Responding to the high levels of debt that contributed to the current financial crisis, regulators worldwide, such as the Turner committee in its recent report to the Financial Service Authority, propose a limit on the absolute leverage of financial institutions. The proposals do not fully recognise that new financial techniques have supplanted lending as the primary source of liquidity and leverage creation.
Lending has been increasingly “derivatised”. As Will Rogers’ drolly observed: “You can’t say that civilization don’t advance; for in every war they kill you a new way.”
The purchase of $10 million of assets traditionally requires commitment of cash. Now the trader enters a total return swap (“TRS”) where he receives the economic return on the asset (income and increases in price) in return for paying the cost of holding the asset (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the assets but increases its return through leverage. TRS technology is widely used to provide leverage in all asset classes.
Derivatives are routinely also used to create “embedded” leverage by increasing the amount of potential gain or loss for a given event.
In a normal option to buy shares at $100 (the strike), if the share price is $110, then the purchaser of the option makes and the seller loses $10 (the share price minus $100). In a digital or binary option, the parties can agree that if the share price is above $100, then the option payoff is a nominated fixed amount – say, $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. For a relatively small move in the share price (from $100 to $100.01), the option buyer gains and the option seller loses $25 (25% of the value of the share) embedding tremendous sensitivity to price movements (i.e. leverage).
Collateralised debt obligation (“CDO”) transactions also embed leverage. Assume a $1,000 million portfolio made up of $10 million exposure to 100 corporations where 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 ($20 million divided by 3). 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).
These techniques increased leverage and created complex risks that exacerbated losses in the present financial crisis. Importantly, these structures do not show up in traditional measures of leverage focused on the level of borrowings.
The current regulatory debate seems informed by John Kenneth Galbraith’s observation: “Between human beings there is a type of intercourse which proceeds not from knowledge, or even lack of knowledge, but from failure to know what isn’t known.“
Until the issues of derivative leverage – both disguised lending and embedding leverage – are properly recognised and regulated, the proposed limits on absolute levels of leverage and greater financial disclosure will do little to address the problems in financial markets that led to the present crisis.
Implementing absolute leverage limits will merely force changes in the methods by which leverage is created. Addressing the leverage in the financial system properly is one of the key elements of financial system reform that current reform proposal fail to adequately address.
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).