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Wednesday, June 9, 2010

Leveraged ETFs - An Accident Waiting to Happen?

There are stocks and there are bonds. All other financial instruments were created to get around some regulation. Frank Partnoy made this point in "Infectious Greed", published in 2003 to discuss the history of derivatives up to that time.

What about a 5-year average life collateralized mortgage obligation (CMO) This is an instrument created by carving up the cash flows of 30-year mortgages and placing them in a specific tranche so that a treasurer can get around the investment policy statement requiring investments to have a maturity of 5 years or less. What about an inverse floater CMO? This is a highly leveraged instrument created to make a significant bet on interest rates moving lower by those who are not allowed to legally borrow money to become leveraged. How about a structured note whose payment depends on the return of whatever has been the hottest stock market in the world over the past 3 years? It would be for the treasurer who is not allowed to invest globally. What about the municipality that wants to play the yield curve? There are structured interest rate swaps to do this.

The process is usually the same. The suits from Wall Street show up, find out what you want to invest in or explain what you need to invest in, and then go out and create it - the investment policy statement (IPS) be damned. They will create an instrument that lawyers can defend and that circumvents the intent of the IPS. This is a big bucks operation that ends up hurting a lot of people and sometimes soaks the American taxpayer.

The most recent manifestation was the toxic securities created from subprime mortgages sold around the world. These were sold to entities that were not allowed to invest in low-quality instruments. This is where the rating agencies showed up, carved up the cash flows (a process they have had plenty of experience at) and, again, produced securities designed to get around the safeguards - a triple A rating is (or at least has been) a powerful gate opener in the investment world.

Today people seem to agree that leverage is a problem. For example, it looks like bank capital requirements will be raised and bigger banks (read: "too big to fail") may be required to hold a greater proportion of assets as capital.

In hindsight, there are those who argue that the Federal Reserve should have reduced leverage by increasing margin requirements early on in the stock market run up in 2006/2007. This, they argue, would have mitigated the 2008 downturn.

All of this, of course, is similar to the community that puts up a traffic light after a horrific automobile accident has occurred. It's on the order of tightening up oil drilling after oil is washing up on America's beaches.

Still, despite the general agreement that leverage needs to be controlled, there is a proliferation of leveraged products in the form of ultra exchange traded funds. These can be used, by the average investor, to make leveraged bets on the direction, up or down, of stocks and interest rates and can get 2 to 3 times the move in the index.

Is this an instance where we, once again, turn in the other direction and then express surprise and consternation when the train wreck occurs?


  1. The main problem is that the gains are private, whereas the losses are spread across the population. Look at the bonuses that the fat cats are getting, and then look at the widespread financial damage.

    That these guys can shove off all the costs onto others is the real problem. Self-regulation in that sense certainly doesn't work!

  2. Excellent point! We need to stop socializing the losses.

  3. I think we certainly have a problem learning from our mistakes. Didn't this same issue of overleverage cause a crash a little over a decade ago? It's not rocket science, and I think the increased capital requirement is a good move personally.

  4. I completely agree that long term leverage exposure (greed) is no good for society. It really makes us seem like we cannot learn from our mistakes in a macro environment. However, in short-term cases, like the onset of a period of reduced consumer confidence, leverage in investments can become an advantage.

    I think the moral is that leveraged investments, as all other investments, are only tools. Treating every tool the same in all market conditions is a good way to lose money individually, and when playing with other people's money, a good way to destroy economies.

  5. You guys aren't thinking flexibly enough. You're forgetting what happens when brilliant investment men practice the big leveraging process. I mean, take a bunch of nobel prize winning laureates to make a complex mathematical model that (in theory) should be able to generate returns that make others look silly for their non leveraged conservatism.

    Oh---You say Long Term Capital Management tried that?

    Gotcha! And you guys thought I was disagreeing with you.

  6. I'm not sure if the problem is that we don't learn from our mistakes. It seems sometimes it like a game of musical chairs. We know we're going down the wrong road but we keep going because as long as you can find a chair when the music stops you'll do all right. Even with Long Term Capital Management some people walked away with huge payoffs after bringing the global financial system to its knees.
    I agree that leveraged investments are tools and tools need to be used the right way. One of the problems is that the tools that are leveraged are used to gamble. If mortgage downpayments are 5% or less even they may in some instances be suitable but in others pure speculation. At 5% it only take a 6% drop to wipe out equity. On the other hand a 5% increase in the home price and the speculator doubles his money.