Sic Semper Tyrannis

While discussing hedge funds and the state of the financial economy in private correspondence, Steve Waldman pointed me to his recent blog article on leverage and risk. It is excellent so give it a read; I'll post some excerpts here:

Recall that any leveraged, limited-liability entity can be understood as a call option. If a business owes the bank $1M, but its assets -- including the present value of expected future profits -- are worth less than that $1M, it can declare bankruptcy. Its owners hand over all assets to the bank, and walk away without paying off the loan. On the other hand, if equityholders believe the business is worth more than a million, they pay off the bank, or rollover the loan, depending on the operation's current liquidity and available investment opportunities.

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Investments whose returns are like options have an unusual property. Usually, investors hope to minimize risk and maximize returns in their investment choices. But the expected return of an option increases with the risk (or volatility) of the underlying asset. ... An unleveraged, risk-averse investor always prefers sure cash to a fair coin-flip. But a very leveraged investor who has the option of shifting costs to the lender, takes the coin-flip. If she loses the flip, she loses nothing, the lender takes the cost. If she wins, she's turned other peoples' money into a cool million for herself.

A 100% leveraged entity is a zero-cost bearer of risk. The downside of any potential investment is immaterial. Only the probability-weighted magnitude of the expected upside matters. A 100% leveraged entity prefers volatility to safety, even if the "average" outcome of a gamble is not particularly good. Even if the coin in the previous example were rigged so that the fund loses 2 out of 3 flips, equityholders still prefer to play than to hold cash. Since creditors bear the losses, the only cost to a bad gamble is the opportunity cost of better gambles that might otherwise have been undertaken.

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In markets awash with liquidity, borrower reputation may substitute for balance sheet due-diligence in the decision to extend credit.

The trading of financial derivatives is supposed to transfer risk exposure to its least cost bearer. In light of the foregoing discussion, what might a least cost bearer look like? As we've seen, entities that are nearly completely leveraged ... face a low, or even negative, cost to bearing risk! This is counterintuitive, since these are the sorts of entities that face the greatest likelihood of bankruptcy. But that is exactly the point. Bankruptcy transfers the cost of risk gone bad to others. The least cost bearer of risk is an entity with few nonmonetary costs associated with failure, and a reputational or strategic capacity to take on leverage without surrending its ability to take risk. It should be no surprise to anyone following financial markets that this sounds a lot like a highly regarded hedge fund. Think Long-Term Capital Management.

The point of this essay is that LTCM-style meltdowns are not aberrations, but are a rational, structural consequence of a financial system in which the returns of some entities have high optionality, offering the possibility of high-returns for a low sums put at risk of total loss. LTCM should not be regarded as a failure or lapse of judgement on the part of its managers or investors. Its failure was a "normal accident".

A "normal accident," folks. This describes the situation well. Nothing has changed; in fact, since LTCM in 1998, the situation has only become more extreme. Hedge funds were not done imploding with LTCM; witness the hedge fund-polluted collapse of REFCO and MotherRock's recent belly-up flip.

Clients and other market participants intertwined with hedge funds (like banks) should see these failures and take them into account in their willingness to do business. But the mindset that hedge funds and their ilk are making a non-issue of risk seems to still predominate. To me, this seems like a very bubble-like behavioral quirk, adding an irrational element to the total result on the financial economy.

Underlying all of this is how in recent years we have dramatically increased the general availability of credit-money. This has allowed a side-stepping of proper risk treatment and sane risk premium evaluations, and transformed bankruptcy and other similar "callable" arrangements from benign "safety nets" to highly-gameable and infrastructurally-exploited loopholes.