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.
If I invest $1B and borrow another $9B, my base returns need to exceed the borrowing costs of the $9B just to break even.