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Quote of the Day
“That’s one of the commonalities across all these big frauds we’ve seen: there is collusion — and it is has gone in most of these cases up to the very highest levels of the company. That is how you bypass controls.”
-Cynthia Cooper, whistle-blower in the WorldCom accounting scandal. From this 2008 interview with TIME magazine
February 6th – This Day in Stock Market History
February 6, 2001 – Cisco puts final pin in dot-com bubble.
Although the NASDAQ peaked on March 10th, 2000, there was still plenty of optimism in some of the very largest tech companies. One example was Cisco, which at the time was the largest publicly traded company.
On this day, Cisco reported earnings that missed estimates by $0.01. On the earnings call, CEO John Chambers announced that orders had suddenly ground to a halt, describing the slowdown as a “100-year flood.”
Cisco’s stock had already fallen nearly 50% from its peak of $82 per share on March 27th, 2000. But this round of negative news was enough to deflate the company’s stock entirely. By the end of March 2001, Cisco’s stock was around $13 per share, down another 50% from its value on this day in 2001.
February 6, 2002 – WorldCom’s Audit Committee Gives All Clear
As reported above, by early 2002 the bubble had burst. Overcapacity plagued the industry. Revenue was falling, competitors were issuing profit warnings, and many were going bankrupt. Yet, WorldCom continued to report remarkably stable earnings and healthy margins.
This day marks a milestone for the WorldCom fraud, and was likely responsible for it continuing as long as it did.
On February 6, 2002, the Audit Committee of WorldCom’s Board of Directors met with partners from Arthur Andersen, the company’s external auditor. This meeting occurred in the shadow of the Enron collapse (which had implicated Andersen just months prior).
During this meeting, Andersen presented its report on the 2001 financial statements. They explicitly discussed the company’s accounting practices and internal controls. Andersen attested that WorldCom’s processes for line cost accruals and the capitalization of assets were “effective”.
The problem was: At that exact moment, WorldCom CFO Scott Sullivan was orchestrating an $11 billion fraud. The mechanism was simple: WorldCom was paying billions in “line costs” (fees to other carriers) to lease network capacity. These were operating expenses (OpEx). Sullivan was booking them as capital expenditures (CapEx).
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Effect: OpEx reduces current profit immediately. CapEx is moved to the balance sheet and depreciated over 10+ years. By capitalizing line costs, Sullivan moved billions in expenses off the income statement, artificially inflating EBITDA and Net Income to meet estimates.
On February 6, 2002, WorldCom stock was trading in the single digits (down from highs of $60+), but it still held a multi-billion dollar market capitalization. The “effective” approval provided by the auditors on this date allowed the company to survive for another five months. It allowed insiders to sell stock and bondholders to retain positions in a company that was effectively insolvent.
When the fraud was finally uncovered by internal auditor Cynthia Cooper in June 2002, WorldCom filed for the largest bankruptcy in U.S. history (at the time). The stock went to zero. The fallout destroyed Arthur Andersen (already wounded by Enron) and led to the passage of the Sarbanes-Oxley Act (SOX) of 2002, which fundamentally changed financial reporting requirements.
February 6, 2018 – The “Volmageddon” Aftershock
The trouble began on the afternoon of February 5, 2018. The S&P 500 experienced a sharp, but hardly unprecedented sell-off, dropping roughly 4% intraday. However, the reaction in the volatility market was explosive, and the consequences carried into the morning of the 6th.
As equity prices fell, the VIX spiked. The issuers of the inverse volatility funds (Credit Suisse for XIV and ProShares for SVXY) were mandated by their prospectuses to rebalance their positions at the end of the trading day to maintain their target leverage. Since these funds were inverse products, a rising VIX meant their net asset value (NAV) was falling. To reduce their exposure as their capital base shrank, they had to buy VIX futures to cover their shorts.
This created a catastrophic feedback loop, or “doom loop.”
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The VIX rose.
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Inverse funds needed to buy VIX futures to rebalance.
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The buying pressure from these funds (which held a significant percentage of the total market open interest) drove VIX futures prices higher.
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Higher futures prices drove the NAV of the funds lower.
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The funds had to buy even more futures to rebalance.
In the after-hours trading session, liquidity evaporated. The VIX index famously jumped more than 100% in a single day, an event that statistical models deemed virtually impossible.
The Death of XIV: Before the market opened, Credit Suisse announced the “acceleration” of the XIV note. The prospectus contained a termination clause: if the intraday indicative value of the note dropped by more than 80% from the prior day’s close, the issuer had the right to liquidate the fund and return the remaining pennies on the dollar to investors. On the morning of February 6th, Credit Suisse exercised this right. The note, which had traded over $100 just days prior, was effectively worthless. Billions of dollars in investor capital had been incinerated overnight.
The liquidation of the short-volatility products caused a “gamma squeeze” in the broader equity markets. Market makers who had been on the other side of these volatility trades were forced to hedge their exposure by selling S&P 500 futures.
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The Dow Jones Industrial Average (DJIA) opened on February 6 with a plunge of nearly 600 points.
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In a display of extreme bipolarity, the index then rallied aggressively, entering positive territory.
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It then swung back down, oscillating wildly as algorithms struggled to keep up.
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The Dow eventually closed the day up 567 points (roughly 2.3%), essentially mirroring the magnitude of the drop from the previous day.
This violent “V-shaped” intraday recovery on February 6th was characteristic of a technical washout. There was no fundamental economic news to justify a crash or a rally of that magnitude. It was purely a market structure event due to the clearing of a leverage.
Read of the Day
Volmageddon and the Failure of Short Volatility Products – This paper is an in depth look at the 2018 volatility crash. The paper details the feedback loops created by ETP rebalancing and offers models for understanding “gamma” exposure. Essential for understanding modern market structure.
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