More Leverage Won't Add Balance

If a hundred experts were asked to identify the 25 things that need fixing in the U.S. economy today, I doubt that increasing the amount of borrowed money available to hedge funds would be on any list.

After all, we've just had a spate of hedge funds that have failed or been forced to close their doors because of some big bets made with lots of borrowed money that didn't turn out as well as expected. And with returns plummeting, a shakeout in the trillion-dollar hedge fund industry is underway.

So it's all the more curious that the Securities and Exchange Commission and the Commodity Futures Trading Commission are about to adopt new rules that would effectively lower the amount of their own money that hedge funds or any large investor must put up to buy and hold stocks, options, swaps, futures and other derivative products.

As it happens, this reduction in margin requirements is being pushed not so much by the hedge funds themselves as by the brokerage firms that handle their transactions and lend them the money, along with the New York Stock Exchange and the Chicago Board Options Exchange. Their longstanding complaint is that business has been moving to brokerage firms in London and other foreign financial centers where margin requirements are lower and more flexible, or don't exist at all. And they know that, given the chance, hedge fund and other institutional investors will use the greater leverage to double-down on their existing bets, using the same amount of their own capital to leverage bigger positions and generate higher fees.

The initiative goes by the name portfolio margining, and the theory behind it is certainly sound.

Under current rules, which date to the 1930s, an investor has put up at least 25 percent of the cost of buying a stock. That way, the broker still has enough collateral to cover the loan as long as the share price doesn't fall by more than 25 percent.

But these days, sophisticated investors don't trade just in stocks. They trade in all sorts of fancy instruments that may be derived from stocks but go up in value when the stock price goes down. So why not allow the broker to use sophisticated computer programs to look at an investor's entire portfolio, determine the real risk to the lender once all the bets and hedges are netted out, and adjust margin requirements accordingly?

Actually, there are two reasons.

One is that these risk-management systems aren't as infallible and impervious to manipulation as the industry would have us believe. Under the proposed new rule, all brokerage houses would be required to use the same, relatively simple modeling system designed by the leading options clearinghouse that considers a limited number of trading instruments. But the industry is already hard at work on Portfolio Margining 2.0, in which each brokerage would be allowed to use its own risk-management software, set its own worst-case scenario parameters and factor in all sorts of newfangled derivative instruments. The second iteration would effectively eliminate all government-imposed margin requirements and allow the industry to self-regulate.

The other reason for skepticism is that margin requirements serve a broader purpose than simply making sure brokers have enough collateral to get their loans repaid. These rules were put in during the 1930s because of a widely held belief that highly leveraged trading had contributed to the stock-market bubble and crash that preceded the Great Depression. And what was true then is still true today: Highly leveraged trading contributes to speculative bubbles that pose risks to the financial system.

Take the recent case of Amaranth Advisors, the once-high-flying hedge fund that lost $6 billion in about a week this summer betting the wrong way on natural gas prices. Commodities trading is not governed by margin rules, and Amaranth's chief energy trader, 32-year-old Brian Hunter, had loaded up on futures contracts that would pay off handsomely if natural gas prices continued to rise. But when gas prices began to fall, a desperate Hunter tried to prop up the value of the contracts in his portfolio by buying even more. The strategy worked as long as Hunter could continue borrowing enough money to pursue it, and as long as his firm's "world-class" risk-management systems gave him the green light to pursue it. In the end, Hunter was allowed to turn what might have been a $1 billion or $2 billion loss into a $6 billion loss.

Excessive leverage is not limited to hedge funds and commodities traders. In the hands of private equity firms, it is contributing to a bubble in corporate mergers and acquisitions. And there is little doubt that lenders offering mortgages with little or no money down have contributed to the residential real estate bubble.

The fact is that for all their sophistication and their fancy risk-management systems, banks, hedge funds and brokerage firms are still prone to getting caught up in speculative manias. In a market economy, it may not be the government's business to protect them from their own misjudgments. But the public does have a legitimate interest in keeping financial markets stable and the economy on an even keel.

That doesn't mean there may not be more flexible ways to regulate financial markets that better reflect the risks and realities of a modern marketplace. And few would disagree with the need to overhaul the regulatory apparatus, eliminating artificial distinctions between securities and futures markets, and setting uniform margin requirements for banks and brokerage lenders.

But it's hard to see the urgent need for, or the great benefit from increasing the amount of leverage in a financial system already awash in borrowed money. It is a solution looking for a problem and another step down the path of mindless deregulation toward the next financial crisis.