Leverage Doesn't Equal Risk, But It Seems To Account For Much Of It

I wrote this post a few weeks ago discussing the use of the Kelly Criterion for scaling allocations to uncertain investments.

By following links in that post, you can read my reviews and discussions of Scott Patterson's recent book, The Quants.

That book, and Poundstone's Fortune's Formula, were the subject of some discussions with a colleague on Saturday morning, as we drove to the Washington, D.C., "Kill the Bill!" rally on the Capitol lawn.

As my friend and I revisited the topic of risk, risk management, and the Volcker Rule, I realized that, despite there being many aspects of risk, Kelly's work demonstrates that, of all of them, leverage is by far the greatest source of risk.

First, our fractional banking system exposes us to constant leverage. The reason you have an FDIC is due to US experience during the Depression with failed banks which had lost their capital through leveraged mortgage lending, and no longer could pay depositors their money.

Fractional-reserve banking provides much of the multiplier effect in our economy.

But we have explicitly allowed leverage in other areas, as well. Margin lending for selling securities short, for example. And, in effect, credit derivatives.

By exchanging risk without the use of exchange-traded instruments, as in those swaps, we learned in recent years that there can be unknown leverage borne by a counterparty.

Many pundits immediately derided the Volcker Rule. It's also no surprise that any bank CEOs who commented on it did so negatively and dismissively.

That, I observed to my friend, ought to tell you how necessary and effective Volcker's recommendation actually is.

Of course, if you are Jamie Dimon, Vik Pandit or Lloyd Blankfein, you want people to believe that a US investment or commercial bank simply must be allowed to engaged in leveraged, proprietary trading. These CEOs easily confuse legislators and regulators by citing a need to provide complete client solutions.

But leveraged proprietary trading isn't customer service.

Like it or not, despite what Jamie & Co. assert, when a financial institutions is highly-levered, and federally insured, and it is allowed to engage in proprietary trading and/or investing, by definition, that proprietary trading or investment is levered.

Why?

Because any proprietary activities' losses hit the institution's equity. And since financial institution equity is often only 5-8% of total assets, it won't take much, as we saw in late 2008, to bring investment banks as large as Morgan Stanley and Goldman to the edge of solvency.

This is what Patterson exposed in his book. By failing to heed the Kelly Criterion, billionaire hedge fund owners levered up and sustained crippling losses.

Imagine if those had been part of insured banks.

Wait, they were! Morgan Stanley's PDT group.

That's why Volcker is right. So long as any institution is implicitly or explicitly federally insured, and operating with leverage, any proprietary losses are, in effect, guaranteed by taxpayers.

Heads, they win. Tails, the rest of us lose.

That is the most frequently observed risk in our financial system in the last 30 years.

But you must notice there are two characteristics which must be separated. And only two.

Leverage and federally-insured deposits or businesses.

For example, suppose Blackstone invests billions of borrowed money in various ventures, and loses it all?

As a private equity firm, its partners/owners lose a lot. Its lenders, presumed to have analyzed Blackstone's balance sheet and operations, will probably take painful writedowns.

Losses like these could come from bad private equity deals, or even bad startup venture funding.

Or, they could come from Blackstone's own proprietary trading operations.

So long as only private sector counterparties risked their capital, whether as a creditor via loans to fund the balance sheet, or a creditor via counterparty risk, the rest of us aren't directly hurt.

It's only when federally-insured entities lose in leveraged proprietary trading that we all suffer directly.

That's why the Volcker Rule is so simple and effective. He identified the only two practices which should never occur together, i.e., proprietary leveraged trading and government guarantees of deposit insurance.

We shouldn't care if an unlevered Chase lost on proprietary trading, because those loses are limited to its own capital. But as soon as the bank is allowed to lever, implicitly, its losses can outstrip its capital.

Risk management is challenging enough without adding leverage to increase it. All the squawking over Paul Volcker's recommendations indicate that they address a serious problem. One which should be solved along the lines of his Rule, while ignoring the bleating and complaints of those in the sector who know they will lose valuable access to federal bailouts if his idea is put into practice.