Traded financial derivatives, it is often claimed, permit markets to find the "least cost bearer of risk". But if this is true, what exactly does it mean? Who are the least cost bearers of risk? Highly diversified investors with very strong balance sheets? It'd be natural to think so. But think again. Perhaps the least cost bearers of risk are aggressivley speculative investment funds intentionally leveraged to the point where the potential upside is very large, and the corresponding downside triggers bankruptcy.

Recall that any leveraged, limited-liability entity can be understood as a call option. If a business owes the bank $1M, but its assets — including the present value of expected future profits — are worth less than that $1M, it can declare bankruptcy. Its owners hand over all assets to the bank, and walk away without paying off the loan. On the other hand, if equityholders believe the business is worth more than a million, they pay off the bank, or rollover the loan, depending on the operation's current liquidity and available investment opportunities. Thus, the value of this entity to equityholders can be described by the red curve below.

Investments whose returns are like options have an unusual property. Usually, investors hope to minimize risk and maximize returns in their investment choices. But the expected return of an option increases with the risk (or volatility) of the underlying asset. Consider the case of an idealized entity operating entirely on borrowed cash. It holds $1M in assets, all borrowed, no owners equity. On the graph above, it sits at the point where the dotted line intersects with the red line. Suppose equityholders had a choice, hold the million dollars cash, or flip a coin in a bet that either doubles their money or loses it all. An unleveraged, risk-averse investor always prefers sure cash to a fair coin-flip. But a very leveraged investor who has the option of shifting costs to the lender, takes the coin-flip. If she loses the flip, she loses nothing, the lender takes the cost. If she wins, she's turned other peoples' money into a cool million for herself.

A 100% leveraged entity is a zero-cost bearer of risk. The downside of any potential investment is immaterial. Only the probability-weighted magnitude of the expected upside matters. A 100% leveraged entity prefers volatility to safety, even if the "average" outcome of a gamble is not particularly good. Even if the coin in the previous example were rigged so that the fund loses 2 out of 3 flips, equityholders still prefer to play than to hold cash. Since creditors bear the losses, the only cost to a bad gamble is the opportunity cost of better gambles that might otherwise have been undertaken.

In the real world, very few entities get to borrow all their assets, hold all gains, but walk away from any losses by defaulting. It's a great deal for the borrowers, but a crappy one for lenders, who strive to prevent these kinds of perverse incentives from arising. Lenders typically require borrowers to hold significant equity. A typical borrower sits at the intersection of the red and green lines. At this point on the curve, equityholders absorb most losses, as well as any gains on their investments, and the possibility that some of their losses will be borne by lenders if they lose absolutely everything is unlikely to be particularly relevant. Also, business bankruptcy often exacts nonmonetary costs that mitigate predatory behavior by borrowers. Controlling equityholders of failing businesses lose reputation, their jobs, see their friends lose jobs and retirement security, face lawsuits, etc. Finally, lenders often protect themselves with "covenants" that remove control from equityholders as the degree of business leverage increases, to prevent borrowers from taking big chances after they've borne great losses.

But, nevertheless, the world is a diverse place, with lots of different kinds of businesses and creditors. While very few entities enjoy 100% leverage, some businesses fall much closer than others to the dotted line on the graph above, some businesses have more non-monetary costs associated with bankruptcy than others, some businesses have more restrictive covenants than others. Leverage is no longer as simple a concept as funds borrowed from a diligent local bank. Bonds can be sold to the public, to naive foreign investors, to foreign central banks. In markets awash with liquidity, borrower reputation may substitute for balance sheet due-diligence in the decision to extend credit.

The trading of financial derivatives is supposed to transfer risk exposure to its least cost bearer. In light of the foregoing discussion, what might a least cost bearer look like? As we've seen, entities that are nearly completely leveraged, that fall near the dotted line on the graph above, face a low, or even negative, cost to bearing risk! This is counterintuitive, since these are the sorts of entities that face the greatest likelihood of bankruptcy. But that is exactly the point. Bankruptcy transfers the cost of risk gone bad to others. The least cost bearer of risk is an entity with few nonmonetary costs associated with failure, and a reputational or strategic capacity to take on leverage without surrending its ability to take risk. It should be no surprise to anyone following financial markets that this sounds a lot like a highly regarded hedge fund. Think Long-Term Capital Management.

The point of this essay is that LTCM-style meltdowns are not aberrations, but are a rational, structural consequences of a financial system in which the returns of some entities have high optionality, offering the possibility of high-returns for a low sums put at risk of total loss. LTCM should not be regarded as a failure or lapse of judgement on the part of its managers or investors. Its failure was a "normal accident". Assuming independence of returns across investments, the rational investor should diversify her holdings among a very large number of funds with LTCM-style leverage and high appetites for risk, as these offer far superior return to risk than traditional investments. Many, perhaps most, of these investments would go south, and end up worthless. But the returns on the high-leverage, high-risk funds that succeed will much more than make up for these setbacks. On average, lenders bear most of the risks and equityholders enjoy most of the gains. It's a good deal for investors.

If highly leveraged funds are good deals for investors, than hedge-fund managers ought to be competing to create them. (We've not touched on the much maligned "2 & 20" fee structure of many hedge funds. That adds additional optionality to hedge fund incentives, but it is only icing on the cake.) Funds should be competing to maximize their leverage without compromising their capacity to take-on risk, leap-frogging one another down the slope of a graph towards that dotted line. Speculative derivative positions often offer both risk and leverage in convenient packages whose "rocket-scienceness" helps to obscure both aspects, and make it possible for a fund to take on yet more.

Of course there is a problem here. Somebody ends up bearing all the risk that leveraged funds can write off via defaults. What is rational behavior for each individual fund or investor may turn out not to be so rational, if failures turn out to be correlated rather than mostly independent. If several funds default away large losses, the funds' creditors may in turn default, wiping out other funds' gains and increasing the likelihood of futher defaults. In a typical "tragedy of the commons", rational behavior by investors and managers can lead to a systemic crisis.

I've been pulled from a period of post-nuptial dissolution and lassitude by an astonishing article in yesterday's Wall Street Journal on private equity buyouts. It describes a simple game. Private equity firms persude creditors fund highly leveraged buyouts. The bought-out firm then takes on more debt to quickly pay large sums to the private equity firm, its new owner and manager, in the form of management fees and dividends.

Consider Intelsat. According the the WSJ article, private equity investors put up $515 million, while creditors footed the remaining $5.5 billion to purchase the communications satellite business. Within two years, the private equity investors had extracted more than $576 million in fees and dividends, while still retaining full ownership of the firm. Now that's a good position to be in. After two years, while the underlying firm was struggling, renegging on promised employee benefits, and showing a negative net worth, it's owners had already earned 5.75% annual returns on their stake and recovered their capital in full, while still retaining control of the company and claim to any future profits it might earn! Alluding to a previous post, this is a deal right on the dotted line. For zero net investment, the private equity firm gets to gamble taking all the profit and growth a 3 billion dollar firm can generate, or walking away from the table with a bit of bad publicity and the unwinding of some legal entities.

It's easy, as is apparently the German custom, the think of private equity firms as "locusts". But this is capitalism, and people are supposed to figure out ways to exploit unusual opportunities. It's not the sharks who are feeding, but the rare, bloody meat floating in the water that's the problem here.

There's an old math cliché that you can prove any proposition so long as division by zero is permitted. I think a finance version of this cliché would be that anything is possible if there's a mispricing in any market that can't undone by its exploitation. Credit markets for the past half-decade have matched this description. Central banks have held money cheap, despite unprecedented and every growing use of borrowed funds by everyone from strapped consumers to eager-to-please businesses to multibillion dollar investment funds. In unmanipulated markets, the orgy of borrowing that has characterized the last few years would have led naturally to tighter rates. Thanks to the US Fed, the People's Bank of China, the freewheeling dollar lending of petrostates, and of course the Bank of Japan, that hasn't happened. Money has been nearly free. Banks have had to compete mercilessly for the privilege of lending for any interest at all. Risk has been so sliced and diced and sold and apparently "managed" by the derivatives boom that many creditors have been made comfortable with positions that in the past would have looked like laughably bad deals for them. Global interest rates have been fixed by the behavior of central banks collectively and state-affiliated investment funds at absurdly low levels.

The current private equity boom is largely a means of exploiting that mispricing. The underlying businesses that are bought and sold are means to ends. It is not what they do, what new efficiencies or synergies or what not that can be introduced that matters. It is how well their assets can be used to justify continual leveraging, how cheaply they can be bought, how good a story can be told to keep the terms of borrowing from becoming too onerous even while cash is sucked from the firms by equityholders, that matters most. The underlying business then becomes a lottery ticket. If a firm can, in the course of doing a deal, build a really great company, put together several firms and take advantage of synergies, improve underlying efficiencies, then the value of all those improvements is pure profit for the private equity fund. Leveraged buyers have every incentive to try to build and improve the companies they float through. But in a world of artificially cheap credit, taking underperforming companies and turning them into great ones becomes secondary, gravy. An arbitrage opportunity is better than any risky investement. The first order of business for a rational private equity fund would be to find target investments through which to exploit mispricings in credit and risk can be efficiently exploited.

Of course this will all come apart, rather soon I hope. If collective state behavior does change (a very big if) and the era of absurdly cheap money ends, many of these heavily leveraged deals will go south, and we'll have a predicatable wave of Enron-like scandals, as firms go bust, private equity funds write off their investments, and creditors sue them for fees and dividends they extracted from retrospectiovely insolvent companies. If central banks around the world are determined to keep money cheap, if China keeps ramping its exports and lending away all the proceeds for next to nothing, if the petrostates keep buying up dollar debt with all their oil proceeds, if the Bank of Japan and US Fed get spooked by the prospect of recession and hold rates low, we can put off much of this unpleasantness, but with much worse eventual consequences.

After all, it is not liquidity or interest rates or equity deals that matter in the enterprise of human wealth. It is the business of producing real goods and services. A world in which nominal wealth becomes detached from real production, and bound instead to cleverness in manipulating the machinery of high finance, is a world in which financiers will have an ever larger share of a progressively smaller pie.

With all the fuss about hedge funds and private equity these days, I think it's worth cataloging in simple terms the multiple levels of "agency costs" associated with leveraged investment funds. [1]

1. Agency costs imposed by fund managers on investors
2. Agency costs imposed by fund investors on banks and other creditors
3. Agency costs imposed by bank managers on bank shareholders, depositors and governments
4. Agency costs imposed by investment managers on institutional investors
5. Agency costs imposed by institutional investors on governments and the public at large

1. Agency costs imposed by fund managers on investors

   As is widely discussed, many hedge-fund managers have a "two and twenty" fee structure, meaning they take as fees 2% of the funds they manage under any circumstances, and 20% of any profits achieved. Because fund managers see the upside of gains but not the downside of losses, a rational self-interested fund manager will take more risks than her investors would if they were managing their own money. Also, fund managers often compete on the basis of short-term apparent performance. A rational, self-interested fund manager may prefer a "get rich quick" strategy to a long career. Such a manager might take positions that trade high immediate returns for large future risks. Credit default swaps are an ideal vehicle for this sort of thing. A "get rich quick" fund manager might also aggressively value illiquid investments on the fund's books, creating high phantom returns that cannot be realized when the positions are liquidated. Conversely, she might take-on "off balance sheet" liabilities, inflating the apparent value of the fund. Carefully written "derivatives" permit parties to assume contingent liabilities in ways that hide the leverage of the fund. [2]

2. Agency costs imposed by fund investors on banks and other creditors

   Limited-liability creates a potential conflict of interest between investment funds and their creditors. If a fund is heavily leveraged, fund investors can reap large rewards by assuming risky positions with the understanding that if those positions go sour, a large fraction of the cost can be shifted (via actual or threatened bankruptcy) to the fund's creditors. I've described this at length in a previous post.

3. Agency costs imposed by bank managers on bank shareholders, depositors and governments

   Keynes famously wrote in 1931 that "a 'sound' banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him." [3] There is no reason to believe that bankers are any less sound today then they were in the 1920s, or the 1980s. Banks earn money in a highly competitive environment by lending money, and bank managers are evaluated by the profitability of their operations in relation to those of peers. Leveraged investment funds have become a breathtakingly large clientele. They hold trillions of dollars of equity which they are in the habit of borrowing against aggressively. Since the mid-nineties, the scale of hedge and private equity fund investment has grown astronomically, and few banks have been burned by extending them credit. Suppose that after the late 1990s when the Long Term Capital Management famously blew up, a bank manager decided that future lending to investment funds would be done conservatively and only on the basis of extensive due diligence. How would her performance have compared to that of his peers who lent more freely? A rational, self-interested bank manager may well conclude that her best strategy with respect to the huge, lucrative investment fund market is to "see no evil" with respect to systemic risks. Rational managers would diversify their exposure among many funds, to reduce fund-specific risks, but would want to aggressively pursue business volume in the sector as a whole. This is a classic "tragedy of the commons". By competing well for volume, bank managers exceed performance benchmarks and earn bonuses. But they also diminish the cost and increase the quantity of leverage available to investment funds, magnifying systemic risks. Should a "meltdown" occur, individual bank managers will point to their industry-standard, state-of-the-art risk management practices and demand safe harbor. A few managers with fraudulent books or eggregiously risky positions will be tarred and feathered. The rest will keep their bonuses, while bank shareholders, bank depositors, and eventually taxpayers eat their losses. [4]

4. Agency costs imposed by investment managers on institutional investors

   Like any other sort of investment manager, the interests of those who manage funds for pensions, university endowments, and charitable foundations may diverge from the interests of their diverse clientele. In particular, rational, self-interested managers may determine that pursuing peer-competitive short-term gains is wiser than carefully managing the long-term risks of fund stakeholders. Managers of pension funds, for example, may "chase high returns" via risky, leveraged investment funds, hoping to maintain or achieve "fully funded" status so the plan sponsor can avoid transfers to, or pull cash out of, the fund. In this case, there are two levels of agency cost: the managers who try to please their employers at the expense of fund beneficiaries by implementing the strategy, and the plan sponsors themselves, who impose risks on beneficiaries to extract cash or avoid future payments.

5. Agency costs imposed by institutional investors on governments and the public at large

   It is not only self-interested managers or pension-raiding corporations who impose agency costs on others. Institutional investors that increasingly invest in highly leveraged investment funds don't do so only so fund managers can look good. Institutional investors impose agency costs on the general public, when institutions important to the public take risks whose benefit accrue to direct stakeholders but whose costs would be shared by the community at large. Suppose a university chooses to invest its endowment in highly leveraged investment funds in hopes of receiving outsized returns, which it will use to fund expanded programs, higher salaries, and other good things. The improved endowment returns benefit the university community much more than it does the general public. A catastrophic loss of endowment funds, however, imposes very large costs to the surrounding community, which may have to underwrite a bail-out of some form if important programs are threatened. A rational, self-interested university might choose an investment portfolio which provides high, steady returns in exchange for assuming a small but significant risk of catastrophic loss. In this way, the university community enjoys enhanced programs and salaries under the most probable scenarios, and forces public intervention on its behalf under less favorable scenarios. This sort of strategy can be rationally adopted by universities, important charities, pensions, any sort of institution willing to gamble that, within its own community, it is "too big to fail".

[1] "Agency costs" is economist-speak for the damage done by conflicts of interest between decision-makers and those on behalf decisions are made. If the CEO of a firm acts to provoke an unsustainable spike in his company's stock-price to enhance his annual bonus, the costs borne by stockholders (the inflated bonus, damage to the firm if the CEO's actions fail to maximize is long term value) are agency costs. Other examples of agency costs are political corruption and doctors who over-recommend lucrative procedures to their patients.

[2] Again, credit default swaps are a good example. When it can be argued that a CDS is a simple "loan guarantee", the writer of "credit insurance" may not be required to account for its position as a liability, creating the appearance that the "premiums" are pure profit. I have no idea how widespread this is in practice, but it is a very large loophole in theory.

[3] Keynes quote from "Consequences to the Banks of a Collapse in Money Values", 1931. Hat tip to Calculated Risk, writing on Angry Bear.

[4] Note that bank managers can take profitable risks even when they appear to be shedding risk. When a bank purchases "credit insurance" in the CDS market, apparently the bank is reducing risk, and accepting a fixed cost to do so. But just as writers of credit insurance may seek to keep their positions off-balance-sheet, purchasers would want their positions on-balance-sheet, offseting the assumed of the insurance with an asset. Given a high willingness by investment funds to sell credit insurance, banks may be able to purchase this insurance at unduly cheap rates. When credit conditions change and banks revalue their assets, they can book a profit by upping the book value of their CDS positions from cost to fair-value. In a systemic crisis these positions may turn out to be worthless, as the highly leveraged funds that sold the insurance go bankrupt. (It's oversimplifying, but not inaccurate, to suggest that the banking system is selling insurance to itself by offloading risk to leveraged investment funds. The banks expect to be made whole by the very same clients whose inability to pay off loans may trigger their need to be made whole. Individual banks are lending to and buying insurance from different parties. But banks as a whole are doing much of their risky lending to the investment fund sector, and buying much of their insurance from that sector.)

This is an elaboration of a comment I posted in response to an Economonitor post.

My inner Roubini has been kicking the shit out of my inner Cramer for more than a year now. So it was with some surprise that I found myself nodding along and murmuring "Amen" to Cramer's New York magazine piece on hedge funds, After Amaranth.

Cramer makes some pretty obvious, good points. Like, since hedge funds are supposed to be for highly risk-tolerant investors, pension funds oughtn't be in the game.

Regarding pensions, Cramer offered the following suggestion:

The other way to regulate hedge funds is to say that you can't borrow more than, say, 50 percent of the money you have under management to leverage up, if you are running pension money.

This got me thinking. Why should hedge fund be leveraged at all?

"What?!? Hedge funds are all about leveraged investment strategies!" I know, I know. But hear me out. Hedge funds are for rich people, with lots of capital and risk tolerance, right? So why shouldn't hedge fund investors — people with sophisticated access to capital and credit markets — lever themselves, investing in unlevered funds with their own borrowed money? Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same. And while investors may enjoy letting their bankers share much of the downside of their investments, there's little reason to think this is good for the rest of us. It hardly seems fair for the public to bear systemic risk in order to enhance the private returns of the wealthy. If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed), and better diversified (as the cost of a big fund meltdown would be spread among the many banks who lent to various investors, rather than concentrated in the one bank that lent to the fund). Also, investors could better tailor their hedge-fund investments to their own level of risk tolerance.

Finally, without leverage, hedge funds would have to compete based on the intelligence of their investments, rather than their ability cajole bankers into lending them too much money, too cheaply. In such a world, it might actually be true that these funds would fuction to squeeze inefficiencies out of markets, rather than highlight and take advantage of conflicts of interest between bank managers, depositors, and governments..

I'm not suggesting that hedge funds shouldn't be able to borrow at all, as many hedge-fund strategies, like going short, require borrowing. And the implicit leverage inherent in many derivatives positions would represent a challenge to any regime that purported to regulate hedge fund leverage without otherwise limiting investment cleverness. Nevertheless, at least in theory, is there any good reason why limited liability investment funds for the rich and creditworthy should be permitted to take on high degree of leverage?

Today seems to be the day for waxing cynical about the prospect of hedge fund regulation. John Carney at DealBreaker writes:

It's a pretty simple formula: regulate an industry and you instantly politicize it. Which is another way of saying that you monetize the industry for politicians...

All the other talk -— about “systemic risk” or pension funds or low-liquidity real estate millionaires -— is just the sound of a policy in search of a rationale. And that policy, of course, is the enrichment of politicians. That's always the policy.

Of course loyal readers (hi mom!) will know that I think "systemic risk" is very real, and that it will hit us all like a rocket-propelled two-by-four, soon. But I quite agree with the cynicism about policy and politicians. So what is to be done?

Here's a simple suggestion. Investment funds should not be permitted to be limited liability entities. As legal entities, they should be restricted to organization as ordinary partnerships.

This isn't really regulation at all — It simply amounts to the state declining to confer the privilege of limited liability to certain kinds of organizations. Limited liability is rife with moral hazard problems, but most people (including emphatically myself) would argue that its advantages far outweigh its disadvantages for nonfinancial businesses.

But limited liability, like copyright, is a legal oddity conferred for a specific purpose: to encourage entrepreneurs to start and invest in risky but productive ventures. The businesses that investment funds put their money in should certainly be limited liability ventures. But the risks taken by the investment funds themselves are speculative financial risks. When a fund invests without leverage in a corporation, the fund's own limited liability status is worthless. With or without limited liability, the fund can lose all of, but no more than, the value of its investment. But if a fund borrows from a bank to invest ten times its own money in that same corporation, the fund's limited liability status is a big deal. It lets the funds investors reap investment gains from much more money than they own, while risking no more than the same meagre amount as in the unleveraged case.

There's no reason the state should grant investment funds a special dispensation to encourage this kind of risk. Fund investors should be allowed to take speculative financial risks, sure. But fund investors should be responsible for all the money they lose if things go sour. They shouldn't be able to let the bankruptcy of some shell corporation or LLP shield them from the consequences of speculative financial foolhardiness.

It's one thing to socialize the risk faced by an entrepreneur starting a productive business. It's quite another thing to socialize the risk of taking on leverage to achieve speculative financial gains. Limited liability is a privilege, not a right, and an oddity from a libertarian perspective. It should not be extended to leveraged investment funds.

Yves Smith at Naked Capitalism, riffing on a post by James Hamilton, ponders the question of why some CDO investors might have bought securities that were "losers at the start". Hamilton suggests that investors must not have understood what they were doing. As Yves puts it, "[H]ow could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros." Yves suggests that underwriters, sometimes believing their own hype, sometimes with adroit porcine cosmetology, did a great job of selling iffy paper. Here's another explanation, on the buy-side.

Do you remember the "greater fool" theory of investing from the late-1990s? For many high-flying internet stocks, the disconnect between stock prices and "fundamental" valuation was so obvious that buyers knew they were purchasing securities which, if held for the long-term, offered negative expected return. But it was quite rational to buy them anyway, so long as it seemed likely that someone else, a "greater fool", would buy them at an even higher price than the one you paid. Most serious players understood there would be a reckoning someday, but that there was lots of money to be made today regardless. The risk-return tradeoff on playing the fool for just a little while was quite favorable. Those willing to take big chances for a short time, and smart enough not to try to play "double-or-nothing" indefinitely, did very, very well for themselves.

At first blush, today's markets look nothing like the heady stockmarkets of the 1990s. After all, many of the securities that seem overvalued now rarely trade: structured credits backed by mortgages, commercial debt, credit cards, etc. Generally an underwriter sells an offering to institutional investors, who may plan to hold the paper to maturity. If secondary markets are thin, if no one is buying or selling, who could be the greater fool?

But, in fact, it is not "institutions" that buy this paper, but managers who are paid for performance. And from a manager's perspective, all these securities do trade, about once a year, when bonuses and performance fees are taken. During bonus season, hypothetical valuations of illiquid securities become converted into liquid nonrefundable cash, just like during an ordinary sale. Institutions effectively purchase securities from themselves, at arbitrarily high prices, and pay their managers a commission for the privilege. Financial innovation truly has been a wonder these last years. Institutions have cut out the middlemen and become their own greater fools, to the benefit of managers and the detriment of other stakeholders.

Many managers would be quite content with short, lucrative careers followed by long, wealthy retirements. They are faced with opportunities to "earn" money on so grand a scale that a rational person, looking at historical norms, would sacrifice a lifetime's wages for a few good years. At extremes, shame and legal risk constrain manager behavior. But, to the degree individual managers can attribute self-interested behavior to evolving norms and standards in their profession, they are protected. A "safe" position, from a manager's perspective, is one in which losses to the portfolio they manage are likely to be accompanied by widespread losses elsewhere, so that blame attaches to vast, vague "systemic" problems, and not to the manager personally, who was, after all, only one person, doing her job like so many others. Surely no liability, and no great ostracism, should attach to that.

Like a polluter earning immediate visible profits but exacting diffuse, hard-to-measure costs, managers at hedge funds, endowments, and pension funds are producing cash and "diffusing" risk whose costs will eventually be borne by someone. Institutions may now be their own greater fools, but the rest of us, apparent bystanders, may turn out to be the greatest fools of all.