As Funds Leverage Up, Fears of Reckoning Rise
Fed and SEC Question Wall Street on Policies;
'A Mockery' of Margin
By RANDALL SMITH and SUSAN PULLIAM April 30, 2007; Page A1
online.wsj.com
excerpts:
Hedge-fund manager John Paulson made $1 billion using a complex financial instrument to pump up a bet that the subprime-mortgage market would crater. The parent company of retail giant Sears made $74 million using a similar device to boost its wager that a basket of stocks would rise in value.
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Thanks to advances in financial engineering, investors have never had so many different ways to make commitments that exceed their bankrolls. And never before has leverage wormed its way into so many nooks of the financial world.
We're living on planet leverage, and regulators and market gurus are growing nervous.
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investment banks are pumping out newfangled leveraging tools such as derivatives, complex securities that allow hedge funds and other investors to add leverage without borrowing money.
Finally, mainstream America has gotten into the act. Once-conservative institutions are copying hedge-fund tactics. The Pennsylvania State Employees' Retirement System has begun dabbling in derivatives. Mutual-fund companies such as Easton Vance Corp. and Federated Investors Inc. have launched funds that rely heavily on derivatives. Garden-products maker Scotts Miracle-Gro Co. and other public companies have loaded up on debt to improve returns.
This leveraging binge has regulators and others worried. In the first place, no one knows how much leverage there is. Much of it is hidden, because investors aren't just juicing returns with borrowed money, but with derivatives, which are harder for regulators to track.
No one is sure what will happen to this complex brew in the event of a serious market downturn.
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Some Wall Street analysts have taken to referring to a nightmare version of this scenario as "The Great Unwind."
Timothy Geithner, president of the Federal Reserve Bank of New York, said in an interview that the torrent of money flowing into hedge funds has coincided with a troubling erosion in lending practices.
The Fed, the Securities and Exchange Commission and European regulators have spent months trying to gauge the risk by gathering information from hedge funds and Wall Street firms. They've asked the brokerage firms, among other things, how much collateral they're demanding from hedge funds when they provide financing.
Regulators concluded that Wall Street firms aren't always getting enough information from hedge funds to assess risk,
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The 1998 collapse of highly leveraged hedge-fund giant Long-Term Capital Management threatened to unleash something like a Great Unwind, but a consortium of Wall Street firms, prodded by the Fed, stepped in to prevent such a selloff. Last year, when the leveraged energy bets of Amaranth LLC went awry, the big hedge fund had losses of $6 billion within days
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Estimates by analysts of leverage at major securities firms, borrowing by hedge funds and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002. Hedge-fund borrowing and other financing tools were valued at $1.46 trillion last year, up from $177 billion in 2002, according to estimates by Bridgewater Associates Inc., a Westport, Conn., hedge-fund company.
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"There's leverage everywhere -- whether at corporations or broker dealers or hedge funds or private-equity funds," says senior credit analyst Tanya Azarchs, who follows U.S. banks and brokers at Standard & Poor's Corp. "It sort of feels like something's got to give."
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These days, hedge funds are using derivatives to mimic the effect of purchasing stocks and bonds -- for a lot less money up front. On Wall Street, dealers offer derivatives in dizzying variety. The values of some are tied to single stocks, others to baskets of stocks or market indexes, still others to bonds, oil prices, even the weather.
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Hedge funds are under no obligation to publicly disclose derivatives transactions or borrowing levels. But Citadel Investment Group, a $13.5 billion Chicago hedge fund run by Kenneth Griffin, had to do so when it sold bonds last year. A bond offering document said the fund's leverage ratio -- the value of its assets compared to its capital from investors -- stood at 13.5 to 1, due in part to its use of derivatives.
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Until recently, public companies, mutual funds and pension funds generally steered clear of such risks. But the lines between risk takers and mainstream investors are blurring. In part, that's because stock-market returns aren't what they were a few years back. Between 2000 and 2006, the average annual return on the S&P 500 stock index was 2.5%, down from 28.7% between 1995 and 1999. Using derivatives and borrowed money is one way to try to boost returns.
Pennsylvania State Employees' Retirement System, which manages about $32 billion, has long allocated more than half of its assets to U.S. and overseas stocks. Several years ago, in pursuit of higher and more consistent returns, it began shifting some of that money into hedge funds, while buying swaps to replicate the stock-market exposure it gave up. Currently, the system has $8.1 billion in hedge funds and has arranged swaps contracts for a like amount.
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Last year, Sears Holding Corp., the department-store chain controlled by Greenwich, Conn., hedge-fund manager Edward Lampert, entered into a total-return swap on a basket of stocks with a market value of $387 million -- the swap's so-called notional value. The swap produced $74 million in income last year. Sears reported that the swap involves "substantial risks," and that the company posted collateral worth 25% of the swap's notional amount.
Wall Street sells the fuel for this kind of speculation. Credit Suisse Group, for example, offers total-return swaps through its "Delta One" prime brokerage program. J.P. Morgan Chase & Co. offers a total-return swap through its "Master Swap" program.
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Hedge funds routinely shop around Wall Street to find the derivatives deals that require them to post the smallest amount of collateral. In a speech to bankers last year, Annette Nazareth, an SEC commissioner, said that regulators want to stave off "an environment that encourages a competitive 'race to the bottom' concerning margin."
Dealers such as Credit Suisse and J.P. Morgan don't disclose the amount of total-return swaps on their books.
That's "trouble in the making," argues Janet Tavakoli, a Chicago consultant specializing in derivatives. The collateral provided by hedge funds to secure swaps could be difficult to trade, she says. In a market downturn, attempts to unwind such positions could lead to a vicious cycle of selling that would feed on itself, she says. Representatives of Credit Suisse and J.P. Morgan declined to comment.
Wall Street itself is one of the biggest users of leverage. Last year, the nation's four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders' equity, a leverage ratio of 25.5 to 1, according to research firm Sanford C. Bernstein & Co. In 2002, those same firms financed $1.59 trillion of assets with $72.7 billion of equity, a ratio of 21.9 to 1, it said.
Among the big firms, Goldman Sachs Group Inc. pumped up leverage by the largest degree in recent years. Goldman says it was just trying to catch up to the levels of its competitors after it shifted from a partnership to a public corporation. Its ratio of assets to shareholders' equity, one common measure of borrowing, climbed to 25.2 to 1 in 2006, from 17.7 to 1 in 2002, according to analyst Brad Hintz of Sanford C. Bernstein. (Goldman says it has a pool of easy-to-sell securities valued at more than $50 billion that it could tap if market conditions require it to raise cash.)
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One way Goldman ratcheted it up is through a joint venture with Bank of New York Co. involving repurchase, or "repo," agreements. Goldman uses stock from the accounts of its own traders and its hedge-fund clients, selling the stock temporarily and agreeing to buy it back later. In effect, the cash it receives is a temporary loan. Under the program, Goldman has effectively jacked up debt secured by stocks held for customers and its traders from 90% of the value of those shares to as high as 95% to 98%, people familiar with the program say. More than $50 billion of stocks is involved.
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