Why do you think their use of leverage is illegal?
No, there aren’t. Reg T limits initial leverage for retail investors in equity securities to 2:1 and FINRA rules maintainence leverage to 4:1 [1]. There are no similar broad-market rules for institutions. (Retail investors, likewise, can leverage much more for FX and—more commonly—real estate.)
[1] https://www.sec.gov/reportspubs/investor-publications/invest...
No, there are not for institutional investors. Rentech fell into an interesting dispute (tigger with Deutsche Bank) with the IRS regarding long-term capital gains. If I want to lever my institution 10,000:1, and can find a lender who will lend against it, there is no law prohibiting me from doing so.
Disclaimer: I am not a lawyer. This is not legal advice.
I definitely should have been more clear with my original statements. Maybe something more along the lines of: at rentech's scale, using a margin account at a prime broker, you cannot leverage your firm 16x.
[0] https://www.hsgac.senate.gov/imo/media/doc/REPORT-Abuse%20of...
The Senate report is crap. Yes, Reg T and FINRA rules limit the loans B-Ds can provide clients. But leverage, for Reg T’s purposes, is constrained to lending. I can buy a 3x leveraged ETF [1] as a retail trader without violating Reg T. (With options, I could easily increase that leverage without borrowing.) All of this is not only permitted, but common.
Reg T does not exist to protect investors. It exists to keep broker-dealers from going bust from dud margin loans. (And thereby prompting a systemic crisis.)
The leverage RenTech took is in the non-lending and non-systemic (legal) category. The exposure that most closely puts RenTech in the lending bucket is the exposure Deutsche Bank carried on its balance sheet for tax purposes. (This tax avoidance was the core of the scandal.)
Long story short, unless you’re a politician, it doesn’t make sense to talk about RenTech’s illegal leverage. Lots of other market participants, by regular practice, are levered far more.
Was the leverage in the non-lending category though? Isn't that like saying their gains were long-term? That's the whole point of this, no? They used some different terminology to reclassify loans and taxes, in order to use more leverage and pay less tax than they normally would have.
I guess another way to put it: would there have been a way for RenTech to hold the same portfolio, using the same leverage, with the same payout characteristics, that no government agency would have issues with? Maybe the answer is yes, but I doubt it.
Yes, quite easily. In fact, highly-leveraged portfolios like the one RenTech held are an essential feature of market making, which was historically done using banks’ balance sheets. RenTech’s shenanigans were around tax. Everything else is commentary.
(On the Senate report, the whole thing isn’t crap. But that section is crap as in it’s written for political purposes and has limited bearing with respect to the law.)
This is more about what rentech does after they've made all their money trading... To avoid capital gains taxes. Sure, it's just another way to make more money, but it's not their core strategy.
If I invest $1B and borrow another $9B, my base returns need to exceed the borrowing costs of the $9B just to break even.
It was always about the amount of borrow available, and the tax paid on the gains. The (illegal) strategies they used allowed for much larger borrow amounts, as well as only paying long term capital gains, when in reality there were millions of trades.
The simple setup: Rentech pays the bank $1B for a call option. The call option is on a $10B pot of money. The bank then hires Rentech to invest the pot of money for them. After a year or two, Rentech then exercises it's call option, which gives it everything in the pot except the bank's $9B plus a fee. The banks loved this fee. And since this was a year long call option, all gains are taxed as long term. They avoided $6B in taxes doing this.
So no, your net capital use is not $0 in your example
Three words: Mortgage Backed Securities. Large banks with entire risk modelling departments have made multi-billion-dollar errors in recent memory.
I have a complete lack of faith that any institution whose day-to-day experience completely differs from their catastrophic risk scenario is ever truly prepared.
The personal and organizational strain of maintaining constant vigilance against an invisible enemy is simply too high.
People get lazy, complacent, and think they're more prepared than they are. That's just human nature.
While it is possible that they're making their profits by shifting risk onto unsophisticated players, it's certainly not necessary for them to do that to make money. They have the smartest people in the world working for them.
Of course it isn't just that simple. Leveraging a strategy should increase it's downside risk along with it's returns. But somehow Rentech does it while never actually experiencing that downside risk. That's their mathematical genius. And the fact that they employ so many brilliant mathematical minds leads me to believe that part may be real.
The latest Senate hearing link: https://www.hsgac.senate.gov/imo/media/doc/REPORT-Abuse%20of...