The VIX index has been wildly dancing around, but as I write this it is roughly at around 50% at the moment.
April 16, 2025 futures (the predicted VIX 6 trading sessions later) has it at about 34%.
(Update: by the time I started penning this draft to when I hit the publish button, the numbers changed to 45% and 32%, respectively)
We are seeing a continuation of policy disruption and the realization that traditional structures that have existed are crumbling before our eyes. With the elevation of risk, prices are dropping and we are also seeing a deleveraging occurring.
It is always instructive to remember that whenever a transaction is performed, that no cash or assets are lost or created in the process – instead, the price of the asset is marked to whatever the transaction price is. The power of double entry accounting ensures that “Newton’s Law of Accounting” is followed at all times – assets equals liabilities plus equity.
Say your personal balance sheet looks like this:
Assets
Cash – $100
Stocks – $900 (10 shares of XYZ @ $90, mark-to-market)
Liabilities + Equity
Debt – $500
Equity – $500
Your own personal balance sheet has a gross debt to equity ratio of 100%, or net 80% with cash. Your loan agreement with the bank is a gross debt ratio of no more than 150% or a net debt ratio of no more than 100%.
Some other market participants decide to panic and take down the trading price of XYZ down to $60 because they want to raise cash.
Now your balance sheet looks like this:
Assets
Cash – $100
Stocks – $600 (10 XYZ @ $60, mark-to-market)
Liabilities + Equity
Debt – $500
Equity – $200
This is a result of a $300 loss in the value of the stock (whether it is ‘realized’ or ‘unrealized’ does not make a difference here). The loss flows directly down to equity. Now your gross debt to equity ratio has ballooned up to 250% (net 200%) and your bank is calling you asking you to normalize your debt ratios. So you sell half your stock:
Assets
Cash – $400
Stocks – $300 (5 XYZ @ $60, mark-to-market)
Liabilities + Equity
Debt – $500
Equity – $200
The transaction is a transfer of 5 XYZ in exchange with $300 cash from another participant. The gross debt to equity ratio is still 250%, but the net is now down to 50%. You then pay off a couple hundred dollars of debt to abide by the gross debt to equity ratio covenant:
Assets
Cash – $200
Stocks – $300 (5 XYZ @ $60, mark-to-market)
Liabilities + Equity
Debt – $300
Equity – $200
Now your gross/net debt to equity is 150% and 50%, respectively, which is within the bank covenant.
No cash or shares of XYZ were created in this equation. Instead, what happened is that your shares went to somebody else’s balance sheet in exchange for them giving you some cash. However, the payment (and extinguishment) of debt reduced the quantity of assets in the overall system – you gave $300 cash to a bank, which had your debt as an asset on its balance sheet – it performed an asset conversion (a loan to you to cash), while your balance sheet experienced a significant reduction.
Effectively this is what is happening – debt ratios get triggered with asset price drops and this forces cash to be raised – the pressure to liquidate further accelerates the asset price drop.
In other words, the anatomy of a margin call.
Fundamentally, asset prices are supported by cash flows provided by such assets, tempered by factors such as risks of business prospects and what one can get as a risk-free alternate. This does create a bit of a speculative outpouring where you get participants saying that assets such as common shares of NVidia will grow their earnings 25% annually for 10 years straight and the like – and when conditions change to thwart those expectations, the asset price corrects accordingly and those that have borrowed to pay for the stock will be forced to reverse course.
The net result is that those that are over-leveraged will have their assets taken away from them in a washout scenario. This applies to traders, but also to financial institutions that make bad loans and have an inability to abide by their regulatory limits.
It goes to show that high debt environments create huge amounts of volatility – Uncle Warren has preached about this for ages in his Berkshire letters. The irony is that those that have the highest amount of debt will have the highest amount of success relative to their equity – until a washout will take them out. This is best described in Greek mythology in Icarus, who was given a great gift of wings that could make him fly, but was cautioned to not fly too close to the sun otherwise they will melt – and indeed he crashed down to earth. High amounts of debt cause similar results.
When there is a race for cash, participants try to unload whatever is liquid – stocks, bonds and other alternatives. We see on a day like today that Gold is down 2%, and the two main cryptocurrencies (Bitcoin and Ethereum) are down about 6% and 13%, respectively. However, the world’s leading liquid cash substitute, US treasury bonds, typically a safe haven during equity market declines, have their futures down about 2.5% at present. Presumptively, today can be characterized as a race for cash. The race for cash provides opportunity for those that do not have to raise it – and timed well, can result in outstanding returns.
It is still far from the 2008-2009 days where I remember seeing corporate debt securities of credible and stable entities (e.g. telecom firms) trading at 15-20% yields. 2016 was also another ripe environment for fixed income (I remember the preferred share market was ripe with credible double-digit yields at the time). Perhaps my expectations are still too lofty for these types of returns in a 2025 environment that has been bathed in liquidity – if we receive a continued contraction in liquidity, there might be enough forced selling out there to make it happen. We will see.
It is psychologically damaging to see the equity component of the portfolio flailing so badly in this spiral (should I have gone 75% cash instead of 50%?), but I can only imagine how it would be if the portfolio was leveraged long – the financial stress would be considerable. I took a lot of chips off the table a couple years ago for this reason. I would only want to put those chips back on the table when it would seem to be crazy to do it – and believe it or not, it doesn’t seem like that yet, despite the fact that we live in crazy times (the causes of the increasing mental insanity can be the subject of another future post).