Quality leverage is not that bad, after all
Newsflow over the weekend gave us another reminder that too much leverage in financial markets is a bad thing. The court-appointed examiner into the collapse of Lehman Brothers on Wall Street in September 2008 has now revealed that the bank used an accounting "gimmick" to reduce the apparent size of its balance sheet at each quarterly reporting period. Lehman, it seems, was painfully aware that if the wider markets actually knew how much leverage was being applied to its day-to-day business, investors might panic.
It went to dubious lengths to create synthetic transactions – what are now seen as the notorious Repo 105 trades – to lower its publicly reported leverage ratio. But is leverage – using borrowings to increase the size of a financial bet – necessarily a bad thing?
A report from hedge fund DE Shaw tackles the issue head on. Here's the firm's introduction to "Lessons from the Woodshop":
"Leverage and power tools share three fundamental properties: they can be extremely helpful, they can allow for far greater precision, and they can be really dangerous, even in the hands of experts. We would wager that some of us who took a woodshop or metalshop class in high school had instructors – however masterful a carpenter or machinist – who were missing at least one finger due to the moment of inattention while operating a table saw."
Leverage, DE Shaw reminds us, offers both opportunities and brings potential risks. Debt allows a trader to do more with less. In some markets, such as fixed-income and currency trading, leverage is crucial if the trader wants to exploit small price movements or minute market inefficiencies.
At the same time, the amplification effect applies to risks as well as rewards. As Shaw explains: "Levered investors can lose more than all of their invested capital. Consequently, an investor who employs leverage may leave himself vulnerable to a self-reinforcing downward spiral when the price of an asset moves against her.
"Concentrated exposure to a financed asset means that a relatively small price move could translate into a large capital loss, which may, in turn, force the investor to sell assets to meet margin calls. The sale of assets then puts further downward pressure on the asset's price, creating a vicious cycle of margin calls, forced sales, and adverse price movements. This contrasts with unlevered investors who, in the absence of margin calls, are never compelled to liquidate if they prefer not to."
Clearly, it's important how "levered" the trader is – the ratio of total borrowings to the capital put on the table for any given trade. For Lehman, the real figure seems to have been something north of 80 times at various stages as it staggered towards the end. Clearly, that was too much!
But DE Shaw reminds us that it is not just the raw total of the leverage employed, but also the 'quality' of the borrowed money. Where does it come from? What collateral has been put up to secure the lending? Is the borrowed money likely to disappear?
The firm offers six factors that should be considered when assessing the quality of a particular financing arrangement:
- The borrowing term. Longer lending commitments improve financing quality.
- Haircut/initial margin size. The lower the better, since a haircut is similar to a down payment when financing a home.
- Haircut stability. Constant haircuts are better than 'variable' haircuts since the latter are more likely to be hiked at difficult times.
- Stability of the financing counterparty. Quite simply, a stronger lender is more likely to be able to deal with matters in the event that a problem emerges.
- Valuation and other rights. If disputes arise, it's important to have clear and fair procedures rules to follow.
- Cost. This is particularly important relative to the expected return.
With 20 years of history, like the workshop teacher with the missing pinky, DE Shaw reckons it is more respectful of the dangers of leverage than many younger hedge funds might be. The advice may save you a financial finger or two.
As the country awaits some sort of bailout package from its eurozone partners, financial markets refuse to take anything other than a dim view of its near and mid-term prospects. Consider the chart here from Deutsche Bank, comparing the bank's forecasts for Greek GDP growth over the next few years with those of the Greek Ministry of Finance. There's not much agreement!
Deutsche Bank's Paul Reynolds says that while Greece has promised a fierce austerity programme of spending cuts, tax hikes and structural reforms, delivering on these remains a Herculean task.
As he told Deutsche Bank clients this weekend:
"Where policymakers see GDP growth of -0.3 per cent in 2010, we believe growth could be closer to -4 per cent and the economy could contract by 7.5 per cent in total over 2010 – 2012. Policymakers expect unemployment to rise to over 10 per cent, where we expect an increase to 20 per cent before the adjustment is complete.
"The adjustment process is not impossible. The key risk would be if Greece is unwilling to accept the near-term adjustment costs, hoping that their current difficulties could be solved via external assistance." Late last week, reports suggested that "external assistance" might now be on offer. "Help," Reynolds seems to be saying, is the last thing Greece really needs.
- The author is Associate Editor of The Financial Times
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