Yves here. Wolf is correct to focus on the danger of multiple layers of leverage. That sort of fragile financial edifice was a major driver of the crisis just past. One example was unrestricted rehypothecation, which is not permitted in the US per the Securities Exchange Act of 1934, but in London, no one cared about such niceties. Another leverage-on-leverage vehicle was CDOs. As the Financial Times’ Gillian Tett wrote in January 2007:
Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker with strong feelings about a column I wrote last week, suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage.
“Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.
“I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns.
“I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who . . . privately acknowledge that there is a bubble waiting to burst but . . . hope problems will not arise until after the next bonus round.”
He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital – a 2% price decline in the CDO paper wipes out the capital supporting it.
“The degree of leverage at work . . . is quite frankly frightening,” he concludes. “Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don’t even expect one.”
So you can see why Wolf is more than a tad alarmed.
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Testosterone Pit.
We don’t know what hedge fund manager Steven Cohen will do with the money he’s borrowing from Goldman Sachs’s GS Private Bank. We don’t even know how much he’s borrowing. But it’s a lot, given that the personal loan is backed by his collection of impressionist, modern, and contemporary art estimated to be worth $1 billion. The only reason we know about the loan at all is because Bloomberg dug up a notice Goldman filed with the Connecticut Secretary of the State, claiming he’d pledged “certain items of fine art” as part of a security agreement.
Goldman and Cohen go back a long ways. It provided prime brokerage services to his hedge fund, SAC Capital Advisors that pleaded guilty last year to insider trading charges and agreed to pay $1.8 billion in penalties and stop managing money for outsiders, which will reduce the fund to a family office managing $9 billion to $11 billion of Cohen’s personal fortune.
Cohen made $2.4 billion in 2013, according to Institutional Investor’s Alpha List of hedge fund managers, in second place, behind David Tepper ($3.5 billion) and ahead of John Paulson ($2.3 billion). Wouldn’t that be enough without having to borrow more? And what might he be doing with all this borrowed moolah? He won’t need that much to make ends meet when his electricity bill comes due.
In the rarefied air where these art loans take place, they have unique advantages: clients get to keep their art on the wall, and interest rates are about 2.5% – thanks to the Fed’s indefatigable efforts to come up with policies that enrich this very class of success stories. This is where the Fed’s otherwise illusory “wealth effect” is actually effective.
So why borrow money?
“A number of hedge fund guys who manage their money wisely, they look to put their art collections to work,” explained Michael Plummer, co-founder of New York-based consultant Artvest Partners and former COO at Christie’s Financial Services. “If you can get liquidity out of your collection and pay only 250 basis points,” he said, “it just makes sense.”
So Cohen will invest it. Cheap leverage, the holy grail these days. It’s the driver behind the asset bubbles all around. It’ll goose otherwise minuscule returns. He might invest this borrowed money in his fund, which might for example buy Collateralized Loan Obligations. Banks that carry them on their books have to dump them to satisfy new regulations. But prices have dropped, and so banks are lending hedge funds cheap money so that they buy these CLOs. Some banks are offering to lend as much as nine times the amount that the hedge fund itself would invest. More massive and cheap leverage.
CLOs are similar to subprime-mortgage-backed Collateralized Debt Obligations that turned into toxic waste during the financial crisis. But they’re backed by junk-rated corporate loans, some of them malodorous “leveraged loans” that private equity firms use to strip-mine their portfolio companies. These already overleveraged companies borrow money from banks and pay it out as a special dividend to the PE firms. It pushes the company deeper into the hole, loads up the PE firm with cash, and saddles the bank with a dubious asset, the “leveraged loan.” The bank can then package it with other low-rated corporate debt into an enticing CLO [read.... Banks And Hedge Funds Make Curious Deal On New Structured Toxic-Waste Securities].
So Cohen, using these multiple layers of leverage, might earn a return of 8% a year on his art loan that costs him 2.5% a year. Multiply that out to a billion, and it’s a money machine. That would be on top of the art itself that has seen phenomenal increases in value under the Fed’s money-printing binge.
Absurd? Sure, but this sort of absurdity, an outgrowth of the biggest credit bubble in history, has become the lifeblood of the US economy and its lopsided income distribution.
It’s not just a few people at the top that can benefit from multiple layers of leverage. After the run-up in home prices over the past two years, many homeowners have equity. So it didn’t take the financial media long to encourage them to leverage that equity – through home-equity lines of credit or “cash-out refinancing” – and buy stocks with the proceeds (always buy, buy, buy!).
A homeowner might cash out $100,000 and put it into a brokerage account. To goose his returns like Cohen, he might buy $150,000 worth of securities, with the remainder coming from margin debt. And the security might be IBM, a highly leveraged outfit with $123 billion in debt and tangible stockholder equity of minus $18.3 billion [read.... Stockholders Got Plundered In IBM’s Hocus-Pocus Machine].
Absurd? Heloc originations soared 42% in the fourth quarter. The average credit line for “super-prime” borrowers was $120,000. Even “deep subprime” borrowers got an average credit line of $60,000. And “cash-out refinancing” is hot again, making up about 25% of all new refis in the first quarter, according to Quicken Loans.
Strung-out consumers might blow this money on a car and food and other things and some might consolidate debt and pay off their maxed-out credit cards so that they can charge more in their heroic effort to keep consumer spending from collapsing altogether. But the gorgeously mediatized stock market gains over the last few years, and especially last year, seduced many people to step back into the this craziness, all guns blazing, after having missed the entire run-up. And they’re doing it at precisely the worst possible moment.
This kind of hidden leverage pervades the investment scene at all levels. When multiple layers of debt are used to finance a chain of speculation, with very little equity involved, returns on equity can be eye-popping, as long as everything soars without ever as much as hesitating. But once progression beings to totter, and many feverishly hyped stocks, like Twitter, lose more than half their value in a matter of months, the bloodletting starts and margin calls go out, and banks are suddenly worried about their collateral, and some of the art gets dumped into a market with no buyers, and junk bonds plunge, and “leveraged loans” default, and it kicks off another bout of forced selling into an illiquid market, and the cross-connections and tie-ins and the whole counterparty spaghetti of these layers of leverage get knotted up, and all heck breaks lose. And as the whole construct tumbles down, Cohen and his ilk will once again press their cronies at the Fed and the Treasury to bail out their investments just one more time.