Geared, Levered, Piston Broke

We recently spent a couple of weeks on the road in Europe and the Americas hawking around a presentation entitled "Something Wicked This Way Comes." 1We mentioned some time back that we had been seeing increasing interest in the region from chunky-sized funds who have decided that they want to trade Asia since it has been becoming harder and harder to make money from their traditional strategies. And this broadening of interest in the region was also reflected in the number of non-Asia specialists who attended our various meetings along with their dedicated colleagues.

Even within institutions it is telling to witness the divergence of opinions between the old hands and the neophytes. While even for misery-guts such as ourselves there are good structural reasons to be upbeat about the region over the medium term - see our piece from last week entitled "Property Perfect" as one good example - many of us who have witnessed Asia's depressing global cyclical correlations and lack of investor protections are wary about getting too carried away that this time is different. However, the cross-over money seems to view things differently. In a world where making money in convertible arbitrage or US relative value is becoming harder and harder, when the fresh MBA analyst discovers Asian stocks are cheap from his global screens, his bosses seem more than ready to take a punt.

Perhaps we are just too long in the tooth and so deeply scarred and cynical that we cannot recognise that things have structurally changed for the better. If so, we will likely be out of business in a couple of years' time and looking to retrain as a plumber. Nevertheless, if we are even half right about some of the dangers out there then some of this cross-over money will head for the hills just as fast as it is coming in now. And it will be the North Asian cyclical markets, especially our bête noir Korea, that will be most exposed. For while we continue to extol the virtues of looking further south, liquidity constraints mean that the multi-billion dollar funds that are starting to play cannot trade these smaller markets.

Returning to the subject of leverage, the global financial system, to us at least, seems somewhat akin to LTCM writ large. Falling rates of return and exceptionally low volatility have encouraged and/or compelled investors to gear up their balance sheets in order to maintain headline performance. Disentangling accurately the aggregate numbers and individual exposures is an almost impossible task but the macro data, which has notable gaps and exclusions, continue to paint a picture of rising and rising risk profiles. A selection of indicators illustrates the point:

  • US financial sector debt has now topped 100% of GDP or US$12 trillion. Non-financial debt is an additional 200% of GDP despite corporate de-leveraging. Such levels of debt have virtually no historical precedence save at the end of extended periods of warfare.2

  • The BIS in its latest quarterly review focuses on hedge fund activity in Caribbean offshore centres and notes that loans to Cayman Islands non-bank entities reached US$436 billion at the end of Q3 2004. 3This loan stock has doubled since the end of 1999 and is now third in the world in size behind only claims on US and UK non-banks. Note that the BIS data does not cover other important offshore hedge fund centres such as the BVI.4

  • Aside from loans extended to hedge funds by the likes of prime brokers and investment banks, many fund-of-fund strategies have also geared up. Moreover, banks are offering individual clients loans to buy funds or fund-of-funds. In essence, the levered bets are pyramided up into what are often already crowded strategies.

  • Investment banks increasingly resemble hedge funds since as returns from other business areas have fallen they have been encouraging their own traders to take greater risks with the firms' own capital. VARs have been on the rise for a number of years now.

  • According to the US Office of the Comptroller of the Currency, the notional outstanding value of OTC derivative contracts stands at US$85 trillion while these markets turn over US$1.2 trillion per day according to the BIS.

  • While notional figures overstate exposures at risk and large potions of the market exist for genuine hedging purposes, a fair chunk also represents outright speculative positions. While the securitisation of risk via products such as credit derivatives - now a US$10 trillion market of which over half resides with non-banks - has obvious benefits for those who can reduce their exposure concentrations, it cannot eliminate risk for the market in aggregate.
Many of you will doubtless yawn and say that this is nothing new. Indeed it is not and the perma-bears have been fretting about the damage potential of a major spike in volatility for so long so as to have little credibility left. However, this does not mean it will never happen and it certainly does not mean that the prudent investor should just close his eyes and be maximum exposed. For as and when volatility does spike, for whatever reason, we believe that concentration of positions and the fact that so many funds have their fingers on the exit trigger should problems arise, could cause major price gapping since there will be few people there to take the other side of the trade. Counterparty and delivery risks are also likely to be understated in our opinion.