Solution: More Leverage!

Friday, November 14, 2008

by: Brandon Rowley

How can we solve our current financial crisis? More leverage! While some parts of our financial world delever, other parts lever to even greater levels. In 1998, Long Term Capital Management blew itself up through trading complex derivative instruments. Under the management of absolutely brilliant academics, they leveraged their hedge fund to unbelievably high levels. With deep backgrounds in statistical modeling, these men bet with a "reversion to mean" philosophy by fading extreme moves in various financial markets.

When LTCM dramatically collapsed in two months after the Russian government defaulted on its debt, market participants were shocked. Banks, institutions and government's around the world were appalled to learn that LTCM had leveraged their fund 30-to-1. LTCM collapsed because of a liquidity squeeze. They could no longer meet their margin calls as the massive tightening of credit markets affected most of the fund's positions. The thousand year flood had come and LTCM was caught all in, more than all in. Fearing a major financial meltdown with the unwinding of LTCM's positions, America's largest banks formed a consortium to buy LTCM's book and unwind it slowly. The amount of leverage LTCM had was seen with disgust for the irresponsibility and the arrogance it implied.

Fast-forward ten years and we found America's five-largest government-regulated investments banks with similar leverage ratios. Early 2008 saw Bear Sterns with a leverage ratio of 33-to-1, Goldman Sachs at 20-to-1, Morgan Stanley at 32-to-1, Lehman Brothers at 44-to-1. These astronomical levels of debt led to a rapid deterioration of banks' balance sheets when creditors and investors became jittery amid the worsening credit crunch. These investment banks enjoyed outsized profits for several years. Yet, they failed to predict the impacts of a slowing housing market. They failed to see that their levered derivative positions in mortgage-backed securities could cause massive losses if their calculated default rate models proved to be incorrect. And, incorrect they were. The ensuing writing down of these securities created holes in the balance sheets with writedowns exceeding $965 billion by the end of 2008. With a spiral of equity losses, ratings downgrades and credit constriction banks found themselves with lots of debt and no cash. By the end of 2008, Wall Street had dramatically changed. Bear Sterns was acquired for $1.1 billion by JP Morgan, a sliver of its 2006 assets of $66.7 billion. Lehman Brothers declared bankruptcy on September 15th of 2008. Merrill Lynch was purchased by Bank of America that same week. Morgan Stanley and Goldman Sachs converted to traditional bank holding companies to give themselves greater access to capital. Traditional banks have regulated leverage ratios around 10-to-1 forcing these two giants to significantly reduce the leverage in their balance sheets.

Now, it seems that the mistakes of these five companies would be learned by our country. But, we are not going to allow for a massive deleveraging process, it would be too painful. So, America has now tapped its most capitalized balance sheet to leverage our way out of this mess. Congress recently approved a $700 billion Troubled Asset Relief Program (TARP) to buy debt off banks' balance sheets. We have turned to the United States government for more leverage. The US government has chosen to leverage its creditworthiness in order to bail out the US economy. We now have a government deficit as large as our one-year gross domestic product. We currently produce about $14 trillion and hold $14 trillion in debt. And, since the government uses cash-based accounting, not accrual-based, the unfunded future liabilities of Social Security and Medicare likely raise the real debt level much higher. The US government already has plans to spend over $1 trillion bailing out financial companies.

In the midst of a financial crisis largely a result of overleverage, we have chosen to avoid the bulk of a painful deleveraging process by leveraging up our government. There is some evidence that our banking system is deleveraging as our top five investment banks no longer exist and the two able to survive are now regulated traditional banks requiring them to lower their leverage ratios. On the other hand, we also find companies creating complex derivative products with greater leverage than ever before. How can investors quickly recover their recent stock losses? Leverage, of course. Now, the average investor can buy a three-times leveraged exchange-traded fund. The BGU is an ETF recently created by
Direxion that seeks to create moves 300% of the Russell 1000's daily movements. They also created the BGZ moving 300% the inverse of the Russell 1000. The SSO now looks tame with its movements of 200% of the S&P 500 Index. At the height of calamity in the financial markets we now have products allowing the average investor to leverage 3-to-1 by simply buying a publicly-traded ETF. This has to remind us of the problems found in 1929 when investors were able to buy stocks with 10% margin and the market crash revealed heavily inflated stock prices.

The United States government has levered up its balance sheet to avoid the pain of a recession. Our government nationalized the most levered of companies, Fannie Mae, Freddie Mac and AIG, and injected billions into other surviving financial companies. The nearly $1 trillion in losses from banks seems to have
simply been transferred to our government's balance sheet. We have even created new financial instruments to allow individual investors to leverage their stock portfolios. The government's actions likely help our economy and financial markets in the short-term but the long-term poses serious danger. Leverage is great when times are good, but deleveraging must inevitably occur at some point. No institution, fund or government can continue to leverage itself indefinitely. Foreign countries will continue to buy our debt...until they don't. Our day of reckoning will come at some point. It seems that we have not learned. We will feel the pain of deleveraging eventually.

When Genius Failed, Roger Lowenstein


Anonymous said...

Great article. I agree that we should not use "the lever(age)" to artificially prop up financial strength. The rule should be, "you can't beat the market in the long run, eventually it will knock you back to where you should have been without your lever." It's easy to see how leverage/greed can be addicting. As Nancy Reagan used to say..."Just say NO!"

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