By James H. Nolt
Last week I discussed the trade-off between risk and return, but also suggested the relationship is not as simple as is commonly understood. This week I delve into bullish strategies in more detail. Everyone understands the basics of the bullish position: If you own an asset—for example, your house—and it goes up in value, you gain wealth. Likewise, owners of stocks and bonds gain wealth as these assets soar. Much more powerful bullish strategies are to own an asset using other people’s money or simply to bet on its rising price using derivatives.
The majority of Americans also have leveraged asset bets. Buying a home using a loan from a bank is a leveraged bullish position. Most people think of their homes primarily as a place to live, but a home is also an asset that may increase your wealth. If the interest cost of the bank loan is less than the annual gain of your home’s value, then your real wealth is growing, leveraged by the use of other people’s money.
Professional bulls may leverage to a much greater extent. There is no theoretical limit to how much you can leverage and therefore magnify your gains. Real-life bulls may leverage debt 40 or 50 times or more. Even infinite leverage is possible, if you are betting entirely with borrowed money and therefore you have no “skin in the game,” as Wall Street lingo would say. There are, however, two practical limits: your credit-worthiness and bearish strategic adversaries. People not accustomed to thinking strategically ignore the bearish adversaries and may be blindsided by them. The two are linked, because it is creditors acting strategically that are the most dangerous bears.
First consider a simple mathematical example: If you have $1 million to invest, but are really confident that some asset will rise in value, you could borrow another $50 million to purchase vastly more of your favored asset. You must be considered a wizard of Wall Street to do this, but some well-connected hedge fund managers have found creditors willing to lend them such a stake, often very short-term, perhaps by overnight loans that must be renewed each day. If your credit is good, the interest rate on such loans is low, say 2 percent annual rate.
Now if you were to invest this $51 million in something simple, say, Google stock, no creditor would be foolish enough to stake you such leverage (unless perhaps you are a Google insider who can reliably influence the stock price, but then that would implicate insider trading laws). Any particular asset has price swings that are hard to predict. Since your leverage is 50-to-1, even a 2 percent fall in the value of the asset would wipe out your entire capital and lead your creditors to think there is no longer any point in rolling over your loan. The day of the 2 percent loss, they might call and inform you of the bad news: You are no longer creditworthy. You must liquidate the stock at a 2 percent loss and pay the loan back. Your original $1 million in capital is gone. If the stock fell more than 2 percent, you would have to sell something else you own to cover your losses.
So you cannot get the leverage you need with such a simplistic strategy. Now you will understand how the term “hedge fund” originates. Hedge funds must leverage but they must also insure against losses, or at least appear to. You might still buy $50 million of Google stock using the loan, but then insure against losses by buying at-the-money overnight put options on that Google stock. Suppose they cost 1 percent of the face value of the stock, a plausible price. A put is the right to sell something within a specified future time at a contracted strike price. Since it is “at-the-money” that means the strike price is the same as today’s market price. If tomorrow the stock price falls, you exercise your put option to sell it at yesterday’s price instead. Your loss is limited to no more than the cost of the option, in this example, a maximum of 1 percent or $500,000. On the other hand, if the price goes up more than 1 percent, the cost of the options “insurance” is covered and the rest (minus the daily interest on the loan of 2 percent/365, which is less than $3,000) is profit. If the stock goes up 2 percent tomorrow and you sell the stock to lock in the gain of about 1 million dollars, minus the half million cost of the options, your profit for the day is a half million, or a 50 percent profit on your capital for a one-day trade! That is the power of leverage: Using debt, you can magnify your gains while still reassuring your creditors by insuring against loss. Wall Street refers to a well-designed hedged position as a “money machine.”
Notice that there is never such a thing as a perfect hedge, though, because the “insurance” you buy using derivatives is a cost no matter what happens. If your leveraged position is bullish, you can gain massively on the upside, but if the gain is too little to cover the cost of the hedge or if the price of the underlying falls, you still lose money. The main thing the hedge accomplishes is to reassure your creditor so that you can borrow to leverage in the first place. Banks require mortgage borrowers to buy fire insurance on their homes for the same reason. If you default on your home loan, the bank recovers either the home or (if it has burned down) the insured value. If a hedge fund is right most of the time, the leveraged profits it makes should be more than enough to cover the hedged losses when it is wrong. At least, that is the theory.
Keep in mind at the present moment there is close to a quadrillion dollars in outstanding derivative contracts, all of which are two-sided bets. World GDP, in round numbers, is roughly $100 trillion, or approximately one-tenth of all the outstanding derivatives bets. The top several financial companies in the world all have assets of a few trillion each, but each of those is managing derivatives bets on its own account and those of its clients of many tens of trillions of dollars. Many of you might be thinking, “So much wealth at stake in all that gambling!” You are right. But if you think strategically, you should also notice the enormous centralization of financial information this represents.
The top banks are like enormous bookies. They know more than anyone else who has placed bear bets and who has the bull bets and how leveraged they each are. Each has a statistically large sample of all the outstanding financial bets. No government has so much information. Governments collect data, but it is always old news by the time they process it. Banks monitor the flow of computer-recorded trades hour-by-hour—or faster. They are not all knowing, but they have better information than anyone else. If bullish traders are heavily leveraged in certain asset classes and top banks do not share their optimism, it is in the banks’ interest to curtail their credit, but doing so is usually a self-fulfilling prophecy, because it will also force those bulls to unwind positions quickly, selling assets urgently to repay debt. Such forced sales cause rapid price drops that panic even more bulls into joining the sales frenzy. When prices fall far enough, the banks and their favored clients can jump back in, buying the depressed assets cheaply while at the same time putting a floor on the price fall.
Debt leverage is so tempting to make “sure” bets pay off big, but it also represents a strategic vulnerability. Nobody is more alert to that vulnerability than the creditors who stake the bets in the first place. Next week I will examine a famous real-life case illustrating these points: a celebrated, though short-lived, hedge fund known as Long-Term Capital Management.
James H. Nolt is a senior fellow at the World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of mireyaqh]