With his valuation expertise rooted in derivatives, Ice Farm’s Michael Green, whose work has frequently graced this website in the past, has always been one step ahead of the market and built his career at Canyon Capital profiting from mispricing and arbitrage in CDS, which he believes are currently underpricing risk in today’s markets.
Just as the hedge fund community vastly overpaid for its CDS protection following the 2008 downturn, today in an interview with Real Vision TV, Green says it’s the other way around and suggests that the market is selling insurance over and over again without recognizing what they are actually selling, effectively paying more premium for doing the same thing.
Green, who founded ICE Farm Advisors in 2014, has had a unique approach for years. Starting out at Bain Capital, he fine-tuned his approach to modelling and valuation in small cap value stocks at the sharp end of the dot com cycle, initially turning down the opportunity to join Canyon in ’99. Seven years later he opened Canyon’s New York office, which he built from scratch to a $2 billion plus operation, focusing on macro expressed through derivatives.
Everything Flows Through Derivatives First
Outlining his perspective, Green said there’s a ton of academic research that’s come out in the past couple of years which validates this, but the one place you’d go to if you have knowledge to express your point of view, is the market that rewarded you for the accuracy and timeliness of your information. “Into the derivatives world you would go,” he said. “You’d buy calls instead of buying stock. And there’s a ton of empirical research that supports this idea, that information flows first into the derivatives market.”
Green said his initial approach focused on the idea that, instead of trying to value the derivatives based on an assumption of log normality in terms of the distribution of probabilistic outcomes, he would take the prices as a given and then compare that distribution to the historical empirical in order to try and understand where the market is expressing preferences. This method delivered some fascinating insights.
The Black Swan was Overcooked
If you rewind to 2008, Green believes all the signals from the derivatives market suggested that selling insurance was a sensible strategy. Nassim Taleb’s Black Swan is often cited as the catalyst for the shift towards ‘owning the tails’ but Green said in his view, people over-interpreted some of that and paid way too much for that insurance.
“If you look at 2007 when Taleb published The Black Swan, if you’d gone into the market and you tried to purchase a put option that paid out in the event that the S&P fell by 50% over the next two years, the market would have priced that somewhere around 5%, a 5% probability, which relative to the empirical, the historical distribution of about 4%, it was like 25% markup. And that’s pure profit for an investment bank that is underwriting those puts,” Green said.
“By the point that that market peaked in June of 2012, the probability that the market was placing on that 50% decline over the next two years had risen to 47%. And this is three years after the market had been rallying, 3 and 1/4 years after the March, 2009 lows that you were seeing this sort of pricing that exists in the market.”
This was simply a function of there being non-economic buyers of insurance, he said, while the ability to sell those derivatives had collapsed.
“One of the things I spent a lot of time writing about and communicating with investors, clients, is the idea that the world has now shifted completely in the opposite direction, that people are selling that insurance over and over and over again, not recognizing what they’re actually selling, and not necessarily conducting an evaluation of, are there cheaper ways to sell that– or more expensive ways to sell that same insurance, effectively capturing more premium for doing the same thing.
“And it’s become a market where in 2012 I would talk to people about the strategies. And I was, again, very fortunate that Canyon would allow me to do, selling this insurance and selling these puts. And we were generating fantastic returns. And probably the biggest benefit I provided to Canyon Partners was saying, don’t overpay for the insurance that everybody wants you to have in your portfolio.”
Hedge Funds Getting It Wrong
Back in 2009, Green said, every hedge fund on the planet had to show investors their book of hedges which were designed to prevent a repeat of the impact of the 2008 crash. “And this was happening in the context of a market that had already fallen by 50%, actually 60%. And they were just fantastically overvalued. People would be buying 9% yielding investment grade paper and think they were getting a fantastic deal, and then buying CDS protection or buying puts on the underlying equity that had an effective yield of, in some cases, as high as 50%,” he said.
“And it was just, it was an amazing, amazing time. And what I kept articulating was we should be selling the insurance and shorting the underlying securities. And by and large it was a great strategy. Today it’s the opposite. People are selling insurance on both sides. And honestly, the more frightening thing is they don’t know that they’re selling insurance.”