LEVERAGE ('le-va-rij): To the Physicist, is defined as the use of a rigid object to multiply the force applied to a resistance. To the Finance person, the use of financial instruments or borrowed capital to increase the potential return of an investment. To the average Joe, a double edged sword which allows you either to multiply a portfolio or cause it to go to zero or in some cases, negative. To the company or country which realizes too late it has too much of it, a guillotine which causes decapitation.
Much of the financial crises that we have seen in the past is all about leverage, also known as margin.
Simply put, it is borrowing too much that you have no way of paying it all back. The fall of many companies and economies can often be traced back to balance sheets stretched too far, to the point of breaking. And much of what is going on nowadays is because of it.
Remember the company Long-Term Capital Management (LTCM)? LTCM was a hedge fund in the 1990’s headed by John Meriwether, a famous trader from Salomon Brothers. The fund had the who’s who of the finance world, including Nobel-prize winning economists Myron Scholes and Robert Merton (really smart guys who invented financial option pricing formulas, really complicated stuff).
With the brightest finance minds around, the fund was destined for success. Its strategy was simple—to make money by making “convergence” trades—finding securities that were mispriced relative to each other and taking a long position in one versus a short position in another with the bet that they would “converge” to the theoretical price. They ran computer models on their trades which told them their net exposure to the market was small, after all, their positions were “hedged.” The argument was valid, but to be able to deliver the returns they promise, hedge funds employ leverage, which changes the picture of risk dramatically. By 1998 the fund had $5 billion of equity, but had borrowed over $125 billion. This had allowed them to enter into their convergence trades which at that point had a total outstanding notional amount of $1.25 trillion! The beginning of the end came later that year when Russia underwent financial crisis and defaulted on its government debt. In addition to having direct positions in Russia, the ensuing volatility in other markets caused many of their convergence trades to trade out of whack, way beyond what their computer models indicated. With their humongous trades now losing a lot of money, many of the banks they transacted with were at risk that they wouldn’t pay up. The Federal Reserve Bank of New York had to step in and work out a rescue package involving a group of banks which injected $3.5 B worth of capital and unwound their positions. Even with that, many banks had to take substantial write-offs to LTCM exposure.
When you read about the US economy nowadays, there’s a lot of talk about unemployment and the lack of sustainable growth. Why can’t they seem to get their act together? They are having a tough time because the problem is deeply rooted in their housing market, now etched in history as the Subprime crisis. “Subprime,” to explain simply, happened because people who normally wouldnt be given credit were allowed to borrow, to purchase houses they could not really afford. With no downpayment and sometimes even without proof of income documents, homebuyers who could fork out the monthly installment of a few hundred dollars on an adjustable rate mortgage were allowed to buy half-a- million dollar homes. The banks did this because they were making money from these loans and they were selling them off in securities called CDOs and CMOs, which the ratings agencies happily rated with a AAA rating.
This was all fine when interest rates where low and housing prices continued to go up. But when interest rates started to move up (funnily because the economy was overheating because housing prices were going up too fast), then the whole thing started to unravel. Homeowners couldn’t afford to pay their higher monthly mortgages, the banks started to foreclose on houses and the prices of them CDO’s started to plummet. Fast forward five seconds and you had the Financial crisis of 2008. All because a few Joes wanted to keep up with the Joneses who just bought a mansion. The situation in the US will take time, because the deleveraging process is necessarily a painful one. And ironically, it takes takes leverage to delever—i.e., the Fed’s Quantitative easing—QE1, QE2, QE3?
Ever been to Athens? A city steeped in 3400 years of recorded history, once the center of philosophy when Plato and Aristotle where flexing their brains, and home to the Acropolis and Parthenon, architectural symbols of civilization. Lately, its been the site of riots as Greeks protest austerity measures the government is introducing in an attempt to rein in debt and avoid a credit default.
As late as 2008, Greece was ranked the 36th richest country in the world in terms of GDP per capita ($30,500). As of last week, it pays more than 100 percent on its one-year local debt, is threatening to bring down a few French banks (among others) and is potentially causing the break-up of the Euro currency as we know it. Add to that the volatility of all other markets around the world as investors speculate on whether its going to default. Again, a result of living beyond its means, borrowing too much relative to what it can afford.
I have a friend who recently started trading Foreign Exchange online.
The FX trading platform allowed for leverage, which allowed you to trade 100 times the amount of equity or starting capital you had. It started out fine at first, with the returns astounding as the right calls were made. But a few bad calls and a one too many big positions later, the account was down to little over 10 percent of the starting value! It has recovered lately, up around 100 percent. But even my third grade son knows that making 100 percent after losing 90 percent does not give a 10 percent return. Good thing it was still a “practice” account.
Dont get me wrong. Leverage credit, debt, gearing, whatever your banker wants to call it, does have a place and is a beautiful sword, double-edged it may be. But the improper use of it, or worse, the ignorance of its presence, can hurt, and is what I call—the Error of Margin.
