The great unwind...

Ever since stock market returns began to deteriorate after the collapse of the dot com boom, investment managers have been scrambling to find alternative sources to satisfy their quest for double digit returns. A quick fix arrived in the form of additional leverage, widely used in the hedge fund world. Globalization and the resulting breakthroughs in financial engineering have led to a rapid growth in new products particularly in the derivatives markets. Today, we find derivative products that synthetically replicate the performance characteristics of a single stock or a basket of stocks. Others provide a type of insurance against the default of a bond with very poor credit quality. The point is that many of these instruments provide leverage to the buyer and when a large number of buyers tend to be hedge funds in a relatively unregulated environment, it becomes very difficult to quantify the amount of leverage in the markets. The issue with this situation is that it is difficult to predict what will happen in the event of a crisis if we don't know how much leverage we have.