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Volatility and The Big Short

by Rick Johnson

As a 13-year-old boy I had always been fascinated with the mysterious events that occurred in The Bermuda Triangle.  The area where ships and airplanes would simply vanish into thin air, otherwise called Devil’s triangle, was located in the western part of the North Atlantic Ocean.  The fact that no one could explain these tragic events generated all types of scientific theories, not the least of which was the possibility of extra-terrestrial activity.

Needless to say, it didn’t take much encouragement for me to get my hands on every book about the Bermuda Triangle I could find in the school library. Firsthand accounts of people who survived Devil’s Triangle all recounted similar experiences where suddenly their navigational instruments went haywire.  Unbeknownst to them, this would become a test of instincts and experience versus instruments. A test where relying on instruments and indicators alone, was exactly the wrong thing to do.

Throughout every facet of our lives, we rely on instruments and indicators to reveal what we cannot see with our own eyes. Instruments become tools if not extensions of ourselves. Whether we’re talking about business, medicine, or economics we have created tools and indicators to guide us safely through all types of Bermuda Triangles.


While I sat in my car looking out over the boats in the Marina City harbor, I was thinking hard about what had just happened in the markets during the week. I took another look at the charts on my phone, and clearly this could be a sign of something big. There is a saying about “waiting for the next shoe to drop”, which defined what I had just seen. Making things even more strange was the possibility that I was the only one who linked these events with those that occurred almost 10 years ago in the markets. Yet the distinct probability of drinking too much caffeine that day was still a valid theory.

During the week of February 5, 2018 the Credit Suisse (XIV) Inverse Volatility ETN opened up at a price of $109. The very next day on February 6th,  it would close at a meager $7. Until that day the XIV tracked with reliable precision, a rising SP500 index. There was no reason to think that this was anything but a solid derivative of volatility backed by a reputable institution, Credit Suisse. The sudden collapse even surprised the news media, who are still searching for a reasonable explanation. More importantly, they had no choice but to conclude that perhaps the Inverse Volatility Exchange Traded Note, may require a closer look-and even suggested it was rigged.  To be clear, it was designed to fall with rising volatility, but no one could have predicted a “cliff dropper” wiping out billions of market capital overnight.  But the worrisome part was the fact this was clearly one of the worst collapses of any single traded asset in a very long time.

Credit Suisse responsibly had always listed the fact that volatility derivatives are designed for day trading and warned against holding such as asset overnight- no kidding! Nonetheless, the XIV on February 6th,  fell over 80% during a market correction leaving many to question what this meant for stocks in  the short term.

Yet despite the drama and immense losses those investors in the XIV Inverse Volatility ETN suffered, this collapse meant something far more meaningful to me. As I sat in my car, I felt validated about what the collapse of the XIV Inverse Volatility ETN may have been suggesting pertaining to my own research on derivatives and The Subprime Mortgage Crisis. Despite the implementation of “Dodd-Frankenstein” a piecemeal attempt at financial reform and regulation, the proverbial shoe had just dropped hard and fast. I thought about all of the people whom had lost their homes. I thought about all the hearings on Capitol Hill trying to make sense of “moral hazard” and “too big to fail” in 2009.  I thought about how seniors got the news that they were investors of  “funds of funds” tied to Bernie Madoff.  Was it the coffee?

I went to a coffee shop to open up the latest Berkshire Hathaway Annual Report. There was something very unique about his stock holdings. As a huge fan of Warren Buffet, his investments provide a glimpse into the old adage “always buy when people are selling”. But his confidence and brilliance suggests something a little different to me. You see Warren Buffet  may have been handed the investment opportunity of a lifetime as a result of the Subprime Mortgage Crisis. The question is, suppose Warren Buffet knew what I had already come to believe, that the 2008 crisis was a well crafted hoax. If not a hoax, then perhaps a significant financial restructuring positioning the Federal Reserve as the largest mortgage institution the world has ever seen. Opportunistic is defined by the Federal Reserve’s incredible profits since the crisis, as stated in their annual reports. Taking nothing away from Warren Buffet’s impressive history, his current holdings suggest a “super human intuition” which at the time to him, must have felt like an absolute “free throw” (I don’t have statistical evidence of how often Warren Buffet makes his free throws).

In 2007 I came across and read a few credit default swap contracts, and my response was “Holy Cow”!  So I can only assume Warren and many others saw the writing on the wall, which they would later admit as represented in books and movies. That said, the list of Berkshire Hathaway’s most profitable holdings tells a story all its own:

Shares Company Percent of Company Owned Cost


Market Value
700,000,000 Bank of America 6.8 5,007 20,664
11,390,852 Goldman Sachs 3.0 654 2,902
24,669,778 Moody’s Corporation 12.9 248 3,642
482,544,468 Wells Fargo 9.9 11,837 29,276
2017 Funds of Funds  (confidential) 21.8% ROI


Like an archaeologist who finds fossils from an era long gone, the above list of stocks could be called the top ten of The Subprime Mortgage Crisis. We can conclude the Buffet mantra has always been “buy when people are selling”, but this list and the size of the positions speak for themselves. In my opinion the lucky winners from The Subprime Mortgage Crisis found  a “no risk” opportunity that would be like winning a chess game against a blind man”. That while people were losing their homes to foreclosure, some were reaping profits not because they were smarter but because the crisis was a hoax.



Keith Geithner as the man in charge of The Treasury with ties to the Federal Reserve, along with Mr. Paulson, would continue to talk about contagion in the markets. They would sell ” the sky is falling”. They would use instruments and indicators that were created to identify contagion within the Subprime Credit Markets.  One particular index called the ABX.HE  was one such instrument gauge in their cockpit. It was used to get a  read on the financial condition of subprime borrowers via late payments, foreclosures, delinquencies, etc. This index, containing a relatively small sample size, was a proxy for the entire subprime mortgage market.

The ABX.HE (BBB) was created by a company called Markit, its starting price was $100 on its first day, and was used as a reliable indicator by people such as Timothy Geithner, though it was only a few years old. It’s fascinating that no one questioned the validity of the index back then. But today, we are not ruling out the suggestion of a rigged derivative asset in the XIV Inverse Volatility ETN.  Just like the XIV collapse this past February , the ABX Subprime Index (BBB) experienced a similar cliff dropping collapse. Both of these collapses are roughly in the range of a whooping 80%.  One can make a valid argument that the valuation structure of the ABX Index (BBB) was built upon a similar derivative model as the XIV Inverse Volatility whereby prices of their underlying assets are loosely based on consensus rather than volume. In many ways they mimic a sort of price fixing, not unlike LIBOR the London Interbank Offered Rate ,where a bunch of bankers agree on rates they can borrow from each other.

When I heard discussions about volatility “rigging” I could not believe my ears, as to me this solidified what I suspected about potential ABX “rigging” and the instruments used in 2008-2009 Crisis. The ABX Subprime Index however would carry far worse implications, acting more like a time bomb than a financial instrument. Enough to perhaps suggest changing the mantra from “Too Big To Fail” to“Set Up To Fail”.

Toxic Assets


When we speak of toxic assets we generally conclude a runaway train that no one understood. I think enough people understood them to know they wanted to jump onboard. A seldom discussed fact is that the engineers of the “train” include Moody’s and S&P Ratings companies. The credit agencies approved the construction of toxic assets specifically the “over-collateralization” of mortgage backed securities. Over-collateralization means simply that “quantity” of assets within a MBS mortgage backed security bundle, can be stuffed with assets of lesser credit quality to make-up for the lack of credit worthiness. So an MBS bundle the would typically contain $10 million in AAA mortgage assets, could be substituted with a bundle that contains, $15 million of mortgage assets where $5 million of the bundle would be subprime BBB mortgages. I call this “frankensteining” as it pieces together an entity that looks like a real man, but it walks funny and can’t speak. Certainly the credit agencies fueled the growth of these types of MBS. Then brilliant investors can use credit default swaps to “bet” against this particular bundle. It’s not clear if over-collateralization was something transparent about specific MBS bundles as underlying assets of other derivatives.

The conflict of interest is the following, the same credit agencies that approved the MBS “over-collateralization”, are the same people or company who can downgrade a real estate firm’s credit, like Country Wide for example. Credit ratings or downgrades are determined by a small group of people, and when derivatives of credit are priced, this group of people have unusual influence via consensus. Moody’s and S&P had unique perspective and control over credit events. Berkshire Hathaway happens to own 12.9% of Moody’s per the 2017 Annual Report.

In the classic movie “The Big Short” it tries to sell the fact a few rogue traders, and Goldman, took a huge gamble. The Wikipedia definition of the ABX.HE index clearly states that all of the big investment banks were market makers of the ABX.HE Subprime Index, which allowed investors to bet against subprime homeowners. That does not sound like a few rogue traders. But like any sure bet, things can go horribly wrong, ask Tom Brady. The fact is millions of subprime homeowners would be more current than expected. In reality, employed people continue to pay their mortgages. But a rigged Subprime Index has the ability to present its own interpretation of subprime markets.  Once a reading of growing subprime defaults was sold to the credit agencies, they could revise the underlying BBB rates that comprised the ABX Index. Banks now had the justification they needed to take back homes, down payments, and billions in profits in the form of credit default derivatives, just from a reading of a newly created 2 year old index?

Wikipedia lists the underwriters of the subprime mortgage index the ABX.HE as:  Goldman  SachsJPMorganDeutsche BankBarclays CapitalBank of America, BNP ParibasCitigroupCredit SuisseLehman BrothersMerrill Lynch, and RBS.   

The “Big Short” does a poor job of explaining an interest rate swap which requires some explanation and lots of capital when betting on mortgages going bad. In an interest rate swap two parties take opposite positions on future rates. One party wants a fixed return on their assets, and the other party is betting on rising rates or a variable return on their assets. The party who is betting on rising rates must pay the current fixed rate spread between two rates. So if the subprime BBB rate is 3% and the AAA rate is 1.5%, the fixed rate party is guaranteed a payout 1.5% on $10 million ($150,000) every month from the other party.  But if the subprime rate suddenly shoots up, the swap deal changes quickly:

Let’s say the subprime rate rockets to 6%, the variable rate trader is in the money big time! So instead of paying a fixed 1.5% on 10 million ($150,000), the variable rate party is now receiving 3.0%  on the $10 million or $300,000 monthly. (6% Subprime BBB – 1.5% AAA = 4.5% – [agreed payout of 1.5%] = 3%). Due to the huge win for the variable rate trader, it is common practice to negotiate a lump sum buyout of the swap agreement-just like lotto. If the agreement was a 2 year deal now worth $7.2 million ($300k x 24 months) , a lump sum settlement could chop 10% off the total for an overall payout of $6.5 million. This lump sum , a 10% reduction of the amount is known as a “haircut” in the business. A haircut is not  a rule or law, but simply fair dealing and moral ethics between financial professionals. There happens to be a scene of Christian Bale in The Big Short negotiating the “haircut” after his huge win. So now we have some idea why those with a bet against subprime borrowers, were hungry for the credit agencies to hike subprime rates

[During the Subprime Mortgage Crisis there would be firms who absolutely refused to accept a “haircut”. This would suggest the market players and beneficiaries of the Subprime Mortgage “trade” wanted to intentionally inflict as much pain as possible to counterparties.]

Despite the large number of bets against subprime borrowers, there was no valid and convincing evidence of a genuine crisis. Fannie Mae and Freddie Mac already forecast annual foreclosures as part of their standard best practices. As they hold significant volume it is safe to assume they should be the ones to alert the credit agencies, versus some derivative index the ABX.HE. The hoax starts here, as the so called default or delinquency rumors were only the readings of the ABX.HE (BBB).  You see mortgage payments are confidential transactions. So information plugged into the ABX.HE could be easily rigged, non-verified, misinterpreted or loaded with bad data used to officially raise the subprime mortgage rate for the entire country.

Certainly with the the help of the news media to sell the alleged subprime contagion, no one would question it. Leveraging existing notions about minorities having poor credit, or other stereotypes made the reports believable by everybody, including minorities. It needs to be said that certainly many people experienced foreclosures, and delinquent payments.  However, with the exploitation of ABX.HE (BBB),  a few shaky mortgages were conveniently turned into a story where millions upon millions were walking away from their homes, missing payments, and foreclosing overnight. It is key to understand that without the ABX.HE Index, subprime rates don’t change, banks continue to lend, buyers keep buying, home prices don’t fall, mortgage payments do not rise, foreclosures are prevented.

Race and class also plays its part as the engineers of the hoax are in full realization of the nuclear effect the crisis would have on minority homeowners.  We will never know the racial motivations and how much they played a part in the motif for the subprime hoax. Clearly the role that banks played by freezing lending activity could be seen with malicious intent to accomplish the following agenda:

  1. Use mark to market real estate valuations to “immediately” reduce home value
  2. Raise the mortgage rates immediately so even employed people whom have never missed a payment will find it difficult to pay the increases
  3. Use mark to market real estate valuations to “immediately” reduce home value for retirees whom will find themselves upside down and unable to find work to pay the new mortgage
  4. Suspiciously removing the option for refinancing, even while the banks received stimulus money for assets that have always and historically appreciated in value.
  5. The most important aspect of “the trade” was also removing what is called pre-payment risk via foreclosures. Since the bet against mostly low income minorities and middle class was so leveraged, those whom owned these contracts actually “needed” people to walk away from these loans. These bets against credit and subprime borrowers required foreclosures to become profitable.
  6. The Federal Reserve as buyers of Mortgage Backed so called “toxic” assets also had skin in the game whereby a slow moving economy assists their own position in these assets. In other words, it’s logical that the US recovery never had a chance if the Federal Reserve encouraged a “no lending” US policy to insure their own assets, which represented bets against subprime borrowers, had to continue their payout cycle.

The ABX.HE Subprime Index fell 80% in a few days which suggests an underlying asset controlled by very few participants and market makers.  The ABX.HE (BBB) index however was sold as an accurate barometer but in reality was anything but, and like the XIV inverse volatility index would plummet from $90 to less than $10. This is the “lightning” I have been patiently waiting to observe in a large well publicized tracking index, wherer it was not a matter of “if, but when”. The ABX.HE defined today as:

Wikipedia (2018)

…they launched the Home Equity (ABX.HE) ABX on 19 January 2006. Advertised daily prices were availability on the Markit website. The purpose of the indices is to allow investors to trade exposures to the subprime market without holding the actual asset backed securities. The ABX.HE Index was created from “qualifying deals of 20 of the largest sub-prime home equity ABS shelf programs from the six month period preceding the roll.”(Wiley, 2006 & 11) The market makers of ABX.HE were listed as Goldman SachsJPMorganDeutsche BankBarclays CapitalBank of America, BNP ParibasCitigroupCredit SuisseLehman BrothersMerrill LynchRBS GreenwichUBS and Wachovia.(Wiley, 2006 & 13)

These investment firms had “anticipated the crisis. In 2006, Wall Street had introduced a new index, called the ABX, that became a way to invest in the direction of mortgage securities. The index allowed traders to bet on or against pools of mortgages with different risk characteristics, just as stock indexes enable traders to bet on whether the overall stock market, or technology stocks or bank stocks, will go up or down.”

“Lightning Striking Twice” suggests the crisis created using the ABX.HE, bares some resemblance to the fundamental vulnerability of the XIV (created by Credit Suisse).  They both represent inverse tracking derivatives and backed by underlying asset prices determined by select market instruments and participants. As stated previously, Credit Suisse was very clear in the profile for the XIV Inverse Volatility ETN, regarding the dangers of holding such an asset.  But the key difference here, the ABX.HE (BBB) would make no such disclaimers regarding its volatility, nor any information regarding the integrity of its pricing structure, or how the qualifying mortgages were acquired. An index designed to know whether millions of people paid their mortgage on time is absurd, and the mainstream press never questioned it. To this day I even ask people whom have worked in the financial services business, if they have indeed heard of the ABX.HE Subprime Index, no one has ever said “yes” to this question.

In the case of the ABX.HE, the index tied itself to questionable mortgages and risky homeowner profiles to eventually “sell the sky is falling” scenario. To this day it has caused our economy to fall off the rails as we are being sold that the engineer, the Fed, has everything under control.  At the end of the day, it contributes to the false readings on our economic instrument panel as we fly aimlessly into the Bermuda Triangle of economic instability. Yet, under this challenging scenario, the Federal Reserve along with people like Warren Buffet have made billions.


Fannie and Freddie

During the Subprime Mortgage Crisis, Fannie Mae and Freddie Mac as “Government Sponsored Enterprises” GSE’s , were under the eye of public scrutiny as we were told they became financially crippled. Yet, the truth is Fannie Mae had an extremely successful and profitable business model. After the crash global investors demanded investments be backed by assets…debt. Fannie Mae had a lock on selling mortgage debt as people in the US typically stayed in their homes and paid mortgages with relative consistency. Their Mortgage Backed Securities business, whose foundation was ultimately backed by the US government offered an outstanding investment for investors all over the world. It beat the hek out of AOL or Webvan by a long shot.

As Fannie had a booming business in mortgages, they had plenty of debt paper to sell. They were hard to compete with. But something changed. As others institutions wanted a piece of the MBS market, the qualifications had to change to create additional mortgages for MBS markets. No better way to create mortgages than to offer them to people whom could never previously own a home. Specifically, exploiting race and the income gap to create products that could be used in the “over-collateralization” of Mortgage Backed Securities bundles. So while people believed they were being sold homes on interest only-future refinancing terms, in reality their mortgages were being exploited for debt paper. The debt paper which included questionable mortgages intentionally, could then be used as to short against.

As we were watching Freddie and Fannie go into receivership, some of my own research revealed a startling surprise about Fannie and Freddie to further underscore The Great Hoax. It appears this was overlooked by the mainstream press.

Fannie and Freddie are sister and brother GSE’s which mean they are financially coupled. They employ very smart people whose job it is to insure they can pass any stress test. For the record Fannie and Freddie have always prided themselves in passing these stress tests.  It is yet surprising how easy everyone believed that Fannie and Freddie did not already have tools and strategies in place for a big crash.

It was the careers of many to hedge the massive portfolios of Fannie and Freddie, employing some very smart people. People required to run all types of stress tests under unlimited scenarios under all types of market conditions. But some amazing person came up with a brilliant strategy for Fannie and Freddie to withstand any degree of financial market stress. It was a “delta neutral” strategy which suggests that Fannie was “long” the financial/credit markets, and Freddie was “short” the financial/credit markets. This means that a sharp downturn leaves the GSE’s in reasonbly good shape as Freddie Mac would make profits during a market crash. An important fact completely missed by the mainstream press. Sounds like a Goldman strategy.

So again, Freddie and Fannie were perfectly prepared for a sharp downturn, yet why did the news media not address their former stellar results during the stress tests? Did the people implementing the tests get it wrong?  Were there people who wanted Fannie and Freddie out of the way? Would a viable Fannie and Freddie potentially be a risk to another portfolio of MBS assets?


VI. The Race Card

Race and class could be used whereby stereotypes of low credit worthiness would be an easy sell. The race card could be slammed to the table to profile the subprime mortgage holder. But something happened. Low and middle income homeowners were not defaulting as expected. With such a large US population, gambling on masses of people losing jobs and being delinquent was a poor gamble. People were doing anything and everything to keep their homes. However, the ABX.HE had the ability to carve out the worst and highest risk mortgage holders to construct an alternative scenario. A scenario where  bets against the subprime borrowers could finally pay off.

The Subprime Index, which included the BBB subprime trance in the ABX.HE,  would be designed to collapse and thus allowed banks an excuse to put a halt on lending. When the banks stopped lending, people can’t buy homes. When people can’t buy homes, the market drops under normal market forces. When the market drops on home prices, equity also drops along with prices. At some point mortgage holders go from having equity to becoming “upside down” where the loan is higher than the asset. Banks then demanded significant higher mortgage payments. We can conclude with high probability, that the subprime mortgage crisis was not present from the initial readings of the subprime trance of ABX.HE Index, but was created as a direct result of bank anti-lending policy. Effectively sabotaging the US real estate markets exploiting the ABX.HE as a valid indicator of contagion and risk.

And like the plane flying into the Bermuda Triangle, these instruments or indicators should have never been followed where even 10 years later, the economy is still fighting the impact of the Fed seizing an opportunity to literally become the new Fannie Mae.

If Mr. Buffett knew the Crisis was a hoax, or simply smoke and mirrors, his stock purchases certainly carried significantly less risk than what other market participants may have perceived. Looking at the enormous gains Mr. Buffett has made from these subprime related investments speaks for itself. Buffett has made so much money from his subprime mortgage related stocks, that his insurance companies could literally withstand billions in hurricane claims without significantly affecting his balance sheet.


The Federal Reserve

Under the scenario of the Subprime Hoax, the Fed made an awful lot of money. You see, the Fed has typically purchased short term notes and Interest Rate Futures called Eurodollars. But something changes. Suddenly overnight, the Fed out of the kindness of its heart, decided to own Mortgage Backed Securities. The same typed of securities that previously made Fannie Mae a lot of money.  The same MBS that others would attempt to create by selling bad mortgages could be used for over- collateralization. So a simple question, if this stuff is so toxic, how is it that the Federal Reserve is reaping tremendous profits per their last annual report?

So the Fed became essentially a GSE like institution as they own a large amount of mortgage backed securities for the goal of profit. If the Subprime Mortgage Crisis was a hoax, then Fed policy attempts to manage the economy would create false readings like flying the plane into the Bermuda Triangle. Even today, the indicators or navigation panel of our economy often get criticized as Fed policy has taken 10 years to remove stimulus? This is another verification that the hoax was real because it is entirely possible that all of the “stimulus” may have been unnecessary. Furthermore, it is also possible that the Fed, in achieving its own financial goals, actually found itself with long 30 year mortgages, that like a GSE, they face an odd derived form of institutional pre-payment risk. As we all know the longer it takes to pay debt, the more the lender/bank makes. But did anyone think about the Fed being in the same position, whereby unwinding its balance sheet greatly jeopardizes its bottom line?

The worst misrepresentation about Fed policy are the so called low lending rates that have lasted for almost 10 years. And while large banking institutions have had the ability to manage lending risk with these rates, for some strange reason they have not been lending enough to move our economy forward. This has made the instrument panel of our economy go haywire, as the Fed’s position in long term debt securities, and other securities, may rely on its regional banks restricting lending to aid the Fed while hurting our economy. Let’s be honest that the time our country has been under this “stimulus program” is not only suspicious, it’s embarrassing. Let alone, a bank that could not find a way to make money by lending generously to the public when a nice profit is practically guaranteed via low rates is equally suspicious. And no, I’m not buying how nervous they are-nice try. Watching commercial businesses shutter their doors under a so called low rate environment, is one more clue to the subprime hoax where even the stimulus program itself becomes just a “tell in the scam”. This is the fundamental reason why we heard in the media the banks were “so eager” to pay the money back. Remember and think about that for a moment. The had to pay it back because the entire thing was a hoax, whereby under any normal financial crisis, lending institutions being given the ability to borrow at basement rates, would naturally and eagerly find plenty of borrowers that would serve to primary purposes. First, it would allow the bank to profit from lending like no other time in history. And second, it would be the American thing to do to get our economy back online as quickly as possible.



John Crudele of the New York Post stated, “…the Federal Reserve broke the American Economy”. This could not be said any better. In essence managing the hoax that robbed people of their homes, have corrupted the indicators and economic instruments needed to fly our economy.

I don’t blame Warren Buffet for going after a once in a lifetime investment opportunity. I don’t blame the Fed for trying to make money for its shareholders. However, I blame the politicians for allowing people to lose their assets and children’s bedrooms over a hoax. Once you understand the hoax in its entirety, it becomes crystal clear that entities such as Bank of America and Wells Fargo never sold the homes, and used the collateral to create toxic assets. The same assets which have made the Federal Reserve and Berkshire Hathaway an awful lot of money.

Based on my rough calculations, all of the players of “the bet” could have made significant profits while people stayed in their homes until the mortgage markets bounced back. Yet, it’s hard not to ignore an element of racism that would not permit this to play out under normal market cycles. Revealing intent to cripple minorities and other middle class families using the Subprime Mortgage Crisis as a catalyst. Interestingly, some people talk about the idea of reparations as a “make good” to compensate black people for 100 years of unfair dealing estimated at trillions of dollars . Truth is, the Subprime Mortgage Crisis represents the clearest case to justify a legitimate reparations program, not just for African Americans, but for all homeowners who were innocent victims of The Great Subprime hoax.



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