Brokers and exchanges calculate the level of collateral required to trade securities on margin based on potential losses in stress tests, determined by historical volatility. But stocks, bonds and derivatives busted out of historical volatility ranges in the wake of Lehman Brothers Holdings Inc.'s failure in mid-September, and so brokers and exchanges had to change their assumptions. They increased the amount of collateral needed as the range of possible losses on trades grew. Every time the collateral requirement increased or the account lost a critical mass of money, it triggered a "margin call," forcing funds and investors to sell securities to come in line with the new requirement. So every successive drop in the stock market triggered another round of margin adjustments, another round of margin calls, and another round of forced selling.At this rate, we should expect the New York Times to run an article on the volatility spiral in mid-November, and the Washington Post to deliver a front-page exposé on volatility around March 2009 (which of course will win a Pulitzer).
Tuesday, October 28, 2008