There is widespread recognition that the benign conditions of recent years encouraged a sharp increase in the leverage within the financial system. The build-up of leverage this time around entails a number of surprises. New financial techniques have supplanted lending as the primary source of liquidity and leverage creation reflecting Will Rogers’ droll observation: “You can't say that civilization don't advance; for in every war they kill you a new way.”
Traditional leverage, in the form of borrowings, remains important. A major area of growth has been collateralised lending where holders sell assets against the agreement to re-purchase it at a future date. Growth of hedge funds and prime brokers has fueled explosive growth in collateral and expanded the range of assets against which funding can be raised. Substantial sums can be raised against any type of security or instrument, complementing the long established government bond repo markets.
The borrower posts an initial margin or “haircut” (a small amount of his money) and promises to post more cash if the value of the asset declines. Favourable regulatory rules, optimistic views of liquidity (the collateral must be sold if the borrower fails to pay) and faith in the models used to set the initial margin are driving aggressive use of collateral increasing available liquidity and leverage.
Derivatives have contributed to the sharp rise in leverage. Derivative structures have increased leverage in two ways.
The first is the “derivatisation” of lending. For example, the purchase of $10 million of shares requires commitment of cash. The trader can instead enter a total return swap (“TRS”). Under the terms of the swap (see Diagram below) he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return through leverage. In effect, the loan to the investor secured over the asset has been repackaged as a derivative transaction enhancing the leverage.
The second way in which derivatives can be used is to create embedded loss leverage. For a given event, you increase your potential gain or loss. Two examples – digital options (a common form of exotic derivative) and credit leverage in collateralised debt obligations (“CDOs”) – illustrate the idea.
Under a normal option to buy shares at $100 (the strike), if the shares at expiry of the option are above $100, the gain is equal to the share price minus $100; if the share price is $110, then the purchaser of the option makes and the seller loses $10. In a digital or binary option, the parties can agree that if the share price is above $100, then the option payoff is $25. If the option is in-the-money (above the strike price of $100) then the gain to the buyer and loss to the seller is the fixed $25, irrespective of whether the share price is $100.01 or $200. In effect, for a relatively small move in the share price (from $100 to $100.01), the option buyer gains and the option seller losses $25 (25% of the value of the share) effectively embedding tremendous sensitivity (i.e. leverage) to price movements.
Digital options enable traders to nominate large payouts to take leveraged positions on price movements. Declining market volatility in recent years has meant that traders generate larger premiums by increasing the size of their wagers.
The equity tranche of collateralised debt obligations (“CDOs”) is an example of loss leverage in credit markets. A typical CDO consists of a $1,000 million portfolio made up of $10 million exposure to 100 corporations. The equity investor assumes the first 2% ($20 million) of losses on the portfolio. Assuming a loss of $6 million if any corporation defaults (recovery rates are 40% of $10 million), the equity investor is taking the risk of the first three defaults. In contrast, if the investor invested $20 million in the entire portfolio ($200,000 per corporation), then three defaults in the portfolio would result in the investor losing $0.36 million (loss of $120,000 per company ($200,00 adjusted for 40% recovery rates) times 3). For three losses the equity tranche investor’s leverage to defaults is 56 times (if there were 3 losses then the investors loses the entire $20 million invested in the CDO equity against $0.36 million in the diversified portfolio). By reducing the “tranche width” (the size of the equity tranche) the credit leverage can be increased to over 83 times!
Increasing the amount of potential gain or loss for a given event is now routinely used to create leverage. The use of these techniques is poorly understood. It does not show up in traditional leverage measurements that are focused on the level of borrowings. The additional liquidity and leverage creates complex chains of risk and moral hazard in markets that may prove problematic when prices correct. It is another unknown unknown of modern markets.
As Wells Fargo CEO John Stumpf observed: “It’s puzzling why bankers have come up with these new ways to lose money when the old ways were working so well.”
© Satyajit 2008
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).