Want Higher Returns...Try More Leverage - Oy Vey!

Some things never change. The need to deliver on short term profits is ever greater in this Bonus Baby World. How in the world we can get on Gilbert Arenas and other athletes when he have Financial Professionals is beyond me. At least when athletes screw up they lay low for a while and somewhat change their behavior. When Financial professionals screw up they just pop up like Meriwether, Zell, and the morons at Tishman Speyer the very next week with larger salaries and more capital. The simple fact that John Meriwether who was complicit in two (LTCM & JWM) high profile blowups gets to go out and try it again is befuddling. I am not denying the mans talent, but when does it become readily apparent that being overly reliant on quantitative modeling and excessive leverage is the primary way to blow things up?

http://www.ft.com/cms/s/0/331bae80-be93-11de-b4ab-00144feab49a.html?nclick_check=1

Its truly different every time, but every time its the same characteristics that doom these ventures.

"The fund is expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s."

Meriwether has a brilliant aptitude for complex mathematics, but he long go stopped being a good trader. He is living off of what he did 20 years ago at Salomon Brothers. Investors still obviously judge him on that rather then LTCM & JWN.

"The strategy, described by the Nobel Prize-winning economist Myron Scholes as being akin to a giant vacuum cleaner “sucking up nickels from all over the world”, can be highly successful in periods following market dislocations."

This strategy works but you need an obscene amount of leverage to execute it. Put it this way if one is leveraged 30-1 in this type of strategy, the value of your assets only need to decline by about 4% for your to be completely wiped out.

Also quantitative models don't work in times of market disconnection. This coupled with the excessive leverage makes it more difficult to get price discovery. Did they work last time? Have they ever worked in times of crisis?

Ask LTCM?
Ask Lehman?
Ask Merrill?
Ask Bear Stearns?
Ask JWM?

That is because liquidity dries up and most investors are hitting bids to save their jobs. Nobody wants anything to do with risk when the crap hits the fan. Models are rendered useless.

http://tradersutra.blogspot.com/2009/11/problem-with-var-risk-management.html

http://tradersutra.blogspot.com/2009/08/deleveraging-unemployment.html

http://tradersutra.blogspot.com/2009/03/aig-quants.html

So after all we have been through. After all of the pain that was inflicted on society. After all of the bailouts. After everything we know is to be true about excessive leverage. I give you this gem of a piece from the WSJ.

http://online.wsj.com/article/SB20001424052748704905604575027601300360196.html

This article in the WSJ this morning has me talking to myself to the extent that others think I am crazy. You just cant make this stuff up.

I have been stating for years that if you want to reduce systemic risk in the financial system, one has to change the current market structure. This market structure is dominated by Too Big To Fail Institutions who use excessive leverage backed by quantitative models that don't work well in a crisis environment. Granted the State of Wisconsin Investment Board is not a TBTF institution, but they do have the general welfare of all Wisconsin public workers to think about it.

I understand that pension funds roughly need to achieve 8% annualized returns just to meet their obligations long term, and that recent credit market events make this a certain impossibility, but the choice to leverage up is not in the public's interest.

There are no more arbitrage profits to be made in this market. There is no relative value anywhere. So the idea of risk less profit is a pipe dream. Only through the use of leverage can one achieve results. Only through building a better mouse trap with the use of excessive leverage can one get the results to bring in those bonus checks. Most investment houses and banks borrow short to lend long. This works in a low rate environment. DUH! The only time it doesn't work is when others think you are a deadbeat (LEH/BSC). What happens subsequently is widely called "Duration Gaps" and or "Duration Mismatches." Losses quickly enter the picture. Investment firms that properly mark to market(GS)will be early in selling and will somewhat escape carnage. Others who mark to fantasy/model(LEH/BSC/MER)will be late in selling and will get hammered.

When people reach out for that extra yield, they open themselves up to undo risk. You had all of that foreign money pouring into the US searching for yield. This is where the advent of the Synthetic CDO comes into play. One major theme of the credit crisis was that institutions around the globe were looking around for that extra yield to juice their bottom lines. They accomplished this by buying debt securities that were supposed to be nearly as safe as treasuries, but weren't quite exactly treasuries, and offered a little bit more yield. Existing AAA yield was not good enough for most investors, that is why Super Senior Tranches were developed, so that AAA yields were automatically raised. Banks couldn't sell the Super Senior part of most CDO tranches because of the lower yield, thus had to keep them on their balance sheets. We all know that Super Senior wasn't really Super Senior. We all know how that ended up.

All in all The State Of Wisconsin wants to do the same thing that banks in Norway and Iceland wanted to do. Get more yield so they can goose performance. Do I have to ask how that ended up?

Spreads are the tightest since before the crisis and corporate bond yields are at generational lows. This is not the time to get aggressive. You get aggressive when securities get hammered and lighten up when they run up wildly.

A few sentences from the WSJ article says it all.

"The fund will borrow an amount equivalent to 4% of assets this year, and as much as 20% of its assets over the next three years. Fund officials say that use of leverage could eventually go higher—in theory, at least, up to 100% of assets, according to the staff analysis."

"Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments.

So when did leveraging up fixed income over volatile stocks ever really work? Please speak to Bear Stearn's and Lehman Brothers on this item.

"Low interest rates make it impossible to meet those targets with simple bond investments."

Low interest also push investors to underestimate risk and thus increase leverage.

The only words that come to mind is OY VEY!