Give me a place to stand, and I will move the Earth.
— Archimedes, on the power of leverage
You know something is up when even a blogsite devoted to the hedge fund industry posts a piece entitled "Do hedge funds cause systemic risk after all?"
AllAboutAlpha—which usually has a noticeably positive perspective on hedgies and their machinations—broke with precedent this past Tuesday with the aforementioned post, in which Alpha Male cites both a recent New York Fed study and Richard Bookstaber's new book, "A Demon of Our Own Design," as offering a resounding "Yes" answer to the question he posed in his title. Each of the extensive quotations Mr. Male cites supports the argument made by a wise man of my acquaintance, reported elsewhere and confirmed by research, that embedded leverage among the hedge fund community and elsewhere has a high potential to end in tears.
(Never mind that Mr. Bookstaber is the same individual who by his own admission had a substantial part to play in both the market meltdown of October 1987 and the 1998 blow up of Long-Term Capital Management.1 My wise acquaintance is always grateful for any and all support.)
Now, to be fair,2 hedge funds did not invent the use of leverage in investment management, and they are not the only market participants who use it. Nevertheless, I think few would argue that hedge funds, in aggregate, deploy a great deal of leverage,3 in pursuit of higher returns. Much of this is direct leverage, in the form of margin loans borrowed from their prime brokers, the investment banks. But another substantial chunk consists of embedded leverage, which takes the form of structural leverage embedded in tradeable securities and derivatives. Often, hedge funds use margin loans to purchase and hold structurally levered derivatives, thereby compounding leverage upon leverage. This, as I am sure you will agree, can be a combustible mix.
Complicating the picture is another transformation in the market from previous practice, concerning the distribution of risk. Risk—fundamentally in the form of risky securities and derivatives—is widely believed to have become far more broadly distributed among investors, hedge fund and otherwise, than it used to be. A common example is the new paradigm for corporate loans. Where before commercial banks originated and held such obligations on their balance sheets for the duration of the loan, now commercial and investment banks originate, package, and distribute the lion's share of such loans to a broad universe of investors, thereby diffusing these risks throughout the system.
Some market pundits argue that this development (and analogous developments in other securities markets) has not only made the financial markets more efficient—by directing specific risks to those investors with particular appetites for them—but also safer, since the consequence of any one particular security or issuer blowing up should be more broadly and diffusely distributed across the universe of investors. Should Chrysler go belly up, the argument goes, a great many investors will feel a fair amount of pain, but no one investor or lending institution should blow up with it. Furthermore, the proliferation of hedge funds with different investment strategies means that there are plenty more investors out there to take the other side of losing trades. Shocks to the system should get dampened pretty quickly. Intuitively, these concepts make a lot of sense.
But if this is true, why does the recent meltdown in the subprime mortgage market seem to be spilling over into other, apparently unrelated securities markets, like those for corporate and high yield debt? Do investors really believe that subprime mortgage defaults in Florida and Las Vegas are going to affect Cerberus Capital's ability to repay the loans it wants to use to buy out Chrysler? Why has the blow up of Bear Stearns' subprime hedge funds put the kibosh on KKR's ability to issue debt to buy British pharmacy operator Alliance Boots? Whence this fabled "contagion" whereof everyone speaks? Wherefore the "flight to quality?"
Well, consider this. A fund with a highly levered balance sheet, and its investment fingers in many pies, is hit with losses in one of its sub-portfolios. Due to the nasty two-edged bite of leverage, its equity drops significantly, and the only way it can restore its risk profile is to raise more equity or liquidate some of its investments. Given the poor market conditions in the affected sub-portfolio, it is often more prudent to liquidate securities in other sub-portfolios. But this, as you can imagine, puts downward price pressure on securities in those previously unrelated markets. Presto, contagion. This is the "common holder" problem which some believe is the primary culprit.
Consider further. What if a substantial portion of our hedge fund's holdings consisted of loans to other investors—hedge funds, perhaps—whose own portfolios were experiencing losses? Well, then, "liquidating" those positions and reducing its risk exposure would look an awful lot like calling the loans, or reducing their outstanding balances. Finally, add this to the mix. What if our fund had another side to its business, which generated revenues from the origination, market-making, and placement of securities, which revenues were negatively affected by turmoil in some or all of the markets where it also had investments? Well, that would be a triple whammy, and our little hedge fund would look an awful lot like a prime broker investment bank.
Market-making investment banks are usually net long in many securities markets at any one time, so they are directly affected by declining liquidity and declining prices. Prime broker investment banks are also by definition long credit exposure to hedge funds and other levered investors, and when the portfolio values of those investors come under pressure, the risk and value of those margin loans goes up and down, respectively, forcing the prime brokers to deliver margin calls. (Unlike most hedge funds, clearing banks and securities firms are subject to intense regulatory oversight on their own creditworthiness, so they do not normally have the luxury of sweeping problems under the carpet, as some might suggest.) And finally, investment banks earn substantial fees from activities like M&A, securities underwriting, and securities placement, which all come under pressure in times of market turmoil.
Investment and commercial banks remain the primary transmitters of contagion in times of market stress, because they remain the central nodes through which the lifeblood of credit flows, and because they are exposed so strongly to both direct and indirect effects of market swoons. They remain the lenders of last resort—at least in the short term—as the gently swaying spans of tens of billions of dollars of hung equity and debt bridges can attest. And they are the quickest and fiercest enforcers of the risk reduction and delevering responses to market disruptions, because their own highly levered balance sheets keep them regularly poised on the edge of the abyss themselves. And should their commitment to financial probity waver, or should they be tempted to argue with their auditors over the value of that last illiquid CDO in the portfolio, there is a nasty little man with a briefcase waiting in the lobby to stiffen their spine.
He is from the government, and he is here to help.
1 In the first instance, he was one of the busy little beavers in Morgan Stanley's derivatives business who sold "portfolio insurance" to timid institutional and corporate investors to protect them from equity market swoons. Suffice it to say that portfolio insurance had rather the opposite effect of that intended by its inventors, including such Nobel luminaries as Robert Merton, and by all accounts helped accelerate and deepen the decline when it happened. Perhaps that was because—abstracting from all the pretty Greek letters and partial differential equations used to market the mess—the strategy consisted of selling into a market decline. Hmm ... I wonder why that didn't work?
In the second, Richie-poo tried to figure out why Salomon Brothers' bond arbitrage desk was losing more than $100 million in 1998 with a supposed interest-rate neutral strategy in a declining interest rate environment. Apparently, he couldn't figure it out, so cranky new owner Sandy Weill of Travelers pulled the plug and liquidated the group's positions. This set off a downward liquidity spiral across a number of interest rate markets, which trapped LTCM into similar or identical trading positions of immense size and precipitated its demise and eventual rescue and takeover by Salomon and other Wall Street banks.
Members of the Plaintiff's Bar, take note.
3 Because there has been tremendous growth in assets under management by hedge funds over the past several years, and because there has also been tremendous growth in the volume of derivative securities outstanding, it is a short step to assert that the aggregate dollar amount of leverage in the financial markets has grown substantially. Whether this is in fact true, and the separate question as to whether the aggregate percentage of leverage in the system has increased, are both empirical questions that should be subject to a definitive answer, one way or another. (Perhaps this has been done already.) In any event, unless it is proven otherwise, I will believe on the basis of common sense that at least the former is true. The answer is not central to my argument.
© 2007 The Epicurean Dealmaker. All rights reserved.
