Pimco Sells Black Swan Protection as Wall Street Markets Fear

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Pimco Sells Black Swan Protection as Wall Street Markets Fear

Wall Street???s hottest new product is fear.

Almost two years after Lehman Brothers Holdings Inc.???s failure caused world markets to seize up, Pacific Investment Management Co. is planning a fund that will offer protection to investors against market declines of more than 15 percent. Morgan Stanley strategists estimate demand for hedges against such cataclysms helped drive as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.

The efforts to protect against another disaster, which helped drive up the relative costs of the most bearish credit derivatives to the highest in two years, show that investors??? psyches still haven???t recovered from the Lehman bankruptcy on Sept. 15, 2008, which erased $20.3 trillion in stock market??value??worldwide and caused credit markets to freeze.

???Everyone is starting to realize that this is going to be a much longer, much more difficult path to recovery,??? said??William Cunningham, head of credit strategies and fixed-income research at Boston-based State Street Corp.???s investment unit, which oversees almost $2 trillion. ???It???s really quite fragile and vulnerable in a way that we haven???t seen in our lifetime.???

Demand for protection against so-called tail risks, extreme market moves that Wall Street???s financial models fail to detect, is increasing as investors react to events such as the May 6 stock market rout that briefly sent the Dow Jones Industrial Average down almost 1,000 points, or Greece???s sovere
ign debt crisis, which on June 7 sent the euro to a four-year low against the U.S. dollar.

Black Swans

For much of the year before Lehman???s collapse,??Nassim Nicholas Taleb??warned bankers that they relied too much on probability models and had become blind to potential catastrophes, which he labeled black swans, a reference to the widely held belief that only white swans existed — until black ones were discovered in Australia in 1697. His 2007 book, ???The Black Swan,??? contends tail risks are becoming more severe.

To hedge against tail risks, investors usually look for the cheapest insurance against a cataclysmic market sell-off, mainly through derivatives that are expected to multiply in value as prices plummet for everything from stocks to the Australian dollar.

The Indiana Public Employees Retirement Fund, with $14.1 billion of assets, asked financial institutions in January to send information on a tail-risk management program that would protect it against ???an extreme market downturn,??? according to a request for information on the manager???s website.

Tail-Risk Pioneer

The term long-tail risk is derived from the outlying points on bell-shaped??curves??that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5 percent in an index that most days rises or falls by less than 0.25 percent, are plotted at the ???tails??? of the curve. The greater the deviation, the longer the tail.

Taleb helped pioneer tail-risk hedging in the 1980s, trading options for banks including First Boston Inc., now part of??Credit Suisse Group AG. Taleb built what he later termed a ???massive??? position in options on Eurodollar futures when the stock market crashed on Oct. 19, 1987. The Dow???s biggest one-day drop in history prompted the Federal Reserve to pump liquidity into the banking system, lowering interbank borrowing rates and causing the futures to surge.

???Drop Like Flies???

Pimco, manager of the world???s biggest bond??fund,??Deutsche Bank AG??and Citigroup Inc. are among firms offering clients tail-risk protection, either through funds or traded instruments that act as hedges. Taleb said few will have the stomach to stick with the strategy.

???They will drop like flies,??? said Taleb, now a professor at New York University???s Polytechnic Institute, who in 1999 set up tail-risk hedge fund Empirica LLC, which he ran for six years. ???They and their customers will give up at some point. I???ve seen it before.???

Besides the sovereign debt strains in Europe that led to Greece, Spain and Portugal having their credit ratings reduced, investors such as Kyle Bass, who made $500 million three years ago on the U.S. subprime collapse, are concerned that even top- ranked governments may face hyperinflation from bailing out the global financial system. The U.S. has $8 trillion of??public debt??outstanding, up from less than $4.5 trillion in mid-2007.

China is grappling with a property bubble as its world- leading 11.9 percent economic expansion slows.??Prices??in 70 cities rose 11.4 percent in June from a year earlier following a record 12.8 percent in April and 12.4 percent in May, according to China Information News.

Market Liquidity

At the same time, traders say that market liquidity, or the ability of investors to easily trade in and out of positions as markets change, hasn???t fully recovered from the Lehman collapse. Even though the amount of Treasuries outstanding has increased about 75 percent the past three years, the average daily??trading??volume of the securities among the primary dealers has declined about 12 percent, according to Fed data.

???In some of these asset classes, it???s just not practical to reduce risk by selling given the lack of risk appetite and illiquidity,??? said??J.J. McKoan, co-director of global credit investments in New York at AllianceBernstein LP, where he helps manage $199 billion in fixed-income assets.

Improbable Occurs

Investors were reminded that the improbable can happen by the events of September 2008 — from the government seizure of mortgage-finance companies??Fannie Mae??and??Freddie Mac??to Lehman???s bankruptcy and the near-failure of American International Group Inc., once the world???s largest insurer. Defaults on mortgages given to the least creditworthy borrowers drove financial institutions worldwide to take $1.8 trillion in writedowns and losses.

The seemingly growing occurrences of events that fall on the fringes of probability are prompting pension fund managers and other institutional investors — who once shunned costly hedging strategies — to reconsider. And they???re doing it even as economists predict the U.S. economy will grow an average of almost 3 percent through 2012 and as analysts forecast the Standard & Poor???s 500 Index will gain 17 percent through year- end.

???People are trying to move beyond historic notions that tail risk events are so infrequent on the one hand, and so extreme on the other hand, that there is nothing you can do about them,??? said??Eugene Ludwig, who started a Washington-based risk management firm called Promontory Financial Group after serving as U.S. Comptroller of the Currency under former President??Bill Clinton.

???New Normal???

Pimco Chief Executive Officer??Mohamed El-Erian??developed tail-risk strategies when he was manager of Harvard University???s endowment in 2006 and 2007, and wrote about the importance of such hedging in his book, ???When Markets Collide.???

El-Erian, who describes America???s economic future with the term ???new normal,??? advocated the strategy he applied at Harvard on returning to Pimco in January 2008. Pimco, which manages about $1.1 trillion, opened its first mutual fund aimed at minimizing risks from systemic shocks that October. The Pimco Global Multi-Asset Fund is co-managed by El-Erian and??Vineer Bhansali.

Pimco, the Newport Beach, California-based investment firm that runs the $234 billion??Total Return Fund, is using strategies in many of its funds to protect against tail events, said Bhansali, chief architect of the company???s tail-risk management program.

???Cheap Protection???

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