Financial sector earnings as options (volatility) selling

If you have followed the financial sector at all in your life-u see a recurring theme. Banks, brokers, insurance companies make good money quarter after quarter, and then in one or two quarters lose very large amounts of money-sometimes losing all they made in many years! Some of them gone under in one quarter alone. This is was explained very clearly by Taleb in his book-Fooled by randomness.

The crisis in financial markets since last summer has shows this so nicely, AGAIN. Socgen, Wall Street brokers, Citibank, UBS, CFC---u name it, each has contributed it's massive fat share to the financial sector losses in the world. Banks seemingly disconnected to subprime crisis in the US--banks in Japan, China, and India-have lost money on a financial crisis supposedly started by dislocations in the US subprime market.

That is a good/logical explanation, but I dont think that it is the right explanation.

Anytime you see a steady payoff period after period, and then a big loss in one period-it reminds you of the profit/loss profile of an options seller. The options seller is short volatility---makes small amounts of money for long periods of time, and then has big losses sometimes. Financial sector earnings are the same.

What happens is that markets become used to low volatility-smaller and smaller swings in asset prices. To get the same returns then, if you are a market maker at a bank or a broker-you have to leverage more. Or you take more liquidity risk, credit risk, etc-which deceptively looks cheaper to take! The classic Taleb's turkey-the turkey gets more and more confident as it is fed more and more-and it's confidence is at it's highest just before Thanksgiving day.

Lower volatility is the norm-but one wants to be prepared for the black swan of high volatility out there! The only way to do this is to control leverage-a fixed percent of equity-and be very mindful of other risks-liquidity risk, and credit/default risk the two important ones.

The subprime crisis is just an excuse for a period of high volatility. It is hard to prove that it is THE REASON for higher volatility. Any asset price going down can be attributed to high volatility (bursting the internet bubble, russian default, mexican peso crisis)-but if you have an options seller's profile in your overall portfolio-you will lose big when volatility suddenly spikes. The reason is not known, not is it important. The risk demons you have in your portfolio-of liquidity risk and credit risk-come to bite you hard when volatility shoots up. Bids disappear, bid/ask spreads widen, it becomes impossible to sell or buy in size.

In a few years when all this "crisis" wouldve passed-the press will find another reason for the next crisis. Surely it will happen after a period of low volatility, goldilocks scenario-as we saw in the beginning of 2006.

It is very insightful of Taleb to write about this-he reminds us of banks and brokers losing everything they make in many years in a bad quarter, and this seems to happen with remarkable periodicity! Jim Rogers was also shorting financials in 2006---what a great call by these guys!

Will such a massive collapse in the financials finally wake up people to realize that the financial sector in the US is an overpaid lot---the salaries of many of these funky managers need to come down quite a bit? Will the returns going forward in the financial sector lag the market? Only time will tell. But at least this should serve as a big wake up call to all investors in the financial sector.

Sanjay