So called “Portfolio Insurance” was the culprit behind the first derivatives based market failure in 1987. Since then we have periodically experienced updated versions of the same human error. Twenty years after the crash of 1987 came the The mortgage meltdown of 2008-2009. Now just ten years has passed and we are here again with the current market crash. It is early for wide spread agreement on the current cause, but I will make my case that it is so similar to the events of 2008-9 and 1987 that financial industry “risk managers” ought to be embarrassed if not unemployed.
The “go to” explanation is too much leverage. The problem with this answer is that leveraged financing does not really explain the market failures. Some structures with more leverage are robust while others with less still fail. What all three of these market failures (’87 , ’08 and 2020) have in common is the failure to look beyond a schematic understanding of markets to one that actually incorporates how markets/people react to stress.
Portfolio Insurance was sold as a way out of the markets downside when the investor wanted out. Think of this as an office building that guarantees exit in case of fire but rather than building peak use capacity only builds stairways and elevator service to support average usage of the same. When everyone tried to leave at once there was chaos.
In 2008-9 Mortgages, student loans and other long lived assets were packaged and sold for the long haul with leverage funded by debt-instruments that needed to be repriced as often as every two weeks. On average the supply of short term investors was adequate to support these short term liquidity auctions, but when the demand for liquidity peaked, once again the too many folks were seeking tickets on the last flight from Saigon.
It is to early now to identify whether similar design defects are the cause or the effect but when traditional stable debt markets such as those for “ultra-safe” US Treasuries start jumping around like cats on a hot tin roof, something has gone wrong. We have learned in the last few days that leveraged REITS have been forced to sell assets at distress prices when their access to short term capital was cut off.
Hedge funds too caught up in the market down turn with leveraged portfolios have been forced into raising cash by selling the assets they could sell rather than the ones they might wish to sell. But it is not correct to blame the leverage. The deeper and essential risk aspect of these leveraged transactions is not the amount of leverage but the periodic need for refinancing.
In the Income Sharing Agreement market that Education Equity, Inc. invests in, we too use leverage.
We typically fund ten year ISAs with five and six year debt. The difference though is that the debt we use is fully amortizing and so at maturity it needs not to be replaced. When our debt matures we may, if the terms suit us, apply an additional layer of debt or leverage but we do not have our backs against the wall. We have a choice.
Strategies that earn current returns by binding future outcomes are not necessarily bad ones but they should be recognized for what they are, Insurance policies written. Insurance written must be underwritten otherwise the roles of insurer and insured have been reversed with out at least one party knowing it. This has always spelled trouble and always will.