Who REALLY Benefits from Volatility

Most articles on volatility, its genesis and characteristics, are quite scholarly yet fail to drive home a simple yet essential point: the key beneficiaries of volatility are those with liquidity and an understanding of value, plain and simple. I’m not talking about flow traders who want volatility so they can capture more bid/offer spreads, or position traders who swing for the fences in volatile markets so they can create a winning bet. I’m talking about investors who have discipline, protect their capital against crowded trades and think independently from the rest of Wall Street. It is these people for whom the sun is shining when for others it is raining cats and dogs (and bears), who quietly sit back until the fear across the market is so palpable you could hear a pin drop and then swoop in and deploy capital at precisely the time it is most counter-intuitive yet profitable to do so.

A prime example of this might be Berkshire Hathaway’s recent establishment of a municipal bond insurance unit, at precisely the time when the rest of the industry is melting down. By starting a new vehicle without a legacy of ill-conceived expansion into new (and unprofitable) business lines, it has the ability to garner a Triple A rating and to rapidly secure high-quality (read: profitable) business that the market leaders simply cannot. In fact, it is questionable as to whether the MBIAs and the Ambacs should even be raising capital to defend their Triple A ratings, which essentially results in current shareholders bailing out current management at the cost of stunning dilution to their equity interests. In fact, some have even argued that it might be best for the established firms to shift into run-off mode, paying off risks as they come due and delivering the remainder to shareholders. I think the arguments are pretty compelling, but that’s not the point. The point is that insurers are panicking, issuers are panicking, stockholders are panicking, and Berkshire Hathaway sees gold amidst the detritus that is now so obvious but was so hidden until they said “we’re in business.” And the reason they could do this is because of liquidity and a deep understanding of value.

Is there a reason why most asset managers, hedge funds and Wall Street firms have established pools to buy up busted mortgage paper and other distressed assets stemming from the subprime debacle? Yes, exactly for the reasons I stated above. The fact is, however, that the opportunity will be a lot less compelling for these folks, as there is already a huge amount of capital chasing these assets. The beauty of the Berkshire Hathaway example is that it combines liquidity, a sense of value AND specific business knowledge. Professionals with cash that understand mortgage paper and distressed debt are not that rare - they don’t grow on trees but some reside within virtually every major financial institution of every stripe. The same cannot be said for those within the bond insurance business (at least those who know how to do it well). These situations are also examples of information arbitrage, where distinct knowledge together with liquidity and market opportunity creates maximum value. And it is these people that thrive on volatility and fear.

There is going to be a lot of money made in the next 12-18 months by a precious few, at precisely the time when most are getting brutally hammered. Long live volatility! If you can take advantage of it…

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 01/22/2008 02:13:52 AM

I think the heading of this post is a bit misleading. 

We’ve seen volatile periods throughout the bull market, but volatility combined with lack of liquidity mixed with uncertainty and economic worries is creating these distressed debt situations which flush companies like Avenue Cap, CIG and BerkH., et al can take advantage of.

From a trader’s perspective, a prolonged period of volatility such as this (Summer 07 to YTD) also puts to test one’s risk management and portfolio construction approach, and separates the boys from the men.

Yaser

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