Leveraged Finance + Follow-the-Leader = A Dangerous Brew

October 11, 2010

Reading through the New York Times and the Wall Street Journal, I was struck by a glaring omission. While the public has been mesmerized by currency wars and mortgage moratoriums, along with the usual sex, drugs and rock-n-roll, financial service reform has been largely forgotten. Although a few observers continue to follow the fate of the toothless financial reforms passed a few months ago, Wall Street has returned to business as usual.

Unfortunately, business as usual remains extremely dangerous. The financial system today relies upon a volatile mixture of leveraged finance and socially-driven irrationalities.

Leveraged finance is scary enough, illustrated by a recent conversation I had with a salesperson working for a major prime broker. For those of you who haven’t heard the term before, a prime broker lends securities and money to hedge funds, allowing some to invest more than $30 for every $1 they actually possess. Where does this money actually come from? Despite working at the epicenter of leverage finance, the salesperson seemed to have little idea.

What institutional investors do with borrowed money is even scarier. Simon, Millo, Kellard and Ofer (2010) find that hedge fund managers experienced groupthink in one spectacular financial episode, VW-Porsche. Being over-embedded with one another, one powerful group of managers talked each other into a “consensus trade”. Later, they collectively refused to heed warnings that the trade was becoming dangerous. When this trade inevitably exploded, the hedge fund managers stampeded out with their billions of dollars, briefly creating a spectacular bubble. This episode is consistent with my own research, which shows a follow-the-leader pattern amongst hedge fund managers. Not only are institutional investors gossipy and panicky, but they also imitate the most prestigious investors (e.g. the Tiger Cubs) using their social ties. Statistical analyses suggest that such imitation may occur despite imitators systematically harming themselves.

These cases illustrate why the social studies of finance (SSF) are so important. When socially-mediated irrationalities affect people who control hundreds of billions of leveraged dollars, they could very easily create financial bubbles and crashes impacting the real economy. Understanding these socialized irrationalities remains our best defense against future bubbles and collapses, an eventuality as long as “business as usual” continues.

4 Responses to “Leveraged Finance + Follow-the-Leader = A Dangerous Brew”

  1. danielbeunza Says:

    JC — welcome to the blog!

    I agree with you that the American financial reform has been toothless. But as much as I would like to think that the social studies of finance can help address bubbles, it seems to me a rather tall order. The success of behavioral finance makes one thing: social science only succeeds when it is able to offer simple recipes. Your research offers an incredibly sophisticated network lens to understand hedge fund decisions. But, are there simple recipes that a fund of funds or hedge fund investor could extract from it?

  2. JC Says:

    Daniel, thanks again for the invitation to post!

    Regarding my own research, I think that there’s a very simple recipe for investors. While it is good to have connections, be careful not to blindly imitate the most prestigious firms. Some extra awareness, as well as second-guessing the market on occasion, could yield large dividends.

    The same thing applies to Jan Simon and Yuval’s research. Had the hedge funds embroiled in VW-Porsche taken a few extra minutes to check their assumptions, they might have taken the warning signs a bit more seriously! Here, the general admonitions against groupthink and overembeddedness would apply.

  3. Fabian Says:

    Err… “socially-driven irrationalities”? This rather sounds as a death sentence for the Social Studies of Finance!

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