Here’s a question from a reader a few weeks ago.
I consider myself to be a value investor and stick mainly to stocks
where I feel the asset to equity ratio is reasonable along with
consideration of other factors such as PE & share price to book value etc.
As a result, I am not panicking with the recent mkt downturn and expect
to hold most of my positions thru the major downturn when it happens.
Despite my resolve, I can’t help but feel uncomfortable with the recent
comments on subprime and liquidity etc. Again, I am a very inexperienced
amateur investor, but what I seem to be getting from the reports is that
there is so much leveraged investment in the markets these days that
even these mini downturns may force selling of stocks to cover leveraged
positions and could wash over the entire market. Reports of complete
funds being wiped out as a result of the necessity to cover leveraged
positions seem incredible to me. I personally feel leveraging should be
left to very skilled, specialized traders and will only consider it when
I have a portfolio of sufficient size that I would be able to use it as
insurance and in turn cover a position if required.
Having said all of this, I have several questions, if you would be so
kind as to consider.
Is there a way to assess the volume of leveraged positions relative to
the whole market and likelyhood to tip the whole market and the average
% the market will retreat based on the amount of leveraging in the
markets and the historical data on the effects?
Are there not rules that govern funds, in order to protect the investors
in the funds from complete liquidation due to leveraging by the managers
and at any rate doesn’t someone review the activities of the fund managers?
Is this leveraging in the marketplace so widespread and common now that
small investors like me are tilting at windmills if don’t participate?
I realize that these questions may be rather uninformed and somewhat
equivalent to “the meaning of life” scenerio, however I have been
reading your blog quite faithfully and with my limited understanding of
some of the technical jargon, find it very interesting.
Thanks for asking your question, and sorry I didn’t get to it earlier. There are several things to write about here:
- How serious are leverage problems in the market?
- There are certain forms of leverage that are well measured, and some that are not.
- Some institutions have leverage rules, and some don’t, sort of.
- Am I at a disadvantage as a small investor, particularly if I stay unlevered?
Let’s go in order. The leverage problems in the market today are significant, though none are urgent at present. The furor over ABCP and SIVs and other bits of short-term lending have largely passed. Good collateral got rolled over, bad collateral got picked up by stronger institutions. That said, there are other important problems in the market that are not at a crisis point yet:
- Falling residential real estate prices, and the effect on mortgage default, and the effect on those that hold mortgage securities.
- Private Equity’s ability to repay debt on new acquisitions.
- The willingness of the investment banks to takes losses on prior LBO lending commitments.
- Losses in the CDO market, and who owns the certificates with the most exposure to loss.
- Losses from high-yield lending to CCC, and single-B rated firms.
- Are any significant financial institutions overexposed to the above items, such that they might be impaired?
Now, some of the leverage is well measured, and some is not. We really don’t know with derivatives what the total exposure is, and whether the investment banks have been clean with their counterparty management. (That said, so far it looks like it is working. There may be a Wall Street rule, that if someone is near the edge, find a way to kick them over the edge, so that you can foreclose with more collateral.)
We also don’t know about lending to or from hedge funds, and hedge fund-of-funds. Non-bank lenders, we know about what they securitize publicly, and that’s most of it, but the rest, we don’t know. Foreign lenders to the US — the Treasury collects some data on them, but the detail is lacking.
All of these are areas where reporting requirements are limited to non-existent. Regulated domestic finance — we know a lot about that, and that’s a large part of the system; the open question there, is how much the regulated part of the system has lent to the non-regulated part of the system. Difficult to tell, but given the slackness of bank exams over the past five years, it could be significant, but I doubt perilous to the system as a whole.
Banks, S&Ls, Mutual funds, Insurance companies, and margin accounts have leverage rules. Many non-regulated entities face leverage rules from the ratings agencies, which limit their ability to borrow and securitize. Still other face limits on leverage from those who lend to them, in the form of debt covenants. Almost everyone is limited in some way, but in a bull market, those limits often get compromised as a group. The limits are not as wide as would be optimal for financial system stability.
So, there are some protections for those who lend to hedge funds and hedge fund of funds, but little protection to those who invest in them. Hey, if you’re a big institution, and invest here, you are your only protector; no one is coming to rescue you in a crisis.
But onto the last question: Am I at a disadvantage as a small investor, particularly if I stay unlevered? You have many advantages as a small investor. One of the largest advantages is that no one can force you to be hyper-aggressive, except you yourself. If you are reasonable in your return goals, you can safely achieve better than your average levered competitor through a crisis. An unlevered investor can’t be forced by anyone to take on or liquidate a position. Levered investors, or those with return requirements from outside parties, do not fully control their own trades.
Second advantage: you can be more picky. You can avoid trouble areas in entire if you want. Many institutional investors face diversification or tracking error requirements, which force them to in vest some in areas that they don’t like. As an example, I was one of the few investors that I knew that didn’t take some losses from the tech bubble popping.
Third advantage: you don’t have to take risk if you don’t want to. If the market is too frothy, and shorting is not for you, just reduce exposure, and wait for a better entry point. (Warning: that entry point may not come.)
A disciplined private investor may not have the same level of knowledge as the institutions, but he can have a longer time horizon, and play the out of favor ideas that might threaten job security of those who work inside institutional investors. With that, I would advise you to take use your advantages, and invest accordingly. Keep it up with the value investing!
For those with access to RealMoney, I advise reading these longish articles if you want more background on how I think here:
Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2