Rumors of leverage's death have been greatly exaggerated.
In the aftermath of the 2008 financial crisis an abundance of leverage — borrowed money used to amplify returns — was blamed for exacerbating losses on subprime mortgages and contaminating the banking system with catastrophic results. Since then a host of new rules have been enacted to reduce financial leverage, including penalizing certain derivatives positions, such as the credit default swaps (CDS) villainized in the crisis, as well as outright curbing the amount of borrowing allowed at big banks.
While such efforts have made substantial steps in derisking the financial system — especially at large lenders — they've also encouraged the creation of new types of leverage and its migration to different players. Today, much leverage appears to sit on the balance sheets of large and small investors, often fueled by the need to generate returns amidst ultra-low interest rates and high correlations that see asset classes move together and make it more difficult to produce outperformance, known as 'alpha.'
Leveraged strategies may include selling volatility or dabbling in derivatives tied to interest rates or corporate credit. While few are suggesting that the leverage deployed via such tactics could cause a crisis on the scale of 2008, it can create unexpected consequences ranging from a 'flash crash' in one of the world's most liquid markets to constraints on the Federal Reserve's ability to change monetary policy, as underscored by a new paper from visiting professors at the Bank for International Settlements.
Moreover, they underscore the risks facing the market as investors continue to divide themselves between those eschewing the chance to earn a steady stream of returns by betting big — and those willing to risk the chance of outsized losses in the event of a significant change in markets.
The latter group found a posterchild in the way of Bill Gross, the former co-chief investment officer of Pacific Investment Management Co. (Pimco) and erstwhile 'Bond King' who spoke publicly about his use of derivatives to increase returns in the "new neutral" era of ultra-low interest rates, shortly before departing the company in late 2014.
Pimco's flagship bond fund, the Total Return Fund (TRF), sold $94 billion worth of put and call options on floating to fixed income swaps, or 41 percent of the fund's net asset value, according to BIS data. Known as selling or shorting volatility, the strategy allowed Pimco to collect insurance-like premiums as long as interest rates stayed low.
Similarly, Pimco deployed eurodollar futures, a type of derivative that locks-in interest rates for investors, with long eurodollar contracts at the Total Return Fund (TRF) jumping from 250,000 in March 2013 to almost 1.2 million as of June 2014.
While Pimco noted at the time that such long eurodollar futures contracts were "used to manage exposures at the short end of the yield curve and express PIMCO’s expectations for short-term rates," they also come with the benefit of added leverage, in effect boosting returns so long as rates remained low.
Gross's departure from the fund in September 2014 sent the TRF's managers scrambling to liquidate the eurodollar contracts as investors redeemed their money. The liquidation may have exacerbated the flash rally in U.S. Treasuries that took place shortly after, when the yield on the benchmark 10-year note seesawed wildly in the space of a few minutes, the BIS paper said.