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Broker-Dealer leverage drives credit and equity prices

A new New York Fed paper shows that financial intermediary leverage is one of the best performing explanatory factors for future credit and equity returns. High leverage growth compresses risk premia and reduces future excess returns.

Tobias Adrian, Emanuel Moench, and Hyun Song Shin , “Leverage Asset Pricing”
Federal Reserve Bank of New York, Staff Reports, August 2013, No. 625

The below are key excerpts from the paper. Emphasis has been added.

” [Academic papers] have emphasized the role of leverage [defined as the ratio of assets to equity] as a determinant of financial conditions…They emphasize how leverage falls during downturns, mirroring the increased collateral requirements (increased “haircuts”) imposed by lenders, and how the risk bearing capacity of the financial system fluctuates with changes in collateral requirements.”

“We find that it is leverage in terms of book equity [of financial intermediaries] that matters for asset pricing (total assets to book equity), not leverage in terms of market capitalization (enterprise value to market cap). …Enterprise value is about how much the bank is worth, while book assets are about how much the bank lends. Our findings suggest that credit supply matters for asset pricing. For instance, hedge funds that rely on prime brokers to construct leveraged positions will care about lending conditions and their returns will depend sensitively on how easily they can construct leveraged positions.”

“We find that only book leverage of security broker-dealers (“dealers”) predicts excess returns significantly and with the right sign, while other variables are either insignificant or have the wrong sign… As dependent variables we use the equity market return from CRSP, the return on BAA rated corporate bond portfolio from Barclays, and the 10 year zero coupon constant maturity Treasury return. The sample period is 1975Q1-2012Q4…In particular, dealer book leverage forecasts the market return and BAA-rated credit return with a negative sign, consistent with theories that leverage is pro-cyclical…Higher dealer leverage growth is associated with lower future excess returns. Precisely, a one-standard deviation increase of dealer leverage growth is estimated to reduce the market risk premium by a little more than 2 percent per quarter in the full sample from 1975 through 2012.”

“This result is robust across sub-periods, as well as to the inclusion of standard return forecasting variables. When controlling for typical return forecasting variables such as the dividend yield, the term spread, the credit spread, the book-to-market ratio of the market portfolio, the equity share in new issues or the consumption-wealth ratio, the significance of the dealer leverage variable tends to increase. We do not find such robust forecasting performance for alternative intermediary variables.”


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