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Market experts are starting to see parallels to the financial crisis

The biggest three-day slide since 2015
The biggest three-day slide since 2015

To some market analysts and fund managers 2018 is beginning to look like the early days of the financial crisis of 2007-2009. They say it’s not the selloff itself that seems ominously familiar but the underlying causes of the selling.

“Part of what brought down the stock market [this week] was very symptomatic and very similar to what happened in the financial crisis,” said Aaron Kohli, interest rates strategist at BMO Capital Markets in New York. “Secured products, leverage and complexity combining to form a selloff. When you look at 2008 a lot of it was there.”

Much like in 2007, the United States is currently experiencing an economic expansion, the dollar is weakening to its lowest level in years, politicians are calling for 3% economic growth, U.S. economic data is generally positive, but the stock market is in free fall.

This time around, rather than mortgage-backed securities and collateralized debt obligations tied to the housing market, the culprit appears to be volatility trading instruments in stocks.

And the volatility-linked instruments are leading the charge downward. The fire sale in stocks, including Thursday’s 1,033 point drop in the Dow, is dragging down even the stocks of companies with strong earnings and record profits. Apple announced its largest quarterly profit of all time on Feb. 2 and has seen its stock fall nearly 7% since.

According to EPFR weekly fund flow data, this week marked the largest withdraw from equities ever recorded, with U.S. funds posting $32.9 billion of outflows. That comes just one week after U.S. stocks recorded their largest ever weekly inflows.

XIV blows up

The most popular instrument to bet against volatility, which has been historically low over the past few years, is the VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV). It’s generally referred to as the XIV (VIX backwards) because it shorts, or bets against, the Chicago Board Options Exchange’s (CBOE) measure of volatility, the VIX.

There are more than a dozen similar products, with many available to retail investors to buy through exchange traded funds (ETF) on online brokerages like RobinHood or TDAmeritrade. Many of the products are leveraged, meaning their value reflects multiple times the real value of the underlying asset, which in this case is simply a measure of volatility.

Analysts say that many mom and pop investors and even some larger firms had no idea what they were buying or how dangerous it could be.

“Nobody reads on page 170 of the prospectus where it says that this thing could blow up if volatility hits a certain place,” Dennis Dick, head of markets structure, proprietary trader at Bright Trading LLC in Las Vegas, said of XIV. “They’re supposed to be trading vehicles and the investing public doesn’t even understand them and they invest in them anyway.”

Reuters reported that the notes “were worth a combined $1.6 billion on Friday… But ended Tuesday at a more-than-92% discount to their closing value the prior day.”

Credit Suisse, which introduced the XIV fund in November 2010, announced on Tuesday that it would close the exchange traded fund (ETF) effective Feb. 21 and pay investors the cash value of their holdings, which could be close to nothing.

Credit Suisse reportedly held a stake of nearly one-third of the product, but in a statement the bank said on Tuesday it faced “no material impact,” seemingly suggesting the losses would be borne by the investors who bought it.

Still, a number of investors say they’re ready to jump back in and buy more.

Ratings agencies have been quiet

In some ways that is reminiscent of the overconfidence investors and much of the public had about the housing market in 2007. Buyers snapped up shares of debt instruments they didn’t understand in an effort to get a share of the skyrocketing mortgage market that they were certain could only go higher.

Thus far, though, U.S. ratings agencies haven’t published any warnings about the return of volatility in markets or about the volatility-shorting ETFs.

“Certainly some instruments on the CBOE can be complicated in the same way that instruments prior to the crash were complicated but that’s not the reason we’re having sudden volatility in these markets,” said Tom Schopflocher, senior director of global structured finance at S&P Global Ratings Agency.

Schopflocher said that the current stock slump is more the result of a market correction than a systemic problem, the way it was in 2007.

“It’s too short-lived to say what’s going on here,” Schopflocher said. “Too soon to draw any certain conclusion.”

It’s too early to call the crisis

Fund managers generally agreed that it was too early to call for a repeat of the financial crisis, but some saw the potential for the fallout from Wall Street’s tumble to have an impact on the real economy.

“The stock market is not the economy, but these things can become a problem when people suffer from negative wealth effect,” said Brian Battle, director of trading at Performance Trust Capital Partners in Chicago.

The wealth effect is the idea that when stocks go up, individuals and businesses feel that they have more wealth, causing them to spend more.

“[A big loss in stocks] might make businesses pause on capital investment and hiring,” Battle said. “It becomes a psychological problem.”

Battle says that so far, he doesn’t see a direct reflection of the financial crisis because large institutions don’t appear to be tied up in the short volatility trade the way many were tied into the housing market derivative products that began to wreak havoc on the market in 2007 and 2008.

However, Dick, of Bright Trading, says that much of the same liquidity issues present in the market in 2008 – when banking institutions were unable to sell their losing assets – could reappear now as investors try to unload their short-volatility bets.

“I don’t think anybody thought this would happen — the VIX rises 100% in one day,” he said. “That can equal a liquidity event… and then liquidity spikes and VIX [trading funds are] gone.”

What will the Fed do?

The major unknown is what will happen with the Federal Reserve. The Fed is widely expected to raise interest rates at its March meeting, though the stock market’s massive fall has driven rate hike expectations lower. Fed funds futures prices show investors see a 66% chance of a hike next month, down from 78% a week ago.

Raising interest rates could advance the market’s selloff even further, exacerbating losses in a manner last evidenced in 2013 when the Fed announced it would begin to reduce its quantitative easing program.

But holding off on rate increases or reducing the number of hikes currently expected could devastate the Fed’s credibility. It could also “juice” the market, injecting a sense that any major downturn in stocks will keep the Fed on the sidelines and interest rates low, allowing investors to plunge into even riskier trading and deeper levels of borrowing.

The Fed is also moving forward with reducing holdings in its $4.5 trillion bond balance sheet. That could easily trigger U.S. Treasury yields higher and spark further stock market falls. And all of these decisions will have to be made by brand new Fed Chair Jerome Powell.

“We’re certainly not out of the woods yet,” Dick said. “Is it the start of a crisis? I don’t know. But it’s definitely the start of a correction.”

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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