Q&A: Parsing The Confusion Of Confusions With Ari Bergmann

Jun 28 2012 | 4:29am ET

Global risk manager Ari Bergmann’s firm, Penso Advisors, is named for Joseph Penso de la Vega, a 17th-century Amsterdam merchant who wrote the first-ever description of the workings of the stock exchange—a book called Confusion of Confusions. Two years ago, it was Bergmann talking about the confusion of confusions, namely, the systemic risk to the global financial system posed by Greece.

FINalternatives Senior Reporter Mary Campbell recently caught up with the former Bankers Trust exotic derivatives trader to see where he stands on current developments in Europe, and how he's advising clients to deal with the confusion.

The last time we spoke, you said that Greece was “starting to become systemic.” Where are we now?

We are continuing the same issue. Greece is, at least for the meantime, very systemic. But you never know—I think that we might be pushing Europe to basically create firewalls to prevent Greece from being systemic. We’re not there yet, and the question is, are they preparing that?

What would happen if Greece were to leave the Eurozone?

We can divide that risk into three. First, if they go, and there are private sector defaults, you never know who and what it can reach; who is going to be hurt by it. That’s the Lehman Brothers effect.

The second risk is of contagion. We have seen that the banking sector, specifically in Spain, is under duress. At the same time, we all know that the Europeans are in the process of providing a perhaps game-changing approach which would be to create a pan-European facility or regulator to fund the banks. And that can go a long way to stopping the contagion. We’re not there yet: We need the Germans to agree, but my feeling is that we are approaching that, which means that that contagion issue that you’re talking about—and that’s what made Greece so “systemic,” perhaps is going to be lessened by policy response.

The number three risk of Greece leaving is just bank runs, which is an extension of number two. And bank runs, once they take place, are very difficult to stop.

Has anything happened or has any decision been taken in past two years that surprised you?

I think the Europeans have been very consistent in their approach; perhaps they’re being too predictable. [Laughs.] It’s like a bad movie that you’ve seen too many times, but I think right now they are on the verge of something very, very critical in moving Europe forward. I think the markets have not yet caught on to it, but if that happens, I think it will be a very big game changer.

The long-term refinancing operation that the European Central Bank provided was a very powerful tool for liquidity. Europeans need to break the link between the sovereign and banks—because currently, the sovereign has to fund the banks who have to buy the sovereigns, so it’s a never-ending loop. We need to put a stop to it and the stop to it is that funding to the banks will come through the European Community, but not via the sovereign. And Germany has been very much against that, but I think they’re moving toward it. If they do that, they are addressing the solvency of the banks and that’s a very big move forward. And although it’s not entirely unexpected, it’s still a very important step and I think the market is not ready for it yet.

What’s your take on the future of the Eurozone? 

I think it is extremely early to know. Angela Merkel is right: This is a long process and it’s difficult to know. I don’t think there is any resolution or solution coming up yet, but we are in the early innings of a long game.

What do you advise clients looking to avoid fallout from what’s happening in Europe? How do you hedge against what’s happening?

You have to be very smart in hedging because, in this kind of environment, if you put on too many hedges, they make you money, but then you lose a lot of money if, tomorrow, the market goes against you when there’s a policy response. So you have to find a hedge which is effective, powerful and won’t cost a lot of money to hold and to wait, because this is a very long process. If you put a hedge in which is very expensive and very powerful, it’s bound to disappoint you because you’re going to lose so much money that by the time that you actually need it, it will not be effective or worth the cost. It's very similar to the credit default swaps in 2003, ‘04, ‘05—people bought CDS because they thought they were great hedging, and they were, but they bought so early that they lost so much money and they lost patience. Too early is almost as bad as too late—perhaps worse. You don’t want to be what is called dead right—that you’re right but you’re dead by the time that you know it. There is at least some kind of consolation in being dead wrong.

Some argue gold is the obvious hedge against market volatility and yet, gold is not doing particularly well now. What is the story with gold?

I’ll tell you the truth: I really don’t know. I think it is a very tough market, it is a commodity and it really is not a slam-dunk hedge .And, as you know, there’s a lot of official intervention in the gold market, because central banks are buying and selling. I hear both sides, but clearly it’s not a reliable, efficient, effective hedge.

Two years ago, when Germany had just banned naked short selling, you said there would be other attempts at regulating markets. What have been the developments in terms of market regulation?

We had some trials, we had some regulations, but they’re not effective. This is only the emergency response and the reality of it is, we are not there yet.

Tell me something about your own business. What does Penso Advisors do?

We devise systemic risk hedging on a bespoke basis for large institutional clients. What differentiates us from everybody else is we don’t focus on tail risk, we focus on systemic risk—it includes tail risk but it’s way beyond that. Systemic risk is where diversification won’t help you, which means that the risk affects all strategies, all geographies, all asset classes.

The second difference is our strategy is an alpha strategy, which means that after a full market cycle, it should make you money, not cost you money. We do not believe in the idea of spending insurance money; we believe if you spend insurance money and the strategy costs you money, in the end, you lose patience at the time that you need it most. Our brains function either to spend money or to make money, and if you’re out spending money, you end up buying things that are worthless.

Finally, we focus on mispriced risks, buying things that we think are more valuable. We focus on strategies which have limited downside, but with very levered upside, because as we’ve seen lately from the JPMorgan Chase story, you could lose a lot of money in hedging. Therefore, we work with specific clients because what we want is to meet clients’ needs and expectations.

Can you give an example of mispricing that you were able to take advantage of?

Last year rate curves were very steep, so you were able to buy receiver swaptions extremely cheap. We bought receiver swaptions in Australia; the year before, the Reserve Bank of Australia were the first ones to tighten. The market was expecting even more tightening, so you had the full curve expecting rates to go to 6.25%, 6.5% percent, so we bought two-year swaptions with the right to receive 4.5% for two years and three years. The beauty of it is, if you look at the correlation between Australia, China and commodities, it’s unbelievable. The Australian economy is very dependent on commodities and on China, while the RBA is very responsive to a slowing economy with aggressive rate cuts. There is a significant negative correlation between short-term Australian rates and commodity prices. So we bought those options extremely cheaply for clients, and clients made almost 10 times their investment.

Your company is named for Joseph Penso de la Vega, who wrote a book about financial markets called Confusion of Confusions. It takes the form of a dialog between three characters: the Philosopher, the Merchant and the Shareholder. At one point, that Shareholder says, of investing, “If you can keep up your courage and have sufficient funds to wait, you will always win out.” Is that true?

Those two conditionals are very difficult to keep; nobody has infinite time and infinite funds. What he’s saying is a truism: “In the end, everything works out.” But in the end, like John Maynard Keynes said, we’re all dead. The idea is to live to see the next day. You need something to provide you the cash and liquidity and the courage to stay, which is easier said than done.

The beauty of a hedging strategy is that it does that: It gives you the ability to have cash when you need to fund your situations. It allows you to actually have fresh cash to invest and to also psychologically be prepared. You see, hedging allows you to prepare yourself for the disaster so when it comes, you’re ready for it.

I think that a good, well-designed, systemic risk hedging strategy can actually make this concept true: it will give you the cash, the patience and most of all the courage to stay in the game.

I’d go even a step further. You don’t only need the patience and the money to wait, you need to actually seize opportunities. Most people, at best, they’re frozen; at worst, they’re selling at the worst time. Hedging allows you to have fresh cash to switch into better investments. So you do have the trifecta: You not only have the cash and the time to wait, it gives you the courage, the cash and the time to buy when everybody else is selling.

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