In 2008, leverage became the dirtiest word in global finance, closely associated with the acute problems suffered by the financial system. Regulators identified the astronomical levels of leverage in the investment-banking sector, in particular, as a substantial contributing factor in the financial crisis.
Meanwhile, the buy-side became scared of leverage as the value of collateral plummeted, prime brokers took fright and magnified losses from investments in global stock, and debt markets exceeded tail-risk expectations in conventional portfolio analysis.
Fast forward five years and buy-side leverage is creeping back. Hedge funds, so chastened in 2009 when many had to erect gates to stem the haemorrhaging of client funds, are again gearing up to beef up their performance numbers.
“We are definitely seeing a growing desire for leverage among hedge funds,” says Kevin LoPrimo, managing director at Global Prime Partners, an independent prime brokerage house established in late 2009. “We don’t typically offer aggressive leverage, but within reason – meaning two times, three times or four times – is no problem.”
The reasonableness of leverage depends on the historic and potential volatility, and the prevailing valuations of underlying assets at the moment they are levered, as well as the ability of investors to liquidate quickly without prices gapping down against them.
Volatility can appear lowest and secondary market liquidity most abundant just as valuations are getting stretched, increasing the incentives for investors to boost their bets.
“Individual autocorrelation and inverse asset correlations mathematically drive down volatility,” says Frank Jensen, chief investment officer at Origo Asset Management. “As a consequence many need to leverage.”
LoPrimo adds: “The demand is out there among anyone who is looking for returns. Markets are moving in the right direction more consistently now, so it feels like the right time to take leverage on.
“[In fact], all hedge fund strategies appear to be taking on similar levels of leverage.”
However, will low volatility and profuse liquidity prove to have been illusions?
The leverage trend more broadly is causing a stir among regulators and the political class, triggering a push for greater regulation of the shadow banking system and a cap on banks’ debt liabilities relative to their assets, though some believe this move conflates issues.
If markets fall, leverage magnifies losses so its growing use by customers elevates counterparty risks in banks’ trading books, potentially increasing the regulatory push to impose a tighter leverage ratio on financial institutions to curb perceived systemic risks.
Partly then – amid fears that leverage is starting to build up throughout the system, among hedge fund clients and counterparties, and, accordingly, increasing banks’ counterparty risks – the Federal Reserve is widely reported to be considering a high cap on bank leverage. Congress has debated a 15% leverage ratio, with support coming from both parties.
In the UK, Mervyn King, outgoing head of the Bank of England, recently said: “I personally would attach more weight to a leverage ratio as a means of stopping some major problem.
“Supervisors would normally say that they want to use leverage ratios as a backstop. I understand that. It is a sensible thing to do, but I would rather have a tighter backstop than 33:1.”
As regulators continue this debate about banks’ own leverage, the banks are showing diminishing sensitivity to their customers’ leverage, both by underwriting bonds and extending covenant-lite loans to below-investment-grade borrowers and executing trades at high degrees of leverage with investors.
“With secure margins the banks will be OK, regardless of the odd flash-crash,” says Jensen.
Neither is it necessarily a reason for concern among fund managers. “I don’t see a problem as long as there is clarity about the collateral arrangements, which are closely tied to liquidity,” says LoPrimo.
“The liquidity of the positions will determine the amount of collateral, and the more liquidity you have, the more aggressive you can be.”
It’s worth remembering, though, that leverage is no guarantee of improved investment performance, even in the absence of market turmoil.
Senior bank loans, as measured by the S&P/LSTA US Leveraged Loan 100 index, underperformed US treasuries in April, despite returning 2.73% YTD, S&PDJI says, adding that the stronger performance witnessed in January and March had coincided with rising yields.
Ultimately, the passage of time has taken the sting out of memories of the post-Lehman carnage, when liquidity evaporated so quickly. “It’s not only private investors who quickly forget,” says Jensen. “Job rotation and a lack of pragmatic, efficient risk-management systems guarantee there will be new variants of 2008.”
That is not to say the lessons of 2008 have been forgotten. “Several institutional investors are already hoarding non-liquid assets for the theoretical risk premium,” says Jensen.
“The trouble is, when you get a margin call, you sell what you can and not what you should.”