The sorry tale of a Wall Street gamble gone bad

March 1, 2018

Owen Hill examines an obscure corner of the Wall Street casino that may have played an outsized role in the global stock market turmoil of early February.

IN 2012, Seth Golden found the perfect trade. The one-time manager at a Target store left his job to become a day trader who specialized in "short-selling" an unusual commodity: fear.

Five years later, he had grown his net worth from $500,000 to $12 million and was getting ready to launch his own hedge fund, with investors putting $100 million on the table to back him.

Golden was just one of a large number of new investors betting against fear and winning big. But it was a matter of time before it began to come undone--and it happened when the stock market had its big downward lurches at the start of February.

THE MECHANICS of how one bets against fear could charitably be described as opaque--and uncharitably as utterly irrational and absurd.

At the center of all this is Chicago Board Option Exchange's Index of Volatility (CBOE and VIX for short). In the world of finance, an index is a number that measures something. The VIX was created in 1993 by the CBOE as a rough measurement of the volatility of the stock market--whether it's going up or down by a lot or a little.

Generally, the index moves in the opposite direction of the stock market: When investors get nervous and expect stocks to go down, the VIX rises--when they expect stocks to go up, the VIX falls.

While the process of generating the number is complicated, the index was harmless enough early on. Think of it as an overly complex and not very attractive weather vane. Sure, it's expensive and ugly, but it let you know which way the wind was blowing.

This changed in 2004, when the CBOE created a derivative of the VIX: VIX futures.

Pause for explanation here: A financial derivative is something that investors can buy and sell, whose value is based on the value of something else. Typically, the something else is an underlying security (like a stock) or a group of securities (like a stock index).

And here's where the story starts to go off the rails. The VIX itself is just a measurement--it can't be bought or sold. But a VIX future can be traded by investors as a bet on what that measurement will be at some future point.

In the pantheon of Wall Street absurdity, VIX futures carved out a unique niche of frivolity and uselessness.

Commodity futures at least have a tether to reality. They are a contract to buy or sell some amount of a commodity like wheat or iron or oil at some point in the future. There's gambling involved based on investors guessing whether the price for those commodities will be higher and lower in the future, and betting accordingly, but there's still an underlying real thing.

With VIX futures, there's no wheat or iron being sold, just an ugly and expensive weather vane and a bookie arranging bets on which direction it will point in the future.

ALL THIS was weird enough, but early on it wasn't a very big deal, since only a very limited circle of investors were allowed to place bets. This wasn't the kind of market where a former Target manager could make millions buying and selling at home on his laptop.

That changed in 2009 when the investment bank Barclays launched the iPath S&P 500 VIX Short-Term Futures ETN--or VXX. The "ETN" part at the end stands for "Exchange Traded Note," the name for this class of securities based on a market index.

ETNs aren't like stocks or bonds that have certain advantages if they're held for the long term. The prospectus for one group of ETNs launched by Credit Suisse reads: "The long-term expected value of your ETNs is zero. If you hold your ETNs as a long-term investment, it is likely that you will lose all or a substantial portion of your investment."

The reason for the inevitability of losses over time is that loss is built into the contracts. To return to our weather vane analogy, the bookie is taking a cut of each bet, so over time, the total value of what's being traded is going down. It's more complicated than this in practice, but you get the idea.

So how did someone like Golden make millions from a product whose value did nothing but fall? The answer: He shorted it.

"Shorting" is short for "short-selling," which is an investment strategy of selling a stock or bond or other security that you don't own, on the expectation that its price will fall, so you can later buy enough of the security to cover the earlier "sale," and keep the difference between the two prices as profit.

Thus, Golden "sold" shares of these investment vehicles whenever the price spiked, without actually having the shares in hand. He then waited until the price fell again, which it inevitably did, bought enough to cover the shorted shares and reaped the profits.

Golden's bet was twofold. First, he correctly recognized that the losses generated by the futures contracts would pull the price of these ETNs way down over the medium term. Second, he bet that market volatility itself generally tended downward. "The nature of volatility is that it desensitizes over time," he told the New York Times in 2017. "Which is why the index has been tracking down for so long."

Golden wasn't the only one making this bet. Shorting the VIX had become an increasingly common move by investment banks, hedge funds and retail day traders. "Yes, it's a crowded trade," Golden admitted in the same Times interview.

But just how much money was plunged into these futures wouldn't become clear until Golden's second bet proved very wrong--and market volatility started going back up.

ACCORDING TO the general consensus among financial analysts, volatility has returned to the stock market because of two main reasons.

First, the "threat of growing inflation"--we'll leave aside whether there actually is a threat of growing inflation, and the implicit assumption, even if there is, that it's bad for the economy when workers have more money to spend--raised the specter of the U.S. Federal Reserve increasing core interest rates at a faster rater than Wall Street expected.

This would bring to a close a nearly decade-long bonanza of cheap credit that has fed everything from a stock market bubble to a revival of the overheated real estate market from before the Great Recession.

Second, related to rising interest rates, but somewhat distinct, the return on U.S. Treasury bonds have climbed to the highest level since the Great Recession, making them a better investment in a period defined by low returns on capital.

These general concerns have been talked about in the financial press since mid-January, but the unease didn't trigger a major stock market plunge until a February 2 jobs report from the U.S. Bureau of Labor Statistics.

The report listed two developments that spooked investors: first, employers added 20,000 more jobs than expected in January; and second, wages grew by an annualized 2.9 percent, the largest gain since the Great Recession. Both of these factors seemed to confirm concerns about rising inflation, leading to the end of the era cheap money.

Of course, the irony shouldn't be lost on anyone who's been sold trickle-down economics their whole lives: When the "rising tide" finally started to lift workers' boats, Wall Street panicked.

And panic they did. The stock market selloff had begun during the week of Donald Trump's State of the Union address, but on February 5, Monday morning, it developed momentum at a terrifying pace, like a runaway train.

At one point on Monday, the Dow Jones index of stock prices had lost well over 5 percent of its total value in a matter of a few hours, before the market recovered somewhat before the end of the day. Even still, February 5 ended with the largest absolute drop in the history of the Dow, 1,175 points, and the 14th worst day of losses by percentage.

At its lowest point a few days later, the Dow had fallen 11 percent from its high, set back on January 26. The stock market has since gone back up, though by fits and starts, and it has only made back about half the loss.

BUT BACK to our story: If volatility was back on Wall Street, what happened to hedge fund managers like Golden, who had built a career out of always expecting it to fall? The short answer is that they lost their shirts--and their customers' shirts, too.

The poster child for the disaster was derivative created by Credit Suisse and known as XIV, which was designed to bet on the VIX going down through short-selling.

For most of the eight years since it was launched in 2010, this was a lucrative trade. The price of the fund grew from $11.04 a share to an all-time high of $145 a share on January 11.

But less then a month after hitting that record high, the XIV collapsed overnight--dropping $99 a share at the close of trading on February 5, to $7.35 a share at the opening bell the following morning.

Before the day was over, Credit Suisse announced that it would liquidate the XIV on February 20--with a final payout to shareholders of $6.04 a share. With a total of 15 million shares outstanding, this represents an evaporation of about $2.1 billion in the course of a night.

Credit Suisse's XIV was the most spectacular example, but it certainly wasn't the only one. It's difficult to tell how much money was wrapped up in ETNs and hedge funds that shorted VIX futures, but conservative estimates put the total value in the $10-$20 billion range before the collapse.

MSMBC's Jim Cramer, host of Mad Money, estimated that as much as half of the stock market plunge during the week of February 5 could have been traders selling stocks to cover short sales made with borrowed capital.

One academic paper by Vineer Bhansali and Lawrence Harris argues that the money at risk when other strategies around market volatility are taken into account could be as much as $1.5 trillion.

In other words, the crisis of this one obscure part of Wall Street could have caused a major financial crisis, not too far removed from the market meltdown of 2008 during the Great Recession.

SO WHAT lessons should we draw from this story?

First and foremost, the events of February underscore the absurdity and uselessness of the capitalist mode of production. That so many billions of dollars are wrapped up in betting on financial derivatives that are three times removed from the production of any tangible good or service is absurd.

Those dollars represent real social assets that could be used to confront climate change, provide health care or address any one of the many crises facing people around the globe.

A rational and humane system of social organization would use these resources for what people need. But under capitalism, not only are these resources wasted, but they have the potential to become the trigger for the next phase of economic crisis.

The second lesson we can draw from the events of February is that the economy is probably reaching the limits of its current phase of expansion. The diversion of larger and larger pools of capital into larger and larger speculative bubbles is the hallmark of the later stages of the capitalist boom-bust cycle, when the rush to realize a profit becomes ever more intense.

The same dynamic that drove Bitcoin and other crypto-currencies to unprecedented heights in the fall of 2017 was at work in the astronomical growth of XIV and other "volatility shorts."

It isn't clear whether the collapse of these derivatives will have a lasting impact. But we do know that when the next crisis comes, the trigger could very well be one of these speculative gambles--invented by Wall Street firms and traders whose only concern is making more money, not in an economy that serves human need in any way.

Wall Street traders jostle on the floor of the New York Stock Exchange
Wall Street traders jostle on the floor of the New York Stock Exchange (thetaxhaven | flickr)
Alan Maass contributed to this article.

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