Perspectives from a trader through these vicious times...

[Lucky Luciano]

(edited for privacy concerns proud patriot-moderator Democratic Underground)

Well, this has been a hairy couple of weeks to say the least...Like a big game of whack-a-mole. One problems comes up, you try to smash it, and out comes another one...

This is written as thoughts pop into my head. So it is disroganized and a bit rambly....much like trading this past week. I also did not proofread it, so I may look illiterate at times. I just wanted to make sure I wrote something that I could look back on some day to make sure I remember these days.

I have included some fun Bloomberg charts and emails for illustration.

My personality: Extremophile.

Skip to just below the line of ******** after the fourth paragraph to get past my personal life BS and go straight to the Wall St stuff.

Just a little background on myself. I had been lazy much of my life. In fact I went to grad school for mathematics and completed a PhD at (edited) because it meant that I could spend time never getting up early (read: get up at noon) as I took my time to fulfill my academic obligations working just a few hours per day after I finished the first year courses. Of course, I have some expensive tastes such as sushi, a little bit of partying, and exotic world travel (nothing material though). Lo and behold, I found myself in incredible debt upon graduation ($70K on the CCs and $60K in student loans). I was not worried as I felt I was guaranteed to succeed.

It was six months before I defended my dissertation on (edited) theories that I joined DU outraged by the fuck-up in chief - what a fucking muppet that guy is! Well, I never made a resume in my life (Only income I ever earned was from tutoring the kids in (edited) and being a TA for math classes) and I had never had an internship anywhere let alone an I-Bank. I thought my math PhD was my free entry pass. It was not. I had to learn more applied math and C++ to be thought of as a viable candidate as they expect this from PhDs that they hire. So I spent six months after I graduated learning that stuff. After a lot of disappointments (Toughest time in my life actually), I did not get discouraged as I do have the attitude of being invincible and impossible to defeat...but my CC debt increased to 90K. I was "All-In" as they say in poker. I would be a trader or a bankrupt disgrace.

Finally, someone took a liking to me on a quantitativae analyst desk, but only as a temp. They paid me $52 per hour plus overtime - I worked 80 hours a week to pay off that fucking debt. This worked for ten months. I did not want to be a quant - I wanted to be a trader. I wanted to be in the trenches battling and taking risks - not programming and being the nerd. Finally, in July of 2006, I was hired full time on our proprietary trading desk building trading models and trading them (MUCH BETTER!) and had health insurance for the first time in 3 years. I would be paid $110K plus a bonus. During my temp work, I was paid twice as much per week, but long term this would be much better as bonuses are astronomical in this business. Seven months later I got a $200K bonus of which $50K came in stock that had to vest over three years. The big boss probably got $10 to $20MM in bonus. He made a fantastically well calculated play and his personal PnLof over $200MM was realized too - not some illiquid shit with a favorable mark that got many their big bonuses.

Then 2007 came. Our desk did much worse (The big guy left to start a hedge fund and a new guy was in charge - he is competent, but the landscape had changed). In 2006 we made $350MM for the bank, but in 2007 we only squeaked out a small gain. My bonus was only $60K, which sounds great to many, but I live in Manhattan and pay $3,300 per month in rent for a 550 sq foot one bedroom! It is expensive here - and one must not forget that a second year employee expects to get paid at least as much as they did in their first year. The more senior guys have much more volatile bonuses - going from large to small to large to very large depending on their masive PnLs. This year I may get no bonus at all. Our desk is down small - so we are outperforming others by a huge amount as they are down big, but that does not help my bonus which could be zero...might be time to move to Queens - if I still have a job. How depressing.

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The weeks before Lehman went bust were volatile for Lehman's stock and not in a good way. LEH was behaving a lot like Bear's stock was behaving before it got crushed and sold to JPM at firesale prices. Investors knew that if Lehman did not sell its prized asset management division (Neuberger Berman was worht $10B by most) to someone, they were fucked. LEH was $16 when we decided to buy 3,000 Oct $10 puts for $0.77 (We risked $231K = 300K * 0.77 in capital as that gives us the right to sell 300,000 shares of LEH for $10 before the third Friday in October). The options market implied there was a 7.5% chance that LEH would go to less than $0.20 per share. We felt there was at least a 25% chance that they went bankrupt. Sounds like a fantastic bet with great odds in our favor. Unfortunately, we were right. We made $2.7MM on the options trade, but lost elsewhere.

On the Friday before the fateful weekend when Lehman ended, the stock was around $3 per share, but people thought a bailout at the last second would occur, so people were afraid to be super bearish and afraid to short stocks, lest they have their faces ripped off by a bailout that would cause the market to rally huge.

On Sunday I drove upstate with my dog (a beautiful pit mix!) to Minnewaska State Park to hike in what I consider the absolute most beautiful area of New York State. Beautiful vistas adorn and blanket the area. I love that place. I had my cell phone in my pocket to keep track of the time (or my g/f would be furious if I was late for dinner!) as I did not expect any reception. Strangely, at a very remote spot in the park, my phone rang. It was my boss. He said, "I am not sure if you have heard, but it is looking like Lehman is well and truly fucked. You might want to get in at 5:45am (usually it is 6:45) so we can all go over this and also help go through the CDS contracts that we have with Lehman." Since LEH traded CDS with our desk that was now null and void, it cost our desk about $5MM - a relatively small number because we are primarily an equities desk that only occasionally trades CDS.

Oh boy...it was really happening. This is not a test. This is the real deal. Not like Bear Stearns. This would be the real deal. Fannie and Freddie had already been effectively nationalized with the government raking 80% stakes in the businesses after a close look at their books revealed some shenanigans. Who was next? I was wondering. They will likely target Merrill next as they are the next weakest I-Bank. When I got home from the park, I saw that Bannk of America had struck a deal with MER - good move. MER would have been next for sure. The Grim Reaper was coming. The four horseman of the apocalypse were LEH, AIG, WM (WaMu), and the GSEs (Fannie and Freddie). They already got the GSEs and LEH. Next up was AIG with Merrill protected by BAC. AIG had gotten mixed up in the mortgage mess with some shitty SIVs and the sellers, many of whom were short, were pounding the fuck out of them. AIG did not raise enough capital to protect themselves from a ratings downgrade. If they got downgraded, then their positions would require billions more in collateral which they did not have. The downgrade was coming. There was nothing that could be done to save the shareholders. Brokers telling me that they are hearing about a 50 million share block for sale out on the street. The street is dumping. The death is coming. Here is a 30 days trading chart of AIG:



On Tuesday 1.2 billion shares of AIG traded out of a possible float of 2.4B. Insane. Insane. The next day, the US government announced a rescue package requiring $85B in loans to AIG that would have a coupon of 8.50% + LIBOR and an 80% equity stake in the company through warrants. The shareholders were obliterated, but AIG's counterparties and debtholders were temporarily given a stay of execution. AIG defaulting on their counterparties would have obliterated the financial system. There would be no lending of money anywhere. Basically, you were alright if you were living on a commune and required little from the outside world, but ex-that you were going to be hurt by this in a major way...it is a damn good thing that AIG was backstopped. The alternative was so much worse.



This is the top holder's list for AIG. Look at those guys that got fucked in the last capital raise where they paid roughly $40 per share for many millions of shares that are down over 90%. Look at Maurice "Hank" Greenberg - a former billionaire through his personal holdings and percentage ownership in Starr. Look how the US Government is the number one shareholder now. Wow. Crushed.

So, AIG was now dead and old news. The Grim Reaper was on the prowl though. Since everyone is afraid to lend to anyone - no matter how good they had been in the past, overnight funding rates skyrocketed. If this became a permanent development, no investment bank could withstand the oncoming destruction. As good as Goldman had been, if their short term funding were to be cut off, they were doomed. Even mighty Goldman was about to go down. How could this be? WTF! With short term funding very much in doubt, the sellers and the shorts pounded the fuck out of GS and MS (morgan Stanley). They were correct to do this given the news of the day. The shorts are often the best police of the stock market and offer a check on the financial system as well as additional liquidity from their selling and buying. Below are charts on MS and GS (GS had been $160 the week before the Reaper arrived!):




This was absolute madness. I was doing my best to protect our positions. I trade for others in addition to myself. Many others do a lot of analysis and ask me to put on trades. One guy whow was trading in one of his stock saw it plummet by 80% in one day - the stock was trading at 20% of book value (an insurance company that I will not name).

"Hey Lucky (me), what the fuck is going on with XYZ? Why the fuck is down so much?"
I stand up and shout across the room, "I don't know. They are after all things financial. They are crushing everyone. it is indiscrimate. Could be a forced liquidation of a hedge fund. There is no rhyme or reason to this. Let me call around."

I called all my brokers and none of them had any good color. Hard to get color sometimes because so many people trade in the machines and you cannot find out if it is one large seller puking the stock or if there is some fundamental problem causing the destruction that is not yet out there. My guy had 800K shares of this stock at $15. It went down to $3.50 on Thursday at 1:00pm. We were crushed. Selling it would make no point. We had finally got through to the management who said they were going to defend themselves and that their liquidity was fine. They had plenty of capital. We bought 300,000 shares just under $4 per share. The market turned drastically at midday on Thursday as talk of a bailout plan was spoken of. We bought a total of 1MM shares for $5.62 and the stock closed at $9 or so. Good trading, but we were still sideswiped and dizzy - and net down on the day from all the other crap that was happening.

Also on Thursday we continued to see the meltdown in Goldman and Morgan Stanley, but a new problem came up. The Reserve Primary Fund, a money market fund had "Broken The Buck." Money market funds are not supposed to lose money, but this one did because of its exposure to Lehman's commercial paper. This was serious. State Street (STT) and Federated (FII) have large money market funds. If one fund had broken the buck, then maybe others have as well. A panic developed and people started crushing STT and FII. These were very stable companies (although STT did have to raise $3B in capital due to a bad SIV, but they were otherwise fine), especially FII. The sellers came in relentlessly as panic set in and fear of money market redemptions gripped the markets. Lightning struck!!! (STT and FII charts for the week of Sep 15 below):




It was really getting out of control. It felt like the market was going to zero. The stock for my company was down 40% on the week. We were famous for having made some spectacular writedowns as well, but we had a huge deposit base of cash and had already raise $28B in capital with only a small bit of writedowns left to make. I thought we were safe-ish. Our stock was getting creamed. One asshole analyst had put out a note that we would lose $4B from our Lehman counterparty exposure. That was false - it is roughly $300MM. Others defended us...but not before one guy on our desk whom I like a lot, sold $2MM of his personal stock in a panic. I wish he had come to me before doing that because I saw that our CDS was "only" 350 bps for a five year contract. Goldman was out at 700 bps and Morgan Stanley was out at 20 points up front plus 500 bps!!! FAR FAR FAR FAR FAR worse (I will explain if asked why). That our CDS was only 350 bps gave me some solace, but even I was getting nervous....I am usually too cool to get nervous. By contrast, our CDS was about 7 bps during the good times. In other words, during the good times, it would only cost $7,000 per year to insure $10MM of our debt for each year of a five year contract. Now that had grown to $350K per year. The US Government Sovereign Debt even has a CDS. Someone showed me a bid of 22 bps! HOLY SHIT! So, my bank two years ago was a better credit than the US Fucking Goverment is today. That is bad news. Very fucking bad news. Of course, selling USA Sovereign CDS is a lot like selling asteroid insurance. If the US defaults, then all banks are out of business and all central banks are crushed...to the barter system we go! I hope we all like being cavemen! A CDS quote for MS and GS on Sep 17:



Ok....so now it looks like a rescue plan is being considered....but what came next was shocking! The SEC banned shortselling of financial stocks. Ohhhhhhh fuck! Now they are changing the rules in the middle of the game in a big way. Futures were up 3% by 9pm on Thursday. Oh boy. Right when people have capitulated on owning any financial long and have gotten deeply short, the government goes and pulls this stunt! The mother of all short squeezes was coming. It would be violent and unreal. The market was going to absolutely rip higher.

My boss calls at 3:00am and says we need to get in super early - it will be out of control. He was right. There was nowhere to go but up. Nobody but the most dedicated short wanted to stay short (Such a person would likely have a huge position and know they are fundamentally correct - and could ride out the storm). If you did not buy back your short, then the other guy might do it before you driving the price higher. The panic buying began premarket. Millions of shares were trading in the premarket to get out of shorts that would be smoked. By 8:45 or so, the S&P futures were limit up. Futures were not allowed to go up by more than 65 points premarket - that limit was at 1268 for the S&P 500. I don't know the last time that occurred. The bidding interest developed. I saw on my futures trading platform that there were 15,000 e-mini contracts (Each of which represents 50 shares of the S&P 500 or roughly $60K per contract) being bid for by 9:30 - the futures would reopen once the market officially opened at 9:30.

BANG! They opened the futures up at 9:30 with the futures having a high print of 1291 because of all the market orders and lack of sellers sitting in the system waiting desperately to get their fills. The market quickly traced to 1260...and got to a low of 1240 or so and stabilized - it was still up a lot. The day would close with the market up about 4% - a ripping up day. We did well because of that 1MM share purchase mentioned previously - it was on the restircted list and was up about 60% on the day. Still well below book value of the company though and frustrating us. Futures chart - note that futures trade almost for all but 45 minutes a day from Sunday at 6:00 to Friday at 4:15. They do not trade from 4:15 to 4:30 and 5:30 to 6:00pm:



As unreal as all this was, let us remember some things. We still have not had nearly the number of bank failures that we had in 1991. They are coming. The bailout package is not exactly going to be free money. It will prevent chain reaction of bad bank failures from crushing good banks. Sorry to say it, but all but those living on a commune want some kind of rescue to happen whether they know it or not. There will be more failures - WM failed yesterday and was seized by the FDIC, but their assets were protected by JPM who scooped them up at fire sale prices - a great move. JPM took a big write down on WM's bad assets which can be considered the cost of the purchase - which greatly increases JPM's capital - not to mention that they raised $10B in capital by selling their shares to insitutions yesterday (Goldman did it too as did Capital One). Might as well while the short sale rules are in effect. I expect a lot more financial institutions to raise dilutive capital while these rules are in effect. Now or never - no matter what the Treasury does. All banks would prefer to participate minimally in any government bailout especially if executive compensation limits are imposed. Raising capital would be better.

Note also that since the FDIC did not have to use any of their insurance money because JPM protected the assets at WM, the FDIC has a lot more bullets. Another good things is that the FDIC fucked up a little with IndyMac's failure. When they seized IndyMac they started Indy's bad loans at firesale prices causing any and all bidders for mortgage assets to back away lest they get runover! This caused the value of mortgage asets to get marked down viciously further! With JPM stepping in and preventing such firesales, marks don't have to come lower for the other banks. A good thing.

Another interesting thing is the VIX. This is the volatility index. Volatility, intuitively is the lognormal standard deviation of annualized returns for stocks (or whatever asset is being considered). The higher the standard deviation, the more volatile and risky. The options market (puts and calls and more exotic instruments) are priced using volatility. The more volatile a stock is, the more expensive a put or call should be. The options are like insurance and riskier insurance should be more expensive is one way to look at it. Options are priced using six variables. The time to expiration, the strike price, Price of the underlying, dividends, interest rates, and volatility. Volatility is hard to quantify though because past vol is not future vol. Divs and interest rates are not perfectly predictable either, but the option prices are usually less sensitive to these variables. Volatility, on the other hand is very hard to predict, so when pricing an option, it is hard to know what vol to use. Often times, people just take the price of an option and find the vol that would give that price. That is called the implied volatility of the option. The VIX in some sense is the average implied volatility of an option of the S&P 500 index (it is a little more complicated than that, but is good enough for illustrative purposes).

During the good times, the VIX was super low near 10! That is amazingly low! During such times, the markets typically go up in small increments. A very high VIX during a bull market, to me, is a sign of a bubble economy - see 1999-2000 VIX numbers. Anything around 14-16 is average. 10 is very very fucking low and over 20 is definitely high. 30 occurs during times of danger when people start to panic. A VIX of 40 is full blown panic. We did get to a VIX of 42 on Thursday September 17 just before the market popped midday on talk of a bailout.

The VIX has been higher than 42 three times in the last ten years. The first time was during the Asian financial crisis of 1998 that severely threatened global markets until the IMF intervened and lent money in a most predatory fashion. The second time was right after September 11, 2001. The third time was during the crisis of corporate fraud that infected Wall St during 2002. I think the current crisis dwarves all those three other crises and yet the VIX has only reached 42. I think we reach unprecedented levels - possibly around 55 before sanity returns. After a bailout happens (it will - and believe me, it needs to happen), there will be some respite and the VIX will probably return to 25 or so....then Wachovia or someone like that might fail...and maybe Wells Fargo will sccop them up or something (incidentally, WFC made a record high on Sep 18th - pretty fucking amazing for a financial company to be at a record high through this mess)...after that the failures will come in a big way and there will be no bidders. Maybe some bad banks will all join forces at the same time like the crazy merger mania for banks in Japan during their calamitous 1990s. My girlfriend is from Japan and told me stories of four banks merging together at the same time to avoid total collapse of the system.

Here is a chart of the VIX for the last 30 trading days:



As you can see, the VIX has been well above 30 for most of the last two weeks. Very scary times indeed. Also, you can see that VIX, in and of itself, is an extremely volatile index. People would say that the "Vol of Vol" is quite high. You can also trade options on the VIX for which you need to estimate the Vol of Vol to price the option. Here is a very bearish trade one of my options brokers sent to me:



The customer bought 15,000 VIX 50 strike calls (each contract is multiplied by 100). A VIX over 50 truly is armageddon. Someone placed a very large bet there that something very bad was going to happen. The 11/50 C means November 50 strike calls. The customer makes $1.5MM for each point that the VIX goes over 50. I don't know how much they paid for that option though, so the breakeven is not clear.

Here is a VIX chart from 1998 to the end of 2006:



You can see the 1998 crisis that gripped Asia (Russia also defaulted during this timeand Long Term Capital Management went down as well). You can see the VIX was high during the Dot Com bubble. Often in the 20-25 range - that is a very high VIX for an upmarket - sign of a bubble like I was saying. Buying puts was expensive because options traders know that what goes up quickly can also come down very quickly. You can see how the VIX gapped higher after Sep 11 and how high it was during the awful 2002 when corporate fraud scandals gripped Wall St. Once that settled, the market moved steadily higher on lower and lower vol. There was that hiccough you can see when Delphi filed for bankruptcy and Kirk kerkorian started rattling his sword in the auto secor in May 2005....but that only pushed the VIX to 23 or so - which was considered very high! The VIX got under 10 sporadically during this time and the options guys were quite bored.....

UNTIL!

Here is a VIX chart for 2007 to today which also has better intraday lines so you can see true highs and lows - not just a chart of closing VIX levels:



You can see how at the beginning of 2007, things were moving along rather swimmingly with a very low VIX. Then at the February - a major hiccough. China's market was down over 8% in one day and New Century, a subprime lender, looked like they were about to file bankruptcy. Subprime had entered the lexicon in a major way. I was amazed to watch the VIX go over 20 in such a short time. It was kind of exciting and interesting. The VIX retreated from there to 15 or so...not back to 10. People knew things were not quite right anymore, but the alarm bells were not flashing like they should have been. Then, August of 2007 those alarm bells went blasting off pretty fucking loud and things got scary as this "subprime" mess started to cause huge writedowns at the big banks and I-Banks. People got scared. Leverage buyouts immediately stopped as people needed debt for that and nobody wanted to lend money for such risky ventures. Countrywide led much of that scare. The VIX got to 36 very briefly and immediately retreated to the 20-26 range for most of the year. VIX below 20 now seems cheap. Some actions from the Fed did give a false sense of relief by the end of Sep 2007 that pushed the VIX below 20 again and the market to a record high for reasons that are not clear to me - morons were psuhing the market higher. I couldn't believe people were not more bearish.

The fourth quarter brought more writedowns and the market continued to be skittish. Just before Christmas, many people went on vacations (much needed) and the VIX came in again to cheap sub-20 levels. In January there were more big concerns and there was martin Luther King Day when Europe got absolutely hammered due to the subprime issues (but also because of a rogue trader at Soc Gen that forced a HUGE unwind with billions of notional that crushed the market). The Fed quickly intervened and cut rates 50 bps ot support the market. That was the VIX back out over 35, but it was very brief as these forays over 30 tend to be. The next time the VIX got over 30 was the Bear Stearns collapse on March 17 - and that brief as well as the market rallied from there. The S&P 500 actually got to 1440 after that as people thought that the Bear Stearns debacle was a sign of the bottom. The VIX came screaming in to 16. I was sure the VIX was a buy (by buying options - cheap puts sounded good to me), but I am too junior to put that trade on in size. Wish I could have. Now it was oil that was crushing the markets running to $147 per barrel at one time. That and the threat of more writedowns dominated the bearishness, but it was mostly oil now. When oil's price peaked in mid July the VIX corssed 30 again.

Then oil collapsed as all bubbles do and the market recovered some of its luster..and the VIX came in to 18ish near the end of August. I remembered saying, "Wow, the VIX is 18!" A senior trader on the desk who does not know options well asks what I think and I say, "It is a fucking buy. That is super cheap." No way I would get discretion for that as I have 250 million other things to watch let alone such a vol bet. I have to trade all the stock for all the PMs and watch all the news for all the stocks, field all of our phone calls from our 20 brokers, call our brokers very proactively when one of our stock in our massive portfolio moves aggressively without clear explanation...I do this with one other guy as a servies to the 20 others on our desk...and the one other guy and myself also manage our own shit...I am simply too junior to say that we should buy vol now - it is fucking cheap, but it was....As we now can see that in just a few weeks from that time, LEH, AIG, WM, FNM, FRE no longer exist in the prior forms. MER is to be swallowed. GS and MS have become bank holding companies, which will force their leverage and profits down...but the risks will go down too. The bailout package is not done, shortselling is severely resticted (fucking retarded - shortsellers provide liquidity - they may sell to you when you want to buy! Now it is hard to buy and sell in size without having significant market impact! Short sellers are also future buyers - and now I cannot sell to short that is buying back!), and uncertainty looms. This is the longest time I have seen the VIX over 30. Two weeks over 30 is crazy. It usually only lasts for a couple days, but this may last longer. Once a bailout is approved it will no doubt come back into the 20s for a brief respite, but it will come back into the 30s again. I am sure of it. A bailout will not mean we are out of the woods.

The economy sucks. People are unemployed. Oil and other commodities are still fucking expensive. Housing prices have not bottomed. Shit is still twisting in the fan.

It will take a few years to recover. Hopefully, when this mess is over, I can go back to collecting good bonuses - the kinds that grow exponentially from year to year during hte profitable times. I want to have $20MM in cash and a nice house/apartment in 10-12 years. I make no apologies for that. I like what I do, but would quit so I do not have to get up super early and do it every freaking day. Perhaps some consulting work and college teaching would suffice. I would ultimately use my excess spare time for adventure travel - it is my passion. In December I will explore the glaciers of Patagonia in Argentina and Chile. I will love it. I will just need the will to return to work!

I know we live in interesting times. May it not be a curse!