life in financial markets: (part 1) leverage: good or bad?

Leverage in financial markets has been around for many decades. I am starting a series of write-ups (mine or others) that shed light on leverage and its effects.

This first part is taken from http://www.fullspate.net/meltdown.html. Here goes:


Leverage: the Root of the 2008 Financial Meltdown

Anyone following the 2008 meltdown unfold in the media can be forgiven for not understanding how it was possible for so many massive financial institutions to go from boom to bust in such a short space of time. Sub-prime loans have been mentioned a lot and it's clear that something went wrong in the mortgage market, but many of us probably have little idea of why the world of finance and investment has collapsed so dramatically.

Just what led to the meltdown?

Certainly there wasn't a single factor that was to blame. From the mid 1990s financial institutions were putting more and more money into new kinds of very risky investments. Some of these investments – like credit default swaps – are very difficult to understand (the New York Times called them "arcane" in one article) but the particular investments are a less important factor than the technique called leverage that was (and is) used to make those investments. Arguably, understanding what leverage is, is the key to understanding the meltdown.

So what is leverage? In essence, it just refers to the practice of borrowing money to make an investment.

To see how it works and to see both how attractive it can seem and how unbelievably risky it is, lets compare leverage with an old-fashioned investment.
Property Speculation As It Used To Be

Say you have $20,000 to invest in property. You buy land worth $20,000. Over a period of time it's market value increases by 10%. You make $2,000. Not bad. And in the old days you might have been happy with that.
Investing With Leverage

$2,000 is nice, but more would be better, wouldn't it? So why not leverage?

If you have $20,000 (and if the economy is ticking over quite nicely) you should be able to persuade a financial institution to lend you a lot more. Let's say you are loaned 19 times your original amount, making the total sum $400,000. Wow! so you invest $400,000 in property. The value increases by 10%. You sell the property and count your profits and find that you have made $40,000. Instead of the 10% profit you would have made with the old-fashioned technique, you have made 200%!! Of course you have to pay interest on the money you borrowed, and that might cut your profits in half, but 100% profit ($20,000) is still way, way better than 10% ($2,000).

When times are good there is no doubting the attractions of leverage, but when the bubble bursts things can get very, very nasty.

In the old days, if you bought property worth $20,000 with your own money and land values dropped by 10%, you could hold onto the property, shed a few tears about losing $2,000 and wait for the good times to come back again.

What happens to the leveraged investment? Well, after the 10% drop in land values your $400,000 investment is now worth $360,000. The market looks bad and the people who loaned you the money want it back. They loaned you $380,000 (19 times 20,000). You can get $360,000 by selling the property, but you still owe another $20,000. Shit! You started with $20,000 not so long ago, and now you owe $20,000. You haven't lost 10%, you've lost %200!! Actually, it's even worse than that because you also owe interest on the loan, which could be another $20,000, so you lose all your money and owe $40,000 (meaning you made a loss of 300%). You start tearing your hair out. And it's not only you who is tearing out hair. The financial institution is, too, because it isn't an old fashioned bank. It is also leveraged up to the hilt. It has made lots and lots of other loans like yours – all leveraged. In this way, a relatively small downturn in the market (and for the guy who buys stuff with his own money, a 10% downturn is not such a big deal) can send a tidal wave through the investment and finance business, leaving lots of companies bankrupt.

In the example here, the leverage ratio is 19 to one, which might seem like a senseless amount of borrowing for normal people. However, before the bubble burst the ratios were even higher. The mortgage giants in the U.S. Fannie May and Freddie Mac, which were closely linked to the government and were supposedly run to stricter standards than normal, were leveraged close to 100:1. If you surf a little on the internet for investment agents, you'll find some that say it's okay to be leveraged 200 to one (i.e. you have $20,000 and you borrow $4,000,000 to put into risky investments!!).

So what is the lesson to be learnt from all this? As John Stepek put it in Money Week recently: "The only way to stop future crises is to prevent the level of leverage in the system from reaching the point where it becomes dangerous." Leverage ratios above a sensible limit need to be banned. The problem is that it is easy to find support for a policy like this during a crisis, but while the economy is on the up so many powerful voices will insist that such regulations put an unreasonable brake on economic activity.