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Kyle Bass: One of the Biggest Banks...Wants Me to Close My Japan Trade

I found the following comments from Kyle Bass to be both hilarious and scary at the same time. When Kyle Bass speaks, I listen. He is one of the more brilliant and successful hedge-fund managers of late. He and his team implement a macro-driven approach to investing, which fits right in with our "forest and trees" approach to investing.

In this excerpt, Bass points out that the Japanese Yen might be on the verge of a much bigger move downward. As I have been shorting the Yen since it marked 78 yen to $1 USD, this is music to my ears (the USD/YEN is currently sitting at 96!).

Where it gets scary is the part about the amount of risk banks are taking by selling insurance against major down moves in the Yen's value. If Bass is right, then a more significant drop in Yen values than what we have already experienced could be devastating to banks that are making leveraged bets in the opposite direction.

As Bass points out, this is very similar to what happen with the mortgage crisis, when banks were selling leveraged insurance against losses in housing prices. The only difference is the vehicle is even more highly leveraged this time around.

Here is the excerpt from Kyle Bass's recent speech at the University of Chicago (my added footnote commentary in bold throughout the text is mine--all other text belongs to Bass. The underlined portion belongs to Bass but the emphasis is mine):

The AIG of the world is back. Here's what I mean by that.

I have 27-year-old kids selling me one-year jump risk in Japan for less than one basis point. $5 billion worth at a time. (1)

You know why? Because it's outside of a 95 percent VaR. (2)  It's less than one year to maturity. So guess what the regulatory capital hit is for the bank? It rhymes with "hero." Right?  (3)

And, if the bell tolls at the end of the year, the 27-year-old kid gets a bonus. And if he blows the bank to smithereens, ah. He got a paycheck all year.

We're right back there. I mean, the brevity of financial memory is only about two years. I wouldn't sell nuclear holocaust risk in Dallas for less than a basis point. You should be fired for thinking about selling something for less than 50 basis points, you know? And yet, this is happening again.

And it's happening in huge size. You know, huge. We bought $0.5 trillion worth of these options.

Interestingly enough, recently, one of the biggest banks in the world called me and asked me if I would close my position. That was an interesting day for us. That happened to me in 2007, right before the mortgages cracked.

They said, "You know, we ran some new risk tests."

And I said, "Really?"

And they said, "Yeah, you know, our new stress scenario is a little bit more punitive than the last one."

And I said, "Well, what is it?"

And he says, "We don't want to share our proprietary secrets of our bank with you."

And I said, "OK, then I'm not closing it."

And they said, "Whoa, whoa, whoa, whoa. Well, how about: in our old one, we had rates being stressed 50 basis points, and the new one has rates being stressed 400."

And I said, "Ooh, yeah, 400. That would really hurt you on this trade, wouldn't it?"

And they said, "Yeah, we'd like to close that one."

And I said, "Well, I'd like to, but I'm not going to do that for you, so I'm sorry."

But anyway, they are starting to realize. Why would they run a stress test like that? Who would have them run that stress test? This is happening.

My footnotes:

(1) In other words, the bank was selling insurance against a major drop in Yen prices at a cost of only 1/1,000th amount insured against.

(2) meaning the economic models don't register the risk of a major drop.

(3) it "costs" the bank nothing because they do not have to impair capital with the position. Basically another way of keeping risk "off balance sheet". Problem is that when the stuff hits the fan, all that high-leveraged risk comes back "on balance sheet" and destroys the balance sheet and the financial institution with it.

Written By: Joshua Ungerecht
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counterparty risk, Currencies, Kyle Bass, Recommended Reading, Yen