I shared a car service home today with a first-loss fund of funds manager who bragged that he can go to Goldman Sachs and get 20-1 leverage on a 50% net long vs 50% net short portfolio. “Better yet, BNP will offer 50-1 leverage on a portfolio margining basis, maybe even 100-1 if the portfolio is particularly well diversified.”
I had just come from a conference where some hedge fund managers regularly said that they ran exposures 450% net long versus 450% short. “We don’t really worry about our gross footings,” one manager explained. “All we really focus on is what our cVAR expected worst daily loss might be.”
Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
No one ever seems to question the actual logistical availability of such feats of leverage.
Am I just being curmudgeonly, but whatever happened in this world to something called “Regulation T?”
Yes, Reg T limits on margin are still there on the books, but little by little, few elect to adhere to Reg T margining anymore. Instead, sophisticated alternatives to get around that rule have been allowed by the Federal Reserve for banks and brokerage firms that can demonstrate an effective risk monitoring mechanism of their client portfolios.
Behemoth hedge fund managers such as Millennium Capital now regularly take their $35 billion in invested capital and lever up that capital by 6x-7x margin availability from fawning prime brokers.
Within an already highly levered world, is the application of leverage – even on supposedly market-neutral portfolios – really the answer for investors to gravitate towards as a place of supposed safety?
Or are investors really just placing their money in effective “remainder trusts” with toxic tail-risk attributes?
Under most instances, a multi-strategy firm like Millennium Capital might eek out a 3% nominal return on total gross invested assets across a year’s trading, which when applied back down to the far smaller invested capital base, magnifies itself into say a 15% initial investor-level gross return. But out of that comes allocated overhead costs and tons of netting risk between underlying fees paid to individual pods of managers. Millennium has admitted in the past that this such costs can run 6-7% a year to investors. Then comes the 20% firm-level incentive fee. The investor effectively owns a remainder trust on a ton of applied leverage. It hasn’t happened yet at Millennium, but just a -3% loss on gross invested capital would cause Millennium to suffer a devastating -20% or greater net annual loss.
No wonder hedge funds aren’t so popular anymore. This is a situation that will work for investors until someday it doesn’t – with a potential thud.
At a 2014 JP Morgan Thought Leadership Conference, during a Q&A session after an eloquent speech by Morgan head Jamie Dimon, I asked a question from the audience: “Do you ever worry that the portfolio margining rules currently allowed by the Fed might suddenly get changed one day – maybe because of issues in the shadow banking or hedge fund world?”
Dimon’s response at the time was: “What exactly is portfolio margining? I’m not sure that I understand the issue.”
This all begets the question: Have we slowly gravitated back to the pre-Crash of 1929 days when just a sliver of margin sufficed for the shoe-shine boy to lever up and get rich?
Today of course, margin risk managers think that they can analyze well-balanced portfolios to keep banks and brokerage firms adequately protected. Under normal market conditions, they surely can, and have been doing so very well to date.
But even on a retail basis, Interactive Brokers has run advertising campaigns suggesting that investors should consider building a portfolio of high dividend stocks yielding 4-5% and then lever such a portfolio up via ultra-cheap portfolio margining availability. After all, what’s to worry? The Fed has had everyone’s back with Quantitative Easing and the availability of ultra-cheap money.
But in my humble opinion, that era is now ending, and the current market norms regarding portfolio margining will all end in tears. This will be an issue that comes out of left field unexpectedly and undiscussed. But it is a non-trivial vulnerability after eight years of Fed-induced credit extension excess.
Just as Janet Yellen previously missed the importance of the brewing housing mortgage crisis in 2006-2007 while she was head of the Federal Reserve Bank of San Francisco (with mortgage lenders crumbling under her nose), she will miss this issue as well as our current Fed Chairman.
Tant pis. Our financial regulators should be smarter than this. But the regulators, of course, ultimately create the framework and environment that allow such excesses to fester. And today, it is so ever so difficult for these regulators to change what is currently considered normal and acceptable practices without even greater potential negative impact.
David von Leib is a consultant and the author of Not My Grandfather’s Wall Street, available on Amazon.