Leverage Is Taking Down The Whole System

By: ispeculatornew
Date posted: 11.22.2011 (5:00 am) | Write a Comment  (2 Comments)

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Reading the news headlines these days can turn out to be a scary exercise. Just take a look around and you’ll see news about Man Financial, European and US banks, comparisons with Lehman Brothers and Bear Sterns, and the domino effect if a few countries do end up going bankrupt. Why is this all happening? It just seems like leverage is killing the entire system. It’s happening both for large multinationals but also for the now called “99%”.

We often hear things such as leverage ratios. But what do those actually mean? Let’s try a very simplified example:

Imagine that a French bank had a value of $10. Over time, that bank might accumulate large amounts of deposits, debts and other elements on that balance sheet but imagine that the bank is still worth $10 but has $400 worth of assets and $390 of debts. If for some reason, someone at that bank believed that buying Greek bonds was a great opportunity and bet 5% of the bank’s assets or $20 on those bonds. The crazy thing is that these bonds were not forced to be “marked-to-market” in Europe. What do I mean? Even though the bonds started losing value in recent months, the bank still did not recognize any losses on that position and accounts for them as if they were worth the price that had been paid. That is not the case of course.

Now back to reality.. Talks are that these bonds could end up being worth less than half of their value when Greece does eventually default. In the example of the European bank, that would mean a loss of $10-15 on that investment. You probably see the problem by now… the bank, because of significant losses in a fairly small investment is now worthless and will also be forced to go bankrupt.

Because the whole system is now so connected, there is probably a similar US bank that has $20 of its own assets invested in that French bank… overnight, that position becomes worth a fraction of what it once was and the US bank is now in trouble.

It’s a very dangerous domino effect that can go on for a long time.

You’d Think We’d Have Learned

Over and over, the main cause of economic and financial trouble has been tied to leverage and the inability to sustain losses. That is also what happened in the housing sector. Buyers were stressed so thin buying multiple houses that the only way it could work was to have prices going up at all times. As soon as a small decline would occur, the whole system would (and did) go down as mortgages turned underwater and sellers became increasingly desperate.

The Never Ending Temptation

The problem of course is that leverage ends up being a profitable bet for so many. I did look at compensation structures for hedge funds recently and how that encouraged going for more risk (which often means leverage). As for individuals, the main issue is greed. It becomes so tempting to try always reaching for better returns, especially when certain assets keep rising year after year.

Tricky Issue To Tackle

The problem of course is that deleveraging is a complex and tricky thing to pull off. It usually takes a lot of time and it’s a very difficult thing to do in markets and economic environments such as the current ones. Many financial institutions, especially US based ones have diminished their leverage ratios significantly since 2008 but those levels are still too high to sustain big losses such as the ones that might occur if Europe can’t get itself back together.

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  1. Comment by Niklas — November 23, 2011 @ 3:54 am

    Talking about leverage…would you ever consider using debt in your dividend growth portfolio? and comments on it.

    For example if you get 10 000$ bank loan with 2,5% interest rate and you have to start paying the debt back after 15 years(you only pay interest annually before this) would you use it to invest in dividend stocks?

    I mean it is very likely that you would make about 5% annually and if the debt is maximum 20% of your portfolio there is pretty low risk that something seriously bad would happen.

  2. Comment by IS — December 1, 2011 @ 5:27 am

    @Niklas – Great question, I did actually give my take about it here: http://www.intelligentspeculator.net/investment-talking/using-debt-to-increase-your-dividend-portfolio/

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