Sunday, March 30, 2008

Tiny Margins, Mega Leverage

Two trends have dominated financial markets in recent decades. First, there is an arms race going on in instruments and trading algorithms. Math jocks are going braino-a-braino to devise increasingly sophisticated strategies, to the point where even specialists are unsure how to value portfolios. At the same time, there has been an escalation of leverage; unregulated investment funds are lending to the tune of 30 or more times their equity base. Maybe these developments are related.



The current argument is that over-the-top leveraging is the consequence of a regulatory breakdown, and there is certainly truth to the extent that the failure of oversight has enabled investment banks and hedge funds to do whatever they want — but why did they want to extend themselves so far?

Here is one possibility: the new math-intensive strategies are chasing tiny margins. The trading programs are designed to perceive opportunities for arbitrage a nanosecond before anyone else, taking advantage of the slightest misalignment of related prices. We have also witnessed ever more elaborate strategies involving complex tradeoffs between risk and return to create composite positions whose alpha is perceived to be a shade higher in relation to its beta.

The profit margins on these strategies are minuscule, but if everything goes as programmed, predictable. This means that they can be turned into respectable earnings only through intense leverage. By investing in positions at the rate of 3000% of capital, you turn 1% annualized margins (which correspond to much smaller margins on any given trade) into 30%. And the geniuses who devise these opaque instruments tell you that the risk is small relative to the return.

What the risk jockeys always seem to miss is that estimates of portfolio risk depend on covariances among the individual elements, and these in turn are determined by the structural properties of the system in question. And no one can know what they are, because the system is too complex, there are too few data points, and the structure keeps changing. So the models work, trade after trade, until there is an unforeseen systemic event, after which all hell breaks loose.

Then the high degree of leverage, which was necessary to make the strategy pay sufficient dividends, magnifies the risk instead of the return.

If this analysis is correct, it suggests that putting a ceiling on leverage may also slow down the drive toward unfathomable financial complexity. That would be a good thing, and not just for us dummies.

5 comments:

reason said...

This is so obviously true I wonder why it hasn't been said by more prominent people. But you are missing something. Risk for whom? Don't forget the multiplication of limited liability investment firms. The downside is limited. This is a scam. Limited liability and unlimited leverage is a very nasty combination. If the rich were doing this is their own name and not parcelling it out in bite sized chunks via hedge funds, I'd be less angry and less concerned.

PGL said...

When the term financial "engineering" became the cat's meow, we should have known we were in trouble. And you are right - some of these rocket scientists don't get the implications of high correlated returns. But if they don't, should we really seen them as gurus?

reason said...

Don't forget Keynes aside (paraphrased) about prudent bankers being imprudent in the same way as every body else. The downside is limited for the people taking the huge risks. There is a huge agency problem here.

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Unknown said...

The people that put the deals together engaged in this intense leveraging and chased the tiny margins for two reasons.

They got paid! In the street slang sense of the term, they got paid! They got big salaries they had to justify, and even bigger bonus checks for making the deals happen.

If the individuals had to return the bonus money they got for making over-leveraged deals using securities whose value no one had any meaningful way to evaluate, the behavior would change.

As reason said "Limited liability and unlimited leverage is a very nasty combination". It's also very tempting.

As long as they get to keep the big bonus money, why on earth would they not put together these over-leveraged deals?