As an investor who has occassionally traded on margin for nearly a decade, I have over the years come to better understand the benefits and risks of leverage and how it helps in good times and can truly cut like a knife in bad times -- you have given someone else the right to sell your stocks or investment position at a loss.
Debt has a funny way of changing people's business, expansion, and investment decisions and long term business strategies. Indeed, leverage creates subconscious motives and reinforcing positive and negative feedback loops in an economy or market in the way that leverage boosts or destroys capital exponentially over time depending on the alpha or losses created and interest paid.
Currently, a drag to the net well being of the non executive owners (taxpayers) of the lending institution (Federal Reserve) as their capital is lent out at low rates while banking executives are expected to receive large salaries and bonuses for lending out shareholder capital. There is little compensation or reward for bank shareholders to be invested as the banking community is forced to lend money at currently low rates of interest while facing large and unquantifiable risks off loss -- in other words, without the backstop of the government, lending money at competitively low interest rates is a bad business decision.
The only way that lending can be advisable is with a government gaurantee - anyone without uncle Sam on his rolodex can't make a decent risk adjusted return on lending money at ultra low rates. This is one reason more than 119 banks have failed in 2010 -- it pays to know the right people!
In the broader economy, there is now an interlinked and noticeable effect on behavior (correllation) in all market participants' share prices, and corporate behavior as their is little incentive for anyone to take risks because so much debt exists in the system that participants understand the elevated tension and vulnerability that exists. A herd mentality results because everyone is a little nervous about the debt and has to allocate printed capital. They have to own stocks of market leaders, for example, if and when they are going up because the leverage has a small cost of carry and the system is filled with cheap money. Yet no one wants to own stocks right now if they are going to fall as market participants understand that leverage increases the risks substantially. This adds to distortion in equity markets.
In essence, one can think of the current corporate and leveraged debt in the system as if you are a banker lending money to your friend Bill, the CEO of a state of the art lumber mill. You know there are more risks then there is potential reward over time for lending Bill money at 2.5% interest with a 98% chance of him paying it back and a 2% chance (being very optimistic) of him not being able to pay off the loan due to unforeseen circumstances. Bill is a hard capable, honest guy and he is a good businessman and you are pretty sure he is a stellar credit in a growing market, but you are a well paid banker with kids and you would never want to sieze Bills lumber assets and operate a gigantic ban saw for a living -- in essence you are selling a put option on the viability of the system in place and the viability of Bill's lumber yard to produce cash flows for a scant 2.5% per year. Lending the depositors' and/or shareholders' equity to Bill is a virtuous endeavor in your mind and because you are 98% sure he will pay you the interest -- so you make Bill the loan for 2.5% interest per annum.
However, in light of the low rate of interest environment and the cost and option expense that you paid for your nice summer home in Maine, there is very little reward for the shareholders of the lending institution that you work for -- shareholders of companies such as Bank of America (NYSE:BAC) and UBS (NYSE:UBS) for example... to make an investment in Bill's business for 2.5% -- after all you can't resell his equipment or inventory for more than 20 cents on the dollar if he goes into default...
So why aren't these shareholders and depositors throwing in the towel, given that their money is essentially lent out at greater risk than is the reward of the 1.8% after fees and tax rate of yearly return? The only reason that I can see is that the US government has stepped in to back up your particular lending institution. They will lend you double the money you used to give Bill at 1% and you can lend it to Bill for 2%.
The biggest issue with leverage is the hightened vulnerability to Black Swan events that can bite both the lender and borrower at the worst times possible. For example, when a lumber mill shuts down due to the illness of the owner, the interest payments on the debt he owes for his three $50,000 log crane trucks and state of the art milling equipment purchased on margin for $100,000 can really add up! In the scenario I mentioned above, Bill could lose his income for any number of reasons, which incentivizes Bill to take out the largest loan possible right now, given that he does not have to spend his own capital on the business and has only been required to split his share of the profits dedicated to the 2.5% in interest payments. This leaves him and his shareholders with a lot of temporary profits -- but what would happen if Bill's sales fell suddenly off a cliff or if the cost of gas and transportation rose dramatically? What would happen if Bill suddenly dies or gets violently ill...
There are clearly many risks in the system when the economy is bad and deleveraging is taking place. More than ever, companies are operating on a leveraged basis which overstate profits and understate risks from an investment analysis perspective. The higher the leverage, the higher the risk -- so highly leveraged companies in an environment of uncertaintly should naturally carry lower valuations.
So what happens to a business when debt swells and sales are declining? Or in this case, the lumber man grows ill and dies and the idle equipment has been badly damaged and is not sellable. The banker naturally wants his loan repaid but there is no money or equipment as collateral that can be repossessed. Essentially the bank is out the $250,000 while boosting artificially the output and business of the community which paid lower prices for firewood and building supplies.
When you make a wise investment on leverage, you clean up and your profit is double what you would have made if you invested with cash. But when you make a big mistake on margin, you lose everything in one day -- on a margin call.
Debt creates unsustainable boom and bust cycles that never end well...
Clearly, the risks of lending money to Bill's lumber mill are pretty hefty if these risks are interlinked and compounded across all US businesses due to never ending leverage in the system and a complacent or naive shareholder base... in this case, the US taxpayer. If interest rates were to go up, massive corporate defaults would either hammer the S&P 500 or the US debt to GDP would have to go up even more -- IF this latest market rise is a response to a short term blip in the health of the economy due to more risky lending the next round of painful recognition by shareholders will be much worse than the first period of the stock market "correction" we experienced in 2008.
More than likely, we will see a haircut in markets as individuals sell stocks to deleverage, corporations shrink as they cannot continue to borrow to fund operations when revenues decrease and costs increase, and the vicious cycle repeats itself... Either this scenario takes place or inflation runs rampant.
In the 1960's America's economy was extremely robust. We were huge exporters to the rest of the world. The baby boomer's parents were in the midst of a boom in economic activity. Today, the global economy appears very weak except for Asia and commodity countries that are underleveraged.
When you hold cash or gold and silver during panics among leveraged players in markets you can buy from the weak hands at the lows and profit.
Today, corporations in America are all facing the same direction and are on the same side of the crowded trade -- they are all utterly dependent on rising or stable revenues and cash flows to service and pay down debt yet they are facing lower revenues and demand.
With S&P 500 companies at 80% debt to equity and given that proposed changes to lease accounting rules in FINRA could make this number rise dramatically, one has to ask if the risks embedded in the deleveraging process will not only hurt the demand side of the S&P 500 income statement but also the cost of goods sold column as inflation in raw materials could continue to run rampant from constant debasement of the US and European FIAT currencies.
Clearly there are added and unseen risks that come with added leverage in the system.
Knowing how to handle this leverage should keep us invested in the right assets.
For now, I am guarding my clients against the risk of corporate revenues falling and inflation rising and with the squeeze in profit margins should come falling stock prices. With the correllation of everything so high, the risk of a snapback fall in prices is very real.
Disclosure: Author is short SPY, IWM