Invisible Leverage

Recently I shared two chapters of my book with readers.

They were Roots of the Meltdown and The Blame Game, which were my real-time take from early 2008 on the cause for the building crisis.

Today I’m sharing another snapshot from that turbulent time.  This chapter explains how some of the highest leverage in the market came through “synthetic” bonds, something virtually unknown to the public.

This chapter was one of the last ones I wrote during the final sprint to finish the book, written in the week following the emergency “merger” of Bear Stearns into JP Morgan Chase.

Even active participants in the bond market had to be party to the trades to get the skinny.  At that moment in time, if you held a subprime mortgage bond, even a AAA bond, you could only borrow 50 cents on the dollar (1-1 leverage), and then only if you were a good customer the lender really wanted to please.

With that as background, I was amazed to find out from a friend who managed a hedge fund that he was still getting 19-1 leverage on the same bonds.  The way he got that kind of leverage was by buying (or selling short) using Credit Default Swaps.

When I wrote the book, I wrote definitions of some of the bond market terminology, intending for the definitions to appear in little boxes next to the first place the words or phrases were used. You’ll see some of those bracketed calls for definitions in this chapter.  Later in the day I will come back and edit this post by adding those definitions at the end.


Chapter 24

Invisible Leverage

I used to joke with my equity trader friends that they had it easy. If they picked a good stock, it could double. If they picked a bad stock, it could drop by 50%. If they picked an equal number of good stocks and bad stocks, they could make a 25% profit, which isn’t bad.

On the other hand, when we pick a good bond, we feel good if we get 1% extra yield. If we pick a bad bond, we lose 25% or more. We have to be right twenty-five times as often as we are wrong just to break even.

Some very clever bears apparently noticed the same fact, and realized they could get much better odds making their bearish bets on bonds instead of (or in addition to) selling stocks short or buying puts in the options market.

It is certainly more expensive to sell stock short. The market requires traders to borrow the stock and pay margin interest that can be 5% per year or more in addition to having cash in a margin account equal to 50% of the value of the stock being shorted.

By contrast, most corporate Credit Default Swap (CDS) contracts only charge 1% to 3% of the face amount of the bond as an annual payment and the capital requirement is only about 5% of the face amount.

If a corporate bond issuer goes into default, the typical decline in value of the bond is around 30%. For a corporate CDS investor, that’s a 600% return on the 5% capital deposited to enter into the contract. In the subprime CDS market, a 5% capital bet could return as much as 2000% if the bond represented became worthless. Compare that to short sales, where if a stock goes to zero, the maximum return on capital is 200%.

The CDS market was a goldmine for betting against companies. Bearish traders who previously had shorted company stocks discovered that the relatively small amount of capital and low payments for CDS brought them much higher returns when they correctly targeted companies that were in trouble.

Although I work as a portfolio manager for a major financial institution, it was only recently that I discovered how much more leverage can be extended to speculators than to bond investors during a credit crunch.

Terms for swaps between institutional investors are executed as private contracts known as “over the counter” transactions, and they have no public disclosure requirement. The only reason I knew what was going on in the swaps market was that I have friends in the business.

In March of 2008, right at the time Bear Stearns was collapsing, a friend of mine informed me that a trade executed for a hedge fund he managed was going long (selling protection) on the ABX 06-1 AAA index, and that the total cash deposit required was just 5% of the value of the index.

Seven months earlier, the ample credit traditionally extended to finance bond purchases had virtually disappeared. If the twenty bonds in the ABX had been bought directly, chances are that the purchase would have been only 50% financed – if credit were available at all. But ABX investors were getting 95% financing.

Perhaps this is because conventional repo financing for real bonds requires the lender to take the bonds onto their balance sheets, while the derivatives that represent those bonds (the CDS) will only appear as a note in financial statements.

The moral of the story is that high leverage still exists, but not for regulated institutions paying cash and taking bonds onto their balance sheets. Today, the greatest leverage exists only for speculators who comprise the least regulated segment of the investment universe.

Admittedly, this is not a “free ride” for the hedge funds. The hedge fund accounts that went long the 06-1 AAA index are still exposed to the risk of credit loss, and also exposed every night to changes in the market value of the index. The counterparties to swap contracts can (and do) demand more cash every time the price of the index moves down.

On the bear side of the trade, the fund making that bet is also at risk if the value of the index goes up. This downside is naturally limited, however, since mortgage bonds are seldom, if ever, worth as much as 110% of their face amount.

If the index did suddenly move by 10% in either direction, you might wonder how that would affect an investment with 19-1 leverage, or 95% financing. Given the fact that there are thousands of unsupervised hedge funds at work and they have huge incentives to take big risks for big rewards, it’s a near certainty that at least some of them would be unable to pay the extra 10% in cash that such a big move in price would necessitate.

Wall Street’s Prime Brokers are the counterparties who allow the hedge funds to place their bets with only 5% of the value of the bonds they are betting on. If there were to be a sudden 10% move in values and the hedge funds couldn’t meet the collateral demands for more cash, those Prime Brokers are on the hook for any shortfalls.

[Insert Prime Broker definition near here]

Bear Stearns was one of the top three such “middlemen” in its role as Prime Broker for thousands of hedge funds, especially the funds that are active in trading and investing in mortgage bonds and the CDS derivatives based on those bonds.

When the Fed was faced with the prospect of the fifth-largest intermediary in the CDS business suddenly disappearing, it’s easy to see why principles in favor of “benign neglect” or avoiding “moral hazard” went out the window. Least of the concerns at that time was whether bailing out one company that took imprudent risks would encourage others to do the same.

The Fed action didn’t save Bear Stearns, but did preserve its existing contracts so that CDS contract counterparties were not forced to try to protect their rights in a massive tangle of legal action. For those involved in the Credit Default Swap market, having their counterparty simply disappear would be like owning stock on the day the New York Stock Exchange quit handling trades or even publishing stock prices.

If no one was there to take over when Bear Stearns became insolvent, the crisis of confidence would have been one of the most extreme cases of letting the pieces fall where they may that ever happened. There was literally no way to know the outcome, except to say that it would have affected almost every major financial institution in the world.

That’s why JP Morgan, the largest CDS market-maker on Wall Street, got to pull off their purchase in the way they did. While taxpayers could lose up to $29 billion, JP Morgan is likely to make about $2 billion a year in profits on the spread between the yield of the Bear Stearns mortgage portfolio and the Federal Reserve lending rate.

Just how large is the CDS business, and why is it so important that the taxpayers should subsidize the largest participant in the business taking over the fifth largest? In the Bank for International Settlements (BIS) June 2007 Triennial Central Bank Survey, it was reported that the CDS business grew to a face amount over $45 trillion, up from an amount so small that it wasn’t even reported three years earlier. This staggering sum was twice as much as the combined value of all stocks on the U.S. exchanges at the time, and nearly three times the size of our national GDP.

These huge “notional” contract totals are sometimes interpreted to be the economic value of the CDS business. That is like saying the value of all auto insurance is a maximum $300,000 claim times all the cars in America. A more meaningful dollar value would be the collateral held aside by counterparties to the contracts, because that’s how the parties to the contracts actually manage their economic exposure.

[Insert Notional definition near here]

CDS collateral agreements are commonly required from less creditworthy contract participants, but not required from the very best credits. At the time of the 2007 survey mentioned above, 59% of the existing contracts were covered by these collateral agreements, and the total collateral posted in those agreements was $1.335 trillion.

By the time the first survey of 2008 was underway, 65% of the credit exposure from privately negotiated derivatives was covered by collateral agreements, and the total collateral posted was up almost 60% to $2.1 trillion, about 80% of which was cash.

Just like the margin requirements under repo agreements, a party to the collateral agreement can call for additional collateral at any time if the value of the counterparty’s position has declined. Had JP Morgan not taken over the liabilities of Bear Stearns in this regard, a significant amount of the multi-trillion dollar exposure related to CDS would have been uncollateralized.

It is unfortunate that there is no central counterparty for all the participants in the CDS market, the way there is for exchange traded derivatives like stock options. When you buy or sell stock options, your trade is always executed with the Options Clearing Corporation as your trading counterparty.

The reality of Wall Street dealers is that they are subject to a more extreme regimen of financial reporting than any other participants in our markets, except perhaps mutual funds. Nightly calculations of capital adequacy are required, as is same-day reporting of shortfalls. By comparison, banks and insurance companies have almost glacial monthly and quarterly reporting. This is in contrast to the unaudited quarterly reports from public (non-financial) companies released six weeks after the end of each quarter.

In spite of the frequency of measurement and financial reporting, a “run on the bank” can make a major Wall Street house insolvent in a matter of days. When Drexel (of junk bond fame) collapsed in 1990, the entire liquidity event unfolded in two days. Other Wall Street dealers agreed to settle Drexel’s pending trades, and the firm was gone, just like that. Bear Stearns announced it had tens of billions in cash on hand on a Tuesday, and the following weekend, the Treasury Secretary and Chairman of the Fed were negotiating a sweetheart deal for the takeover so they could announce it before the markets opened in Asia.

There is little or no public information available regarding the financial strength of many participants in the credit derivatives market because they are hedge funds. According to a February 2007 report from Bank of America, 31% of all the CDS outstanding were sold by hedge funds. How much capital do these hedge funds have to support their obligations under these contracts?

To paraphrase the Clairol slogan from the Advertising Hall of Fame, the answer to the question is “Only their Prime Broker knows for sure.”

Given what’s at risk, that’s not good enough. All financial institutions with obligations under swaps contracts should receive the same scrutiny, and adhere to the same standards for soundness. Barring that, every entrant into a Credit Default Swap should make a “security deposit” proportional to their exposure.

Particularly ironic is the amount of criticism leveled at the public brokerage firms by the hedge funds, who have to tell no one other than their investors what they hold, what the value is of what they hold, and how they arrived at those values. Here’s a question for every hedge fund investor reading this book: What independent valuation have you commissioned to look at those “side pocket” investments?

[Insert Side Pocket Investments definition near here]

When we look at the enormity and consequences of the credit crisis we need to look beyond subprime borrowers. We need to look at the unregulated entities that can easily jeopardize our financial system with no recourse from our government.

Here are the questions we should be asking ourselves: Is it possible that the undisclosed credit derivative market exposures held by highly leveraged hedge funds is putting our economy at risk? Is it a much larger exposure than subprime mortgages? And are the investing and tax-paying public adequately protected by the handful of qualified high net worth investors whose money is at risk in these funds?

The concept of the “sophisticated investor” has been used to give hedge funds a free pass on public disclosure. The assumption is that institutional and wealthy clients will look after their own money better than some regulator might. That’s fine in theory, but the blanket assertion that these high net worth participants in the market are financially sophisticated is worthy of skepticism (some of them just have a lot of money). Beyond that, when the right of those individuals to look after their own money puts every taxpayer at risk for footing the bill, as it did with Bear Stearns, we have to question the sanctity of their right to privacy.

Bill Gross of Pimco, lead manager of the world’s largest bond fund, probably described swaps and derivatives best as a “shadow” banking system. In just ten years, we have seen the mostly undisclosed exposures of hedge funds grow to a multiple of the old-fashioned publicly regulated banking system we know and use.

The hedge funds have taken over the structured finance market, especially the CDS market. In a report released in August of 2007, Greenwich Associates, a respected provider of information on capital flows and market activities of institutions, described their study of US bond market activity from April, 2006 through April, 2007 as follows:

“In past years, Greenwich Associates has documented the rise of hedge funds from minor players to significant sources of liquidity in certain fixed-income products. However, the recent expansion of hedge fund positions and trading activity has been so rapid and consistent that it is now no exaggeration to say that, during the 2006-2007 [study], hedge funds were no longer just an important part of the market in some fixed-income products — they were the market.”

After the Greenwich Associates study was completed with data ending in early 2007, the volume continued to rise in subprime CDS, and exploded in the CDS tied to CDO’s, alt-A residential mortgage bonds, and commercial mortgage bonds (CMBS).

The capital supporting the huge shadow system Mr. Gross refers to is microscopic relative to the size of the financial contracts outstanding. Yet much of that capital legally resides offshore in havens like the Cayman Islands, beyond the reach of our government in the event of default.

It would be unfortunate if, at some point in the future, our insured financial institutions or our “too big to fail” brokerage firms relied on offshore hedge funds to pay them for large contractual obligations, and those offshore funds reneged.

The impact of this enormous amount of offshore capital on the future health and soundness of our financial system cannot be exaggerated. I believe that these systemic risks outweigh any issues related to the subprime mortgage market.

How unfortunate that some of the enormous hedge fund profits now residing offshore have been made by exacerbating what would have been a serious correction to lending excesses even without their influence.


[Prime Broker – A broker that executes trades and holds a portfolio for hedge funds or other institutional accounts. Providing margin credit, lending securities for customers to sell short, and clearing trades of all types for these accounts is one of Wall Street’s most lucrative businesses.]

[Notional – The face amount of the underlying bond, stock or currency that is referenced by a swap contract. The huge numbers we see of “notional” swaps outstanding includes all the closed-out trades, which are double reported, even though they have no economic impact.]

[Side Pocket Investments – Investments defined by hedge fund managers as “side pockets” are not subject to mark-to-market disclosure, even to investors in the funds. Originally created for investments in private companies, some managers designate almost any difficult to value investment as a “side pocket.”]

7 Responses to Invisible Leverage

  1. […] Hill’s latest posting (I get up earlier than Howard) is another chapter from his book and this one is called “Invisible Leverage” and you absolutely have to read it or go wandering around economically ignorant…which doesn’t seem to bother 306.4 million […]

  2. […] and lucrative. You can find some of the chapters of that book online at Howard’s blog site,  “ Most Corporate Credit Default Swap (CDS) contracts only charge 1% to 3% of the face amount […]

  3. Moe says:

    I’m interested in reading your book. Is it released?

    • hhill51 says:

      Thanks for the encouragement.
      I finished writing the manuscript on Tax Day, 2008, so it’s somewhat out of date. Not being an academic or a reporter (just an insider that helped define the business), I couldn’t get an agent to represent it without quitting my day job.
      Now I intend to freshen it, and possibly check out one of those print-on-demand publishers. As you can tell, I have a different take than what the outsiders who have published so far have said. I will come to some sort of conclusion on what I’m doing with it over the next month or so.

  4. nice post man
    I really enjoyed it
    I will definitely visit your website again
    thanks guys

  5. I’m interested in reading your book. Is it released.

    • hhill51 says:

      Not yet, though I’ve shared a few chapters on the blog. I’m looking at e-publishing as an alternative. If you have thoughts on that, I’d love to hear them via the blowback page. (That sends me an e-mail that I can reply to off-line.)

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