The Second Major Risk of Leverage: Path-Dependency Risk
The more subtle risk to consider with leverage is path-dependency risk, which deals with the details of different types of leverage.
At this point in the article, readers might still feel a bit unsure about the concept of financial leverage. Viewing leverage in the context of a common use case, however, may help to get a better sense of it.
Mortgages represent one of the most prevalent applications of leverage in the United States. The issuance of a mortgage typically involves an initial down payment on a home. A bank then provides the capital for the remaining purchase price of the property. To service the loan, the borrower is obligated to make monthly payments to the bank.
Crucially, a mortgage is not subject to daily mark-to-market valuations. Instead, its valuation is realized either upon the property’s sale or in the event of a default.
If the borrower keeps up with their payments, nothing significant happens until the house is sold or, in a worst-case scenario, the bank takes it back. Even if the house’s value drops, the borrower won’t face immediate consequences as long as the monthly payments are made.
In the event of a value depreciation, the borrower’s equity value might dip into the negative, yet foreclosure actions aren’t initiated if the mortgage is kept up. However, failure to fulfill these payments, regardless of the cause, can lead to foreclosure or a forced sale, potentially at a disadvantageous price, contingent upon the urgency.
To ensure consistent mortgage payments, the borrower must possess one or a combination of the following: adequate cash reserves, the ability to comfortably manage the monthly mortgage payments, diversified income streams, sustained employment (preferably outside the real estate sector, especially during a housing market downturn), or possess skills and experience allowing him/her to get a new job if necessary.
In essence, this translates to a fundamental principle: “The borrower should have diversified income potential or ample capital reserves.”
Comparing this scenario to a financial derivative like a futures contract reveals striking similarities.
If an investor decides to enter a futures contract, they must set aside an initial amount of money, like a down payment on a house, known as the initial margin requirement.
Here’s where it gets different: in a futures contract, the investor doesn’t make a direct payment. Instead, any interest costs are taken out of the profits made from the investment. For example, if the underlying security gains 5% over the life of the contract, but there’s a 2% interest cost, the investor ends up with a net profit of 3%. In other words, no explicit payments have to be made: the interest charged is implicit.
Profit and loss from futures contracts is settled daily, requiring the investor to maintain a certain amount of money in their account, known as a margin account. If the value of the contract drops significantly, the investor might need to add more money to their account to meet the requirements and keep the investment going. This is slightly different from mortgages where the value of the house doesn’t affect the monthly payments.
This is where path-dependency risk is introduced. Even if an investor is right in their view over the long run, if they cannot support their position in the short term, they might be forced to close the trade.
Many investors learned this lesson the hard way in 2008. In a strategy known as portable alpha, institutions replaced core stock and bond exposure with capital efficient derivatives like futures and swaps. They then invested their freed-up capital in hedge fund strategies. However, when stocks sold off in 2008 and their margin capital deteriorated, many hedge funds began to gate redemptions due either to mounting losses or liquidity issues, making it impossible for investors to redeem their capital to replenish their margin.
The UK gilt crisis of 2022 also highlighted the path-dependency risk of concentrated leverage. Pension schemes in the UK hedge their liabilities by purchasing long-dated UK government bonds. Since outright holdings of long-term bonds are economically costly, they employ leverage and pool their assets with other pension funds. As yields spiked in September 2022, large mark-to-market losses were generated, triggering margin calls. To meet these margin calls, pension funds initially sold more gilts, triggering further losses. Furthermore, many smaller pensions implemented this trade via pooled vehicles, which were limited liability. This created a principal-agent problem, as the managers of the pools were incentivized to sell positions quickly, rather than give participants time to contribute to positions. (The Chicago Fed provides a more detailed analysis of the crisis.)
Source: The Federal Reserve Bank of Chicago, https://www.chicagofed.org/publications/chicago-fed-letter/2023/480
In both events, leverage was at the scene of the crime. However, it was leverage and illiquidity or leverage and concentration that caused the problems to spiral.
Investors in futures contracts, therefore, need to have enough cash or other liquid investments that can be quickly turned into cash. This way, they can transfer money to their brokers, or sell profitable investments to support their accounts.
