Wednesday, March 7, 2007

Financial Camouflage For Sitting Ducks

I was talking to a friend in private banking a few days ago and he told me something that I found quite interesting, if disconcerting. He covers major individual accounts and the very first thing his customers ask him when presented with a recommendation is this: How many times can I leverage it?

For those who grew up in a different financial era, leverage is no longer what you think. Stock margin in the US and some other countries may still be regulated at 50%, but in the Wild East margin is unregulated and can be as little as 10-20%. For FX spot positions it can be as little as 1-2%, even for tiny bets.

Most of the products being offered to private customers these days are "structured", i.e. they mostly combine a capital guarantee with ultimate returns tied to a particular index or set of conditions. There are literally hundreds or even thousands of different retail products being offered, each designed to satisfy a separate investment "need". There are products tied to stocks, bonds, commodities, real estate, foreign currencies. I haven't heard of any tied to weather, pollution credits or catastrophes yet, but if they do not exist they soon will.

There are three things these products have in common:
  1. They generate huge upfront fees.
  2. They are practically illiquid.
  3. They depend heavily on derivatives.
In low interest-rate markets such as the EU and Japan such products are all the rage with retail customers (and some sizable state-run banks, insurance firms and pension funds located in countries notorious for cronyism and corruption - see #1 above).

Each product's "flavor" may be different, but the basic ingredients are the same: derivatives (options, swaps, futures, warrants, etc.) and zero coupon bonds (for the principal guarantee).

Such products are almost always 100% bullish in whatever they index, reflective of retail investor patterns. It is a rare individual investor who will bet on the downside of anything - when they turn negative (usually belatedly) they just park their money in cash.

Such structured products, therefore, are major buyers of derivatives that bet on the upside, sustaining and exacerbating momentum trends. Couple that with margin leverage and the resulting effects on volatility and risk premiums (both down) can be very considerable.

What's the moral of the story? Market observers have been saying that the current bull market is not over because we have not yet seen the individual investor arrive in droves, late as always, to jump in with both feet and thus serve as the familiar contrarian sell signal. Well, it seems to me that individuals are in alright - it's just that this time they are using structured products as camouflage. And if heavy leverage is being used, we are not going to see it in the official margin accounts but hidden in the rapidly rising overall credit expansion numbers.

The individual "ducks" are now wearing professionally tailored camouflage, making it hard to make them out, but we can still hear their loud quacking emanating from the pond: absurdly low volatility and risk premiums that no seasoned manager would ever touch. They walk like ducks, they quack like ducks - so what if they are wearing a fake hawk suit? They are still just sitting ducks that have arrived late as always, just in time for duck season.

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