General
Leverage Causes Pain During a Decline
In the physical world, leverage allows a heavy object to be moved a short distance by application of a low force through a long distance. In the financial world, leverage has a different and, in a way, reverse meaning in which use of leverage is an attempt to turn a small gain into a large one.
Buying a $1,000,000 house with a $100,000 down payment and a $900,000 mortgage is an example of use of 10-to-1 leverage. A 10% gain in the value of the house to $1,100,000 increases the original $100,000 of home equity to $200,000. But a 10% decline in value of the house to $900,000 causes a 100% loss of the home equity.
The same type of math has affected the large investment banks like Lehman Brothers that have run into severe difficulty this year. Those banks used large amounts of borrowed money to buy assets worth as much as 30 times the capital provided by the bank’s investors. Some of the assets lost value when real-estate prices declined and impaired the value of mortgages secured by that real estate. A leverage ratio of 30 at an investment bank whose assets declined just one part in 30 (about 3%) causes investors’ entire equity to be wiped out.
Because firms like Lehman Brothers played a large role in global credit markets, high leverage ratios were a source of "systemic risk." The economic system of the entire world was endangered and has been impacted by the use of such high leverage.
In addition to investment banks, hedge funds have been a significant source of systemic risk through the use of high leverage. Many hedge funds try to amplify gains on marginal investment strategies by borrowing heavily so the funds can take positions that far exceed the value of investors’ capital. When a strategy doesn’t work as hoped, a fund can lose all of its equity very quickly. The lenders who provided the borrowed money make "margin calls," demanding immediate deposit of stable assets to ensure repayment of the fund’s debt. The fund is then forced to sell its large positions, often when many other investors are also trying to sell, in order to meet the margin call. Those sales drive prices lower. Much of the sharp decline in stock and commodity prices is probably a result of the actions of hedge-fund managers.
The most galling aspect of the damaging impact of hedge funds is that they are investment vehicles that can only benefit wealthy people (due to "accredited investor" requirements) and the hedge fund managers, whose earnings can be tens of millions of dollars every year. Through the impact the funds have likely had on stock-market volatility, which has induced fear and panicky selling by middle-class Americans, the hedge funds have caused a great deal of pain for people who had no chance to benefit from the existence of the funds.
The process of "deleveraging" will continue for some time still. As long as leveraged investors are trying to sell stocks, commodities, bonds, and real estate in order to pay back some of their borrowed money, volatility is likely to continue and gains in the values of those assets may be fleeting.
While leveraged investors are selling, other investors (like Warren Buffett) are eager to buy while stock prices are low compared to sales, book value, earnings, and dividends. Powerful buying pressure can come from investors motivated by promising indicators of fundamental value. On some days that buying pressure can prevail over the selling pressure from investors who are deleveraging or panicking.
Two good results of the financial turmoil of 2008 are that lessons are being learned and changes are being made. There will be much less appetite at large financial institutions for risky investment strategies. Regulations will be changed to reduce leverage ratios and to increase oversight of institutions that can endanger the entire economy in the pursuit of high profits.