The increasing complexity of modern leverage raises risks

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The writer is a former banker and author of ‘A Banquet of Consequences Reloaded’ and ‘Fortune’s Fool’

With the end of an era of cheap money, concerns over the leverage that has been built up in the financial system over years is rising. But it is not only the quantum of debt. Unlike amplifying returns through simple borrowings to fund an asset purchase, modern leverage is complicated by five factors that increase the risk.

First, multiple layers make the exact debt levels opaque and reduce the quantum of true equity supporting borrowings.

For example, investors make investments in things that are often themselves leveraged. In private equity net asset value loans, funds borrow against the value of their shares in businesses that have significant borrowings. This means that the underlying source of cash flow or returns must be sufficient to meet multiple claims, reducing the margin of safety.

Second, debt is supplied not only by banks but institutional investors, public and private funds, and wealthy individuals. One lender may lend to another who in turn finances another party. Different credit standards and approaches multiply. Risk becomes diffused through an often lengthy chain with complicated financial and legal rights, claim priorities and recovery levels. This shadow banking system now accounts for about 50 per cent of global financial services assets.

Third, with cash flow often inadequate to service debt, borrowings are increasingly reliant on the value of assets over which they are secured. Using high quality bonds or securities as surety creates complicated linkages. A leveraged equity bet secured by long-dated Treasury bonds as collateral is exposed to changes in both share prices and interest rates, which can exacerbate risk and increase calls on available cash quickly.

Secured borrowings also entail additional exposures. Underlying investments or collateral can become inaccessible or illiquid, unexpectedly triggering losses. Capital flow controls, seizures or restrictions on asset transfers can exacerbate the problems of leverage unexpectedly.

Fourth, the types of investments being leveraged is more expansive. Instead of borrowing principally for business uses, against liquid traded securities and traditional real estate, debt now finances the likes of infrastructure, start-up and early-stage ventures, intellectual property, collectibles or bonds that hedge catastrophe (natural disaster) risk. These assets are inherently more difficult to assess, making loan-to-value determinations challenging.

Fifth, there is growth in “embedded leverage” where financial engineering increases loss intensity for a given event. Digital or binary options (which have an agreed fixed payout) allow sellers to nominate large losses in the event of a remote event occurring to increase the premium received.

Junior securities in a securitisation exhibit similar characteristics. In the case of a few defaults, an investor diversified across an entire portfolio of loans would suffer small losses. If they are invested in the riskier equity or subordinated debt tranches that must bear first losses in a securitisation of identical obligations, then the identical number of delinquencies would result in greater losses or the entire investment being wiped out.

Embedded leverage means that the exact exposure to a particular market move or financial event is uncertain. Modest changes can trigger disproportionately high losses, increasing the potential for distress.

Disclosure and more capital — the usual regulatory disinfectants — while useful, are incomplete. Information is available with a time lag and at specific dates usually too late to action. Capital requires accurate modelling of risks which for more complex types of leverage, such as that identified above, is difficult. A significant portion of exposure is held outside the banking system where regulation and oversight is variable and differs across jurisdictions.

Leverage is also an arms race in which the authorities are handicapped. As Hyman Minsky observed, “in a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators”.  

The real constraint is that over time the economy has become reliant on speculation to generate activity and paper wealth, backstopped when needed by governments and central banks using public resources to maintain financial stability. Ultimately, it is difficult to limit leverage in a world where everyone is incentivised to get rich quickly using other people’s money.