Monday, September 22, 2008

The Levered Elite

How Government Regulation Robbed Retail Equity Investors of their Right to Borrow and Gave it to the Investment Banks... (who $%^&ed it all up)

After the stock market crash of 1929, the federal government enacted what is known as Regulation T (Reg T), which effectively limited any participants ability to buy stocks on margin (with borrowed money from a broker). Currently you can purchase four times your capital for intraday transactions and two times for interday. Of course, if someone other than your broker handed you a million dollars as a loan for speculation/investment, you could deposit it alongside your personal capital in a brokerage account and still be in compliance with Reg T margin requirements while in effect having much higher leverage. But there isn't anyone lining up to loan you money to speculate. For an investment bank, however, it is a different story...

During normal market conditions, an investment bank usually has loads of people willing to lend it money. Since these lenders are usually investors themselves (not brokers) they are not covered by Reg T and thus the investment bank may use the proceeds of these loans to speculate in equities. As was already mentioned in the moral hazard section of the glossary, this combined with other loose regulation to allow investment banks to buy assets worth 60 to 70 times the value of their capital.

When market conditions turned sour and lenders stopped throwing money at the banks, it was exactly this level of gearing (leverage) that led to such precipitous declines in asset prices. If you buy a stock for cash and it rises 10%, you make 10% on your capital invested. If you're levered up 60 times and the investment rises 10%, you make 600%. The same is true on the downside, however, and being geared up over 50 times means all you need is a 2% move to wipe you out. This is why banks were indiscriminately selling stocks, because they were all levered up way too much to handle anything but rising asset prices across the board. Once intraday traders smelled blood in the water, the forced selling came in earnest as stop after stop was uncovered.

To understand how this epic amount of borrowing was allowed to take place we have to skim the dense surface of a subject known as financial mathematics. This allowed investment banks to calculate a likely amount that they could expect to lose/earn in the event of certain market conditions. This practice is known as the Value-at-Risk (VAR) model. Statisticians make assumptions about a particular asset's distribution of returns in order to predict, for example, how much a bank could lose during a complete market meltdown. Of course if your assumptions turn out to be wrong, your VAR model will be wrong. Why does this matter? Because of the interwoven nature of banking regulation and financial math.

There has been a push since the early nineties to tie how much a bank can borrow to how "risky" its assets are. Lacking any other way of quantifying risk, regulators and practitioners alike have embraced the VAR model. This would all be fine and just if the models actually worked; but they don't. The reason is that the results these mathematical models pump out are HIGHLY DEPENDENT on what data is used to estimate them. The data that banks and regulators used to define risk was from the last thirty years (most of it from the last ten), which was largely a time of uninterrupted credit expansion. The models were thus completely inadequate for predicting what would happen in the event of a liquidity drought. Most models in the literature don't even take into account the idea of liquidity; being a hard to quantify it was simply left out.

If you are looking for someone to blame in this mess, blame the investment banks who hired physicists to run trading desks. I'm not joking. There are entire programs at well respected institutions that make it their business to turn 40 year old engineers into quantitative traders. As a result, people who had never traded a share in their lives were tasked with running billions of dollars. These financial children were given the keys to the family flatbed truck which was then loaded with gold. They were told to drive 200 mph at what they thought was an even bigger pile of money and when they all rolled over at credit crunch curve we act surprised.


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