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Minyan Mailbag - Leverage



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Hi John,

I hope all is coming along nicely with your hand/wrist/arm infirmity. In the context of the "compression" in yields you mentioned at MIM this past summer and Todd's comment about funds "reaching for yield" by making larger bets and, presumably, using leverage to increase their absolute returns, a question comes to mind. Isn't this the exact strategy / methodology employed by LTCM and, if so, why are said funds not cautious of the strategy? Thanks, John. I hope this finds you and La Familia well. Peace.

Minyan Dean

Hi Dean,

LTCM used extreme leverage to trade "spreads": theoretical relationships between various asset prices. Risk management was based on the fact that if one of these relationships broke down, another relationship between other assets should widen; the loss on one would be offset by the gain of another. When correlations rose dramatically between all financial asset prices in 1998, these offsets all went against them. The "theory" did not meet up with the practice. This illustrates the danger of creating theory exclusively from empirical data.

Insurance companies and pensions are significantly behind in matching their liability streams, so they are taking extraneous risks to close this gap. They are being "forced" (in their own minds) to buy corporates where they should be buying treasuries and buying stocks where they should be buying bonds in order to "make up the difference". This is nothing new in investing, the mis-allocation of risk, and has caused many many corrections before. It is interesting to note that malpractice insurance premiums are much more correlated to investment returns than large malpractice awards in court. This illustrates how insurance companies are levered themselves: they take your insurance premiums and invest them. When they do poorly on those investments, they raise premiums.

So in a sense yes, the liability gap phenomenon is like LTCM not in the details, but in the general sense that risk is being shoved under the carpet in a vain attempt to increase returns.

Prof. Succo

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