Banks warned on extreme leverage

“Under the new world assumption of today’s low volatility and narrow asset risk spreads . . . there is a maximum leverage point . . . beyond which returns can be maintained only with increasing and significant expectations of financial loss,” Mr Gross argues in a note to investors. He highlights CPDOs as one example of an instrument that may mark the market peak.


Banks warned on extreme leverage

By Gillian Tett in London
December 5 2006
Source

Bankers may soon face constraints on their use of extreme leverage to create returns on fixed-income assets in complex structured financial products, Bill Gross, head of Pimco investment group, has warned.

Leverage has risen so far on some products – such as constant proportion debt obligations – that its efficacy is waning, while inherent risk has grown.

“Under the new world assumption of today’s low volatility and narrow asset risk spreads . . . there is a maximum leverage point . . . beyond which returns can be maintained only with increasing and significant expectations of financial loss,” Mr Gross argues in a note to investors. He highlights CPDOs as one example of an instrument that may mark the market peak.

The criticism is striking, since the CPDO instrument – a highly leveraged bet on a basket of investment-grade credit derivatives – has attracted intense interest since its launch in Europe.

Although the instrument can be levered up to 15 times its original face value – or more if the value declines – the three largest rating agencies have all awarded the product top credit ratings.

Since the instrument also promises investors a 200bp spread over Libor, the structure has proved popular with investors, and a host of investment banks are now looking at copying the idea.

This has helped push down the cost of buying protection against bond default, via credit default swaps, since a key component of a CPDO is a contract to sell credit protection on the iTraxx or CDX indices.

Until now, most bankers have been wary of questioning the structure since many banks hope to replicate the idea themselves to earn fees and do not wish to antagonise the rating agencies.

However, the decision to award the AAA rating has provoked intense debate among asset managers. Mr Gross himself points out that “this AAA rating is subject to numerous (more numerous than usual) subjective assumptions on the part of the rating services”.

He also argues that “under Pimco quantitative modeling, current investment grade CDX spreads can only narrow by 3 or 4 more basis points before these CPDO instruments can no longer earn a AAA rating or offer such an attractive 200bp spread. Increasing multiples of leverage beyond 15 times . . . cannot maintain either a AAA rating and/or the 200bp in yield spread.

“The increasing use of leverage appears to have run out of its magical ability to increase returns.”

Copyright The Financial Times Limited 2006