Wednesday, December 13, 2006

The limits of leverage?

Guambat is stressed when he "max-es" his credit card, but Mrs Guambat bears it with gay nonchalance. To her there is no limit, and Guambat wonders just how far it would all go if the bank didn't put a dollar figure on the amount the Guambats can run up on the card. What's the breaking point?

Bill Gross discussed the limits of leverage in his December Investment Outlook, with some usually instructive perspectives that Guambat is about to make a hash of, as Guambat is want. You can't go wrong if you go to the source.

Guambat reckons that Bill Gross reckons there are just too many Mrs Guambats in the world of financial derring-do. He says, "the leverage potency of recent years is reaching a peak, even if economic and financial market volatility remains idyllic."

I write today not to expound on the cyclical economic outlook nor to unnecessarily repeat observations of prior Investment Outlooks conceding that risk spreads are compressed and potential alpha generation likely “anemic.” What I would like to speak to now is the current pricing (overpricing) of certain risk assets even under the idyllic conditions of continued Fed transparency and globalization....

Because the bond market is more mathematically oriented than riskier asset markets, it stands to reason that a quest for certainty and reality in financial markets would begin there.

[A] finer, more precise analysis emanates from the quantitative dissection of a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or “constant proportion debt obligation.” Without too much explanation, these multibillion-dollar instruments lever investment grade indices up to 15 times the amount invested and offer or have offered a spread of 200 basis points over LIBOR with a AAA rating.

Hard to pass up I suppose, recognizing that AAA securities are by definition blue chip with rare, only infinitesimally small annual default rates. But this AAA rating is subject to numerous (more numerous than usual) subjective assumptions on the part of the rating services and in turn vulnerable to quicker downgrades than your normal AAA GE credit rating....

My purpose in bringing up the CPDO, however is not to denigrate the rating sources or to praise GE, but to state that under PIMCO quantitative modeling, current investment grade CDX spreads, shown in Chart 1, can only narrow by 3 or 4 more basis points before these CPDO instruments can no longer earn a AAA rating or offer such an attractive 200 basis point spread.

More importantly, increasing multiples of leverage beyond 15x near current yields spreads cannot maintain either a AAA rating and/or the 200 basis points in yield spread that have made this derivative so attractive and in turn helped to reinforce a declining trend in all credit spreads over the past few months.

The increasing use of leverage, in other words, at least as applied to this particular area, appears to have run out of its magical ability to increase returns. Investment grade corporate spreads therefore are not likely to narrow further. The perceived fat content in this supposed AAA “cream,” is as high as it’s going to get, and skim milk may eventually be the reality.

This is a critical analysis because if extended to other asset markets, it begins to imply that the leverage potency of recent years is reaching a peak, even if economic and financial market volatility remains idyllic.

One gains confidence in this conclusion by applying what is known as a Kelly risk analysis popularized in a recent book titled, Fortune’s Formula by William Poundstone. The heart of the Kelly risk framework, used long ago by the way, by my old math professor friend Ed Thorpe of blackjack counting renown, is to define how much of your wealth you should expose to repeated trials of a bet for which there are favorable odds of winning.

Given an historical alpha-generating trade for instance, such as a corporate bond spread above a certain presumptive level, how much leverage can be applied before the chances of losing all your money dominate the outcome? PIMCO quantitative whiz Steve Schulist presented the following summary analysis to the PIMCO Investment Committee recently as shown in Chart 2.

Its conclusions, under the new world assumption of today’s low volatility and narrow asset risk spreads, reinforce in general what I have offered to be the case with the CPDO in specific.

There is a maximum leverage point, 7-8x in this example and eerily reflective of today’s hedge fund proclivities, beyond which returns can be maintained only with increasing and significant expectations of financial loss.

We estimate that the maximum alpha an average hedge fund can generate in today’s marketplace utilizing a broad array of financial assets which average a 50 basis point risk premium, displayed in Chart 2, is 200 basis points. Any attempt to go further by levering up an already 8x levered portfolio increasingly risks significant and in some cases, total loss of principal.

And so?

No gloom and doom message here. I’ve already endorsed the rudiments of our new age financial marketplace subject to one off and normal cyclical corrections.

If Bernanke’s “transparency” allows bond investors to more accurately time future Fed behavior, then why shouldn’t the risk premium for two-year Treasuries be less than it was in the 70s and 80s when investors had to guess at the significance of Fed open market maneuverings?

If globalization and the sharing of growth benefits with former “emerging market” nations such as Brazil lead to the apparent self-sustaining growth of their dollar reserves, then why shouldn’t their bond spreads over Treasuries be in the 100-200 basis point range instead of 1,000-2,000?

I accept these new realities even within the context of a cautionary note that stability breeds instability and/or that a cyclical slowdown can quickly turn perceived cream into skim milk as it always has.

But we are approaching limits. And just as distortions of mass and time enter physicist’s equations as objects approach the speed of light, so too can cream mutate if its price or spread morphs from old world to new world to unworldly levels.

I can’t guarantee this reality ... [b]ut I have a strong sense that the ability to lever any or all asset returns via increasing leverage is reaching a climax and therefore, that CPDO, corporate credit spreads, and more importantly, sophomoric assumptions of future assets returns in all markets may require some future compromise, as the current masquerade of high asset returns gradually morphs from cream to skim milk.

Felix Salmon at Economonitor offers this off the cuff reaction to Gross' observations, desperately trying to find reason for the "unnatural" froth in markets of late:
[M]aybe the run-up in asset prices over the past few years is a function of leverage rising towards this natural Kelly maximum. Now it's there, we might not see asset prices rise as much in future, but at least there's a good structural reason for their being where they are.


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