And again — there’s no proof as yet that the Fed has been writing options.

Not so, however, for effectively selling volatility. There the Fed’s role is becoming increasingly recognised, and volatility buyers have been happy to take advantage of it. The problem is what happens should enough inflation appear to force the Fed to increase rates, or if its role is suddenly curtailed.

And of course, in the meantime, we’re left with all the effects of ‘moderated’ volatility.

Here’s Deutsche Bank making recommendations to its clients back in September:

By committing to range-bound rates the Fed is reducing realized volatility and putting pressure on gamma (Fed put). In our recent publications we have argued that this free put (i.e. short in high strike gamma payers) could be used to finance positioning for transfer of risks across different market sectors or time horizons. In particular, the effects of this type of policy implementation would be manifested through decline in rates vol and its transfer to FX market, a potential pickup in risky assets if the economy responds positively to the stimulus, and higher inflation in the future.

Related links:
The Great Vega Short – Artemis Capital
The risks and rewards of selling volatility – Atlanta Fed research
CDS index option multiplies along with questions – FT Alphaville
Synthetic junk (or, irrational exuberance, the sequel) – FT Alphaville