Most of what we know about Rentech's strategies comes from Senate hearings regarding the sketchy things they do. The common theme is that they find strategies with fairly low returns (~3%), and very low risk. They then use massive (and illegal) amounts of leverage, as high as 16x, to turn those low risk, low return strategies into outstanding returns. James Simons and Robert Mercer are among the largest donors ever to both political parties, so it isn't much of a surprise that these hearings haven't really gone anywhere.
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.
Not me, The IRA thinks it's illegal. There are limits on how much leverage you are legally allowed to use, and Renaissance has made a name for itself by trying to bypass those laws in every tricky way possible.
> There are limits on how much leverage you are legally allowed to use
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.)
They weren't in violation of Reg T. They were in violation of Reg U and Reg X. You are right that there is no law saying you can't use more than x leverage, but there are absolutely regulations governing loans in margin accounts and using securities as collateral for leverage. And The government believes Rentech was in violation of them.
> there are absolutely regulations governing loans in margin accounts and using securities as collateral for leverage
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.
But there are laws preventing a broker from lending you that money. The hearing cites the SEC net capital rules which Rentech and DB worked together to bypass. There are pages dedicated to how RenTech DB and Barclays knowingly and purposefully circumvented rules with some changing of terminology. Starts on page 79 [0].
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.
I understand where you’re coming from. Let me, too, be more clear.
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.
If a senate report causes issues for you, I don't think it's exactly crap. But I understand your point :) It also keeps mentioning Reg T which I agree is not relevant here. I was wrong to say that RenTech used illegal amounts of leverage, thanks for explaining that. I'm still not convinced it's wrong to say that RenTech worked with BDs to bypass rules that would have stopped them from using the leverage they did in the manner they did.
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.
> 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?
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.)
the subject of this Senate hearing was widely written about wrt rentech back in 2014.
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.
It was never about returns exceeding borrowing costs. Rentech is probably the greatest money manager of all time. They can make returns that exceed the borrow costs.
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.
For a modern hedge fund, leverage doesn’t work that way... e.g. if I buy $1000 of AAPL (Apple) and (short) sell $1000 of MSFT (Microsoft), what is my “capital” and what is my “leverage”? My net capital use is $0 - I got $1000 selling MSFT and spent it again buying AAPL... in the end, it comes to a combination of margin required by the broker(s) - i.e. what they estimate is the black swan scenario where AAPL goes down, MSFT goes up, you start losing money on both trades and they can’t close the position fast enough - ultimately it depends on volatility but can be netted across many trades, and the overall volatility / risk of your strategy (i.e. how much you’re potentially willing & able to lose in a year).
When you short you need to post capital as part of the repo trade. You also need to borrow the shares which typically costs more than the interest you're earning on the posted capital.
So no, your net capital use is not $0 in your example
That depends on your borrowing costs. I doubt they'll be paying margin rates lesser mortals pay. ultimately they are screwing their lender because the lender is taking all the risk here without (seemingly) adequate compensation.
Their lenders likely understand the risks pretty well. Their lenders are going to be large banks that have entire departments dedicated to modeling risks like these, and making sure that the risks don't exceed certain limits on these accounts. Nobody's getting screwed, except arguably the government out of some taxes here.
>Their lenders likely understand the risks pretty well. Their lenders are going to be large banks that have entire departments dedicated to modeling risks like these, and making sure that the risks don't exceed certain limits on these accounts.
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.
This is absolutely true. Due mainly to wishful thinking as well as some bizarrely bad statistical assumptions, the risk of something like 2008 was simply not forseen. There's absolutely no reason to think that other unforeseen crises couldn't arise in the future.
You're right. But there's very good reasons to think that they won't come from levered quant strategies like Renaissance's. They're extremely diversified and tend to be market neutral.
Yes, you can name one time that that happened. But do you understand the types of strategies RenTech is using? They're diversified across thousands of equities on the long and short side. They're market neutral. Taking on amounts of leverage that seem crazy to you is actually very reasonable in this setting, and it's very easy to show that this is reasonably safe.
Nobody outside of RenTech knows what trading strategies RenTech are using, because they're extremely secretive. There is a strong suspicion that they are generating very high returns by passing on concealed risks to other, less sophisticated players - in the case of RenTech, literally anyone else in the market counts as less sophisticated.
That's really not true. Everyone knows what they're doing. They're doing statistical arbitrage. There's many firms that do it, Two Sigma, Citadel, etc.. The only thing secretive about it is the exact details of each strategy. Renaissance, for instance, pioneered techniques like using satellite imagery to track sales. One of their early strategies noticed that the market tended to go up on days when the weather was nice in NYC. Things like this are what they're doing, but on a grand scale and with a lot of very very smart people working on them.
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...