buying stocks with margin vs buying stocks with float

[muscleman]

I have been thinking about BRK and FFH's success, and I wonder what is the difference between buying stocks with margin vs buying stocks with float?

For stocks with margin, the current interest rate is just 1.5%, which is pretty low cost leverage. However, margin calls can potentially wipe out the investor overnight.

But for insurance floats, don't they have similarities? If the float is used to buy stocks, and the stock market crashes, won't regulators ask for dilutive capital increases?

Ideally, if I were a CEO, I would want to have an operating subsidiary which is a stable cash cow, that can be leveraged up, and then I will move the money to the other investing subsidiary to buy stocks. Then I won't worry about margin calls.

Thoughts?

[tiddman]

There was a time in the early 90's I believe when Berkshire had more than 100% of its book value invested in equities, because it had invested in them using float.  So it was in effect leveraged, both to the equities and the float itself.

 

All forms of leverage magnify both upside and downside and can lead to forced selling or a wipeout.  It is a matter of degree though.  With broker margin you might be able to leverage yourself 2:1 which is pretty leveraged and can be dangerous.  Working with float in insurance companies that you own can be safer, especially if you are more conservative, but a lot more know-how is required.

 

BTW where can you borrow on margin at 1.5%?  At TD Ameritrade the base rate is more along the lines of 7%.

[Hielko]

At IB you get 1.5%, but you can borrow even cheaper/close to risk free rate if you use synthetic long positions.

[yitech]

It is only cheaper if you ignore the two-way option spreads and commissions you are implicitly paying when you establish the synthetic position using calls and puts.

[gary17]

Hielko, can you please explain to me how does a synthetic long work... thanks

 

At IB you get 1.5%, but you can borrow even cheaper/close to risk free rate if you use synthetic long positions.

[beerbaron]

Hielko, can you please explain to me how does a synthetic long work... thanks

 

At IB you get 1.5%, but you can borrow even cheaper/close to risk free rate if you use synthetic long positions.

 

If you buy calls and sell putts you are basically taking a long position without putting up any capital. It's a nice way to leverage at low cost and plus sometime it can be more advantageous than buying the stock. I have seen cases where you could take positions SHLD and you would get 100% the upside and 60% of the downside because the calls were so cheap relative to the puts. It usually happens when the shorts are financing themselves by selling lots of calls.

 

Beware tough, options because illiquid as the stock moves out of the strike. Does not matter if you plan to hold until expiration but if you like to trade often you might have bad surprises.

 

BeerBaron

[watsa_is_a_randian_hero]

I have used leverage in the past and don't think there is anything wrong with it as long as its prudently managed.  Keep in mind that insurance companies are levered, but typically the majority of assets are fixed income/lower risk.  I think its rare to find an insurer with its book value leveraged to equities. 

[beerbaron]

If I remember properly it was you watsa that was you that brough the SHLD call/put disparity.

 

BeerBaron

[watsa_is_a_randian_hero]

If I remember properly it was you watsa that was you that brough the SHLD call/put disparity.

 

BeerBaron

 

I'm not familiar with that; I think you may have me confused on that situation

[muscleman]

There was a time in the early 90's I believe when Berkshire had more than 100% of its book value invested in equities, because it had invested in them using float.  So it was in effect leveraged, both to the equities and the float itself.

 

All forms of leverage magnify both upside and downside and can lead to forced selling or a wipeout.  It is a matter of degree though.  With broker margin you might be able to leverage yourself 2:1 which is pretty leveraged and can be dangerous.  Working with float in insurance companies that you own can be safer, especially if you are more conservative, but a lot more know-how is required.

 

BTW where can you borrow on margin at 1.5%?  At TD Ameritrade the base rate is more along the lines of 7%.

 

Yes. So why is leveraging through insurance float a cheaper way to do it than leveraging through broker margin? Both seem to be similarly dangerous to me.

[scorpioncapital]

Every company in the world leverages through margin. Look on the line on the balance sheet that is labelled liabilities or corporate debt or bond issues. And every company pays a price for it.

Insurance you have the chance, but not the guarantee that the rate may be negative (e.g. Berkshire which is an exceptionally run operation). Some insurance operations can even turn the liability into equity by releasing acquired reserves - this is almost like having part of your principle forgiven. Over time and large scales, the cost of funding of insurance may provide a distinct advantage - or it may not. There are also regulations on how float can be invested for most operations depending on type of premiums written, statutory capital , etc..If you look at most insurance companies 50% plus, if not 90% plus of float is fixed income. These companies will never be allowed to own anything else. Here it becomes a closer race between borrowing at say 8% and investing 100% in a business for 20% returns and an insurer borrowing at 0% or even -2% and investing 100% in bonds at 8%.

 

8% * 3x float = 24% roe - (cost of float)

8% debt * 1.5 leverage * return of investment purchased (e.g. 20%) = 30% - 8% = 22%.

 

As you can see, it's a very close race.

[HJ]

There is a world of difference.  It's the nature of financial companies to manage both sides of the balance sheet, the liability side and the asset side.  For certain assets (bonds and loans), where the difference in return on the asset side is measured in basis points, managing liability, and being funded the right way makes all the difference. 

 

I work in the world of creating CLO's, which basically is a product created to invest in LBO loans.  Pre crisis, there are 2 ways to do it, 1) through the use of a total rate of return swap, which is basically buying loans on margin, guys used to do it on a 4:1 leverage, but with mark to market risk, and margin posting requirements.  2) through CLO's, which are financed with term funded, and rated debt, with reinvestment periods (i.e. it's agreed that proceeds from asset maturity can be used to purchase other bank loans for a period of time after the deal is done).  CLO equity pre crisis was leveraged 12:1.  But it's term funded, with no margin calls.  Through the crisis, these loans which historically traded 97%-100% traded down to 60-70, and all the total return swap funded vehicles were forced to meet margin call, most couldn't make it, and were forced to liquidate, handing investors losses to the tune of 70%-80%.  The CLO's, on the other hand, didn't have mark to market trigger, and in fact, was able to reinvest any loan maturities into the crisis, and bought these loans at 60%-70%, with most ultimately fully repay, reaping 50%-60% returns from the 60 purchase price.  Now the investor in those vehicles were leveraged 12:1, so imagine the ultimate realized returns to those instruments.  Even though default rate spiked, it was more than made up by the investments that those vehicles were able to make throughout 2008-2011.  All thanks to the form of the leverage that it took, which at the time actually looked quite inefficient.  The debt issued by those CLO's were downgraded by the rating agencies when it was the bleakest, but now virtually every single tranche is expected to be money good.  Pre crisis, the sophisticated hedge fund investors preferred leverage through total return swap (because they could unwind that trade easily, and there's perceived liquidity, unlike CLO equity, once you bought into the trade, you can't really unwind, other than selling the investment outright, which had bid/ask spreads of 5%+/-), and they thought they were being prudent by being only 4:1 levered rather than 12:1 in a CLO.  So here's my story of mark to market vs. funded term leverage.

 

In an asset class like equity, it's what open ended mutual fund manager deals with constantly, i.e. investor redemption at the worst of times, forcing them to sell into a sell off.  Think Bruce Berkowitz in 2011.  There's a reason he want to live in a different vehicle. 

 

If one were to analyze, on the asset side, (depending on what asset you are buying), you have say a down market every 4-5 years.  For bonds in general, I can think of 90-91, Drexel induced high yield blow up, 94-95 rate cycle, where mortgage funds blew up, and all bonds had a bear market, 97-98, emerging market bonds and specialty finance companies, manufactured housing, Long Term Capital, etc blew up, 00-02, telecom and high yield blew up, 08-09, everything blew up.  For P&C insurance, where it's more liability sensitive, for the smaller guys, whether it's due to mismanagement or what not, you could always have somebody get into an isolated situation, and go out.  But for the system at large, with well diversified liabilities, the cycle is really much longer.  From '91-'92, you really can think of only the asbestos / Lloyds related episode in the late 90's to 2001, which caused industry panic, and put industry solvency into question.  Katrina caused lots of damage as well, but it was much more focused on a handful of companies with cat focus, and much smaller in scale relative to the industry capital, compared with any of the asset cycles that I have just mentioned, and very quick too.  The life companies are a different story, being much more asset sensitive.  But the only time the system was put on a question mark was '90-'91, when Equitable Life was in doubt.

 

Once you have managed assets through several of those down cycles, you would come to realize:  being funded in an insurance company setting vs. margined borrowing, there is a world of difference, potentially the difference between compounding at 20% year i year out vs. being liquidated, at 50% loss.

 

[thepupil]

HJ, really enjoyed this post. thanks for your perspective. the CLO vs. TRS example is great.

[muscleman]

There is a world of difference.  It's the nature of financial companies to manage both sides of the balance sheet, the liability side and the asset side.  For certain assets (bonds and loans), where the difference in return on the asset side is measured in basis points, managing liability, and being funded the right way makes all the difference. 

 

I work in the world of creating CLO's, which basically is a product created to invest in LBO loans.  Pre crisis, there are 2 ways to do it, 1) through the use of a total rate of return swap, which is basically buying loans on margin, guys used to do it on a 4:1 leverage, but with mark to market risk, and margin posting requirements.  2) through CLO's, which are financed with term funded, and rated debt, with reinvestment periods (i.e. it's agreed that proceeds from asset maturity can be used to purchase other bank loans for a period of time after the deal is done).  CLO equity pre crisis was leveraged 12:1.  But it's term funded, with no margin calls.  Through the crisis, these loans which historically traded 97%-100% traded down to 60-70, and all the total return swap funded vehicles were forced to meet margin call, most couldn't make it, and were forced to liquidate, handing investors losses to the tune of 70%-80%.  The CLO's, on the other hand, didn't have mark to market trigger, and in fact, was able to reinvest any loan maturities into the crisis, and bought these loans at 60%-70%, with most ultimately fully repay, reaping 50%-60% returns from the 60 purchase price.  Now the investor in those vehicles were leveraged 12:1, so imagine the ultimate realized returns to those instruments.  Even though default rate spiked, it was more than made up by the investments that those vehicles were able to make throughout 2008-2011.  All thanks to the form of the leverage that it took, which at the time actually looked quite inefficient.  The debt issued by those CLO's were downgraded by the rating agencies when it was the bleakest, but now virtually every single tranche is expected to be money good.  Pre crisis, the sophisticated hedge fund investors preferred leverage through total return swap (because they could unwind that trade easily, and there's perceived liquidity, unlike CLO equity, once you bought into the trade, you can't really unwind, other than selling the investment outright, which had bid/ask spreads of 5%+/-), and they thought they were being prudent by being only 4:1 levered rather than 12:1 in a CLO.  So here's my story of mark to market vs. funded term leverage.

 

In an asset class like equity, it's what open ended mutual fund manager deals with constantly, i.e. investor redemption at the worst of times, forcing them to sell into a sell off.  Think Bruce Berkowitz in 2011.  There's a reason he want to live in a different vehicle. 

 

If one were to analyze, on the asset side, (depending on what asset you are buying), you have say a down market every 4-5 years.  For bonds in general, I can think of 90-91, Drexel induced high yield blow up, 94-95 rate cycle, where mortgage funds blew up, and all bonds had a bear market, 97-98, emerging market bonds and specialty finance companies, manufactured housing, Long Term Capital, etc blew up, 00-02, telecom and high yield blew up, 08-09, everything blew up.  For P&C insurance, where it's more liability sensitive, for the smaller guys, whether it's due to mismanagement or what not, you could always have somebody get into an isolated situation, and go out.  But for the system at large, with well diversified liabilities, the cycle is really much longer.  From '91-'92, you really can think of only the asbestos / Lloyds related episode in the late 90's to 2001, which caused industry panic, and put industry solvency into question.  Katrina caused lots of damage as well, but it was much more focused on a handful of companies with cat focus, and much smaller in scale relative to the industry capital, compared with any of the asset cycles that I have just mentioned, and very quick too.  The life companies are a different story, being much more asset sensitive.  But the only time the system was put on a question mark was '90-'91, when Equitable Life was in doubt.

 

Once you have managed assets through several of those down cycles, you would come to realize:  being funded in an insurance company setting vs. margined borrowing, there is a world of difference, potentially the difference between compounding at 20% year i year out vs. being liquidated, at 50% loss.

 

I agree that if we can get term funded loans that are not subject to margin calls, it is a much better leverage. But for insurance companies, if you buy stocks with float, and the stock crashes, don't you get regulator pushes? That is similar to margin calls, isn't it?

 

For individual investors, what is the best way to get term funded loans? I don't see any way to do this on a large scale.

[tng]

Broker margin isn't guaranteed. They can raise margin requirements depending on market conditions, we saw some of that happening in 2009, particularly with financial stocks. Since the risk of many big banks getting wiped out was very real, it was suddenly no longer accepted as collateral. Also, how much margin you have depends on the current market value of your portfolio, which is far less predictable than float. Your portfolio can fall 50% and the maximum amount you can borrow would get cut in half (or more, as margin requirements typically increase during market volatility). There is probably not much difference if you are going going to leverage 10-20%, but it is a big difference if you leverage more.

[scorpioncapital]

I also wouldn't say that "term loans" imply no discomfort. Have you noticed during the financial crisis as the price of equity fell, it was almost like a margin call? Some companies went bankrupt, others had to restructure their balance sheet. This was also seen when naked short sellers pushed the price of the equities lower, even if it wasn't justified.