Leverage: The Primary Cause of the Economic Problem

Leverage is wonderful when the markets are going up, as they did for years. If you can borrow for 4% and earn 6%, 10% or 20% (pick your own numbers), you dramatically increase your profits. Every major asset class has used leverage extensively, and in many cases has used leverage to grotesque extremes.

The good times ended in late 2007, when the markets started down. When there are losses instead of profits, leverage works in the same way with the opposite effects. It dramatically magnifies your losses. Yesterday's press cited a hedge fund that is now losing 14% on its investments. But it had four times leverage. So, for example, on a $4 billion investment, it lost $560 million this year. But if it had $3 billion in loans that, let's say, cost 4% p.a., that means it had another $120 million in interest. So now it has lost $680 million dollars or 68%, on an annualized basis for the billion dollar equity investment. Very few people are going to stick with a hedge fund that experiences big losses.

But now the problem starts to get really bad. Because the hedge fund is losing money, investors start asking for redemptions to stem their losses. The only way the hedge fund can pay back the investors is to sell investments. A lot of hedge funds selling investments inevitably drives down the price of equity and other investments. It is exactly like a snowball rolling downhill. The further it goes, the bigger it gets. Further losses create the demand for further redemptions, which in turn create further losses from forced sales. When there is no other choice, the hedge fund halts redemptions. If you cannot be sure you will get your money back when you need it, no one will invest in hedge funds in the future.

This over leverage has affected many areas of the financial world, but let's look at just three areas. First, look at hedge funds. The death knell has sounded publicly. The death spiral described above will cause virtually all investors to go out of hedge funds by the end of 2009. Hedge funds as a concept are likely to have such a bad name, that they will never again exist.

Then there is Private equity. The public has heard very little about private equity because there is minimum public disclosure. For example, think about the information available for Chrysler from Cerberus Capital. While there is some presumption of value for the Cerberus people for their 80% investment in Chrysler, the 20% equity investor of Daimler has written off its 20%. During 2009, there will be a lot of bad news on private equity as deals done in recent years start to fall apart from losses, in part caused first by the over leverage and now a downturn in the market.

A good case to watch will be Hilton Hotels, owned by Blackstone. The press reports that of major non-financial bankruptcies in the last year, over half come from either private equity held investments or spin offs from private equity. Like hedge funds, it seems likely that private equity represented by highly leverage deals will also be discredited as a reasonable financial investment by late 2009. Perhaps hedge funds will copy investment banks and try to transition to commercial banks and live with much lower leverage in the future.

Finally, investment banking. Investment banking has died in the US as a standalone major business. Excessive leverage compounded by poor credit is a principal cause of this. Investment banks will recover in a few years with their traditional fee based businesses but minus the assets funded by high leverage.

Disclosure: None.

Comments

[investor88:]

James has written a concise realistic article with the conclusion that the next few years will be quite tough. I quite agree and its no time to be fooling around buying this and that.

2008 Dec 05 09:33 AM

[Steven Hansen:]

James, good write-up. just stay away from things while rome burns. return to pick up what is left from the ashes.

2008 Dec 06 02:07 AM

[Jan VanDenBerg:]

Leverage should be regulated in all financial institutions, just as it is regulated in banks.

The required reserve ratio for all assets should average about 5% and this for ALL financial institutions.

The required reserve ratio is now a regulatory constraint placed on lenders.

There is no equivalent ratio laid on borrowers, such as hedge funds. The lenders are supposed to have the good sense not to lend so much money to such risky borrowers.

If the required reserve ratio is demanded of all lenders, greater lender caution will prevail due to the lack of endless funds to lend and the riskier borrowers will be turned away. The higher reserve ratio would limit money supply growth.

The central bank should target, or at least watch, not just the monetary base, but also broad money growth, including all derivative products and that data should be published.

The Fed's stopping publication of broad money data a few years ago was a bad idea.

It would theoretically be possible to also regulate borrowers who are investing others' money, but this has never been done.

Jan VanDenBerg

2008 Dec 06 01:21 PM