What will be the ultimate effect of leverage within the financial services market?
Margin -- Regulation T-based credit -- has been in the financial services industry since the 30's, but both large IBs and hedge funds are finding ways to gain leverage well beyond that dictated by FRB rules. In a recent case, a highly leverage, multi-billion dollar fund investing in CDOs left its holders with a 100% loss of their investment.
Of note was that the CEO of a large global IB commented that it was "concentrated positions" that led to the collapse of the fund...but the CDOs that the fund was invested in were, by definition, already diversified pools of debt -- leverage, not concentration, was the culprit. Of note is that the particular CEO's firm, an instantly recognizable brand name in the IB community, is rumored to have leveraged its own balance sheet a staggering 25 times.
Which leads me to the question: If a group like Long Term Capital almost crippled the financial services markets, what might be in store for the future?
Clarification added July 21, 2007:
There's some interesting commentary on what caused a particular blow up...but what will be the ultimate effect of leverage on the markets?
One thing I can think of is expensive-to-comply with regulation, particularly if there is a big, visible blow up of a so-called Highly Leveraged Financial Institution. It's already happened with SOX, which is costing smaller publicly traded companies a significant percentage of their per-share earnings -- which has the effect of not only lowering their value and share price, but discouraging smaller companies from going public in the first place.
What other effects of leverage do you see?
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via F
Structuring Complexity Into Opportunity
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I hope I won't disappoint by saying that few if any can have an idea as what the "ultimate effect" of the current leverage wave will be. All previous replies make for possible scenarios, but as Maurizio points out, there is too little insight into the actual numbers to come up with more than scenarios.
Froam an historically informed perspective, one can infer that:
a) more regulation will be enacted (watch out for those Democrats in the US);
b) all the financial instruments developed in this boom are here to stay;
c) alternatives for credit rating (as far as institutions and/or formulae);
d) a new wave of financial "innovation" will gather momentum;
e) unless the Indians and Chinese (Russians, Brazilians, etc.) are brought into the current financial consensus, a world-wide crisis of huge proportions.
I hope the readers will indulge the point (e) above as mere speculation generated by an increasing understanding that more cooperation, at high-levels, is necessary if the current wave of globalization is to continue.
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Kam N
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I do not think, there will be an ultimate affect. For sure there will be mistakes and collapses but remeber that: LTCM's incident confirms an insight often attributed to the economist John Maynard Keynes, who is said to have warned investors that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."
From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to sub-prime mortgage bonds. As the mortgages underlying the CDO's collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings. Many are recording their CDO assets at par due to the difficulty in pricing CDOs. The pricing challenge arises because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses. This is exactly, what happened recently with all the ABS backed CDO's (Sub-Prime mortgages), another example of bad timing. Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners who are trying to refinance out of mortgage (which has gotten more expensive) and consequently leading to slower real estate market which we are already in it. Will it be catastrophic? I do not think so.
As far as future, I am sure there will be more similar incidents with different types of CDO's.
Steven J
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I think the 'large global IB' was right -- it is concentration that's the problem. Just having a lot of something doesn't make it diversified. CDOs only provide diversification over individual creditor risk. If the underlying debt is all subprime and subprime goes into the toilet your screwed no matter how many names are in your portfolio.
Concentration also reduces liquidity when there is a shock, because only a few organizations might own most of a given type of security, and when they want to sell a lot of it there are no other buyers.
Lastly transparency can be a problem, in particular as it relates to leverage. Leverage can be hidden away in various derivatives and only show up when positions move against you.
Leverage is indeed the problem. If you are a "large global IB" (or a hedge fund embedded in same) and you looked at recent volatility as giving license to lever up your positions, the notional amount of your trades becomes the issue.
But it was also concentration. The CDO tranches this particular fund was investing in were (obviously, ex-post) exposed to volatility tails that were not expected, or probably even quantifiable.
I am of the opinion that LTCM did not almost cripple the market. The players that were on the other sides of their trades wanted the music to go on as long as possible.
Maurizio P
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Gentlemen, let's talk numbers and not sensations and we will come to more informed conclusions.
It was undoubtedly leverage that is causing all this mess:
The Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage fund reported $638 million of investor capital and gross long positions of $11.15 billion in the first quarter. A swing of just above 5% negative would have wiped out all the investors capital.
The Bear Stearns High-Grade Structured Credit Strategies fund had $925 million of investor capital and gross long positions of $9.682 billion through March 31. A swing of 10% in the negative of the NAV would have had wiped out the investors capital.
I have been reading a lot of words in the Risk Management community about fat tails, Extreme Valuation statistical techniques etc...
Sorry, I don't agree, was a simple plain old story of greed and stupidity.
Keep sophisticated maths out of this, I have too much respect for quant techniques to mix it with this story.
Concentration might have had a minor part in this, but at that levels of leverage would have not mattered much.
And systemic risk is not likely. Why ?
Let's numbers talk here too.
The ABX subprime mortgage proxy index rated BBB plunged from 97 to 44.5 without any sign of bouncing back from January.
But the AA rated index plunged from 100 to 88 but is now bouncing back to 91 and the AAA rated index plunged from above 100 to 94.5 and is now bouncing back to 97-
The knee jerk reaction of dumping perfectly good and performing mortgage backed securities has met cool headed money on the buy side and the market is probving once more to be a good regulator of excesses and stupidity.
The numbers tell us that even if (and it was not evidently the case..)The Bear Levered Fund would have held AAA rated mortgage backed securities it would have wiped out the investors money.
So, again leverage...plus stupidity and greed.
There will be litigations, enriching lawyers uselessly. The investors in the 2 Funds were all pro, and if Bear disclosed properly...well good night and good luck for the next try boys!!
You invested in that stuff doing the wrong homework don't look to court to redress you.
If Bear did NOT disclose properly...slash and burn them for what is right and just to hit them.
Simple but effective-
When LTCM leveraged itself 300 times off books, the Cash Clearer who blew the whistle to the Fed was....Bear Stearns.
The supreme Irony of History!!
Clarification added July 21, 2007:
There will be a regulation enforced only if the mess spills over and one or more Central Banks will be forced to intervene...and first signs are that this will not be the case . The CDOs mess is now helping Central Banks, notably the Fed, in their most difficult task...dry up liquidity slowly without causing a full blown recession and panic.
The explosion of liquidity was the 1st responsible of the whole mess, simply put, there are mortgages out there that should not have been written, plain and simple. When the going is easy,in this case when the money has a negative real interest rate, as it was till sometime ago (now is almost neutral...i.e. we are still at 0 cost debt compared to inflation !!!) the good old golden rules are superseeded and the ones who recall them are blasted as dinosaurs who can't see the new "parameters".
The facts are that the whole subprime "industry" forgot that it was joe sixpack ability to pay a mortgage carrying a too high premium for risk too high monthly payments and secured at 100% by an inflated home valuation that kept everything going, and the same will happen for overlevereged LBOs...if the company makes barely enough to pay debt and stops investing in the business, in 2 or 3 years will not make enough to pay the debt. So much so if the interest rate went up and the stream of payments to service the debt went up.
What really impresses me is that I'm talking Finance 101 not exoteric concepts.A bad loan is a bad loan period. It has all the probability to end sourly and receivership to collect the collateral will always leave you with 30 cents to the dollar and your book will be ravaged, unless you made appropriate provisions knowing what you did...then you pocket the 30 cents write it off and keep going. Very few did that in this case , and the few were pros dealing with subpar loans for looong time. the newcomers got, rightly enough killed!!
The leverage will be deleveraged by the lenders first, and Hedge Funds principals are already facing margin calls for "change of policy" (I had one a couple of years ago...but I was holding liquid securities at a profit..a nuisance, nothing more) It is a BIG problem when the stuff you are asked to sell in 48 hours was packaged and sold to you by the same lender in generous 98 cents to the dollar lines of collateralised credit!!
The excessive leverage will disappear, and the brunt is borne by the greedy, so no one will listen to help cries and no one will receive help from the Gov. the ones invoking regulations will be the ones who booked 30%pa returns for 2/3 years on "safe, bondlike" securities. Forgetting the basics: 30%pa cannot come from AAA securities...simply, cannot be, and if you believed that...well fools are born everyday.
In this way Central banks will have dried up a large pool of extra liquidity.
A New report from the rating agency Fitch puts credit-oriented hedge fund equity at $300 billion, levered up five or six times to buy $1.5 trillion to $1.8 trillion in loans, mortgage-backed securities, high-yield bonds, less-protected tranches of collateralized debt obligations and credit default swaps. There's additional leverage embedded in instruments like CDOs and credit default swaps, which Fitch does not attempt to estimate.
Mortgage-related assets are only a small fraction of hedge fund credit strategies, which in the aggregate account for 15% of assets if one accepts $2 trillion as the approximate size of the hedge fund industry.
The contraction by lenders will probably continue beyond the subprime scare because it is partly driven by tighter money policies among central banks worldwide. In the United States, many said they expected the Federal Reserve to ease credit this year, but now some predict it will raise rates before the year is over, in response to stronger growth.
The market will still regulate himself...separating fools from their moneys.
