Ah, poor misunderstood, lonely ol’ leverage. The regulator’s whipping boy, but why? In this brief history I’m only going to go back one hundred years to the Roaring 20’s. Why was it roaring? Other people’s money.
Prior to the creation of the Securities Exchange Commission ("SEC"), the investment markets were a libertarian's dream full of sharks and, mostly, minnows. Sadly, it was the minnow's fault that they lost everything and got eaten! Caveat Emptor...
It wasn’t unheard of for investor to have 3x leverage, or more, meaning for every $1 of their own money they were borrowing $3 to invest along side to juice up returns. That's great when things are going up. However, when things start going down they tend to accelerate quickly and you can’t sell fast enough to cover your debts. You end up with none of your own money and still owing the broker $2, if you’re lucky.
So, SEC was created. At that time it was focused on the “retail” investor. Mom and Pop who can’t afford to lose their life savings, don’t have time to study company financials, and have 9 to 5 jobs.
So, the borrowing limits, we spoke about last time, were instituted on retail brokerage accounts but left Qualified Institutional Buyers alone. Unless, of course, they were creating an investment vehicle that would be sold to retail investors. In which case, they were limited to borrowing $1 for every $3 held and had to have funds segregated to cover any borrowing.
Now jump forward to the 90’s:
Long Term Capital Management's (“LTCM”) implosion due to large bets in foreign markets got regulators thinking. Maybe some of these new investment products, like swaps, might have deeper, more widespread, consequences. Should they be looking a little closer and perhaps adding some market bumpers to prevent this happening again?
After the Federal Government bailed out LTCM to "protect" the market, the Commodity Futures Trade Commission (“CFTC”) began to publicly discuss regulating the swap market. That is, until Alan Greenspan, Chairman of the Federal Reserve at the time, while answering questions from the U.S. House of Representatives, Committee on Banking and Financial Services, said, [I'm paraphrasing here]
‘It is not the government’s place. These are professionals and the market will handle it.’
And did the market ever handle it, by nearly burning the whole thing down in 2008-9 and landing us in the Great Recession. This ultimately led to monitoring of large swap traders and systemically important institutions. And now, for the investment managers serving retail clients, we have 18f-4. Thank you, leverage...
For all the libertarians in the audience, you’ll be glad to know that if you have enough money, the government will still let you to blow yourself up, ask Achegos Capital Management.