As a "small investor", I watch the stock market, and its recent rise is worrisome. The WSJ's front page, lead article on Monday reports on the "leveraging" that the big hedge funds practice to make extra returns in the financial markets. "Leveraging" means to borrow money and use the proceeds to buy investments that one thinks will grow in value faster than the interest one will pay on the borrowing.
The classic example of leverage is buying stock on margin. One would buy, say, 100 shares of XYZ corporation for $10 a share or a total of $1000. To "leverage", one would borrow $500 from the broker and put $500 dollars of his own money into it. The investor would pledge the stock to the broker as collateral. Assume that the broker charges the investor an annual interest rate of 5%. After one year, the market value of the stock increases 10% to $11 per share and the investor sells. His gross profit is $100. He pays the broker back what he borrowed plus interest of $25. He pockets his own $500 plus the balance of the profit, which is $75. On his $500 investment, then, the investor made a return of 15%.
Had the investor simply invested $500 without borrowing the broker's $500, He would have made $50 dollars, that is, a return of 10% on his money. He used the broker's $500 to make an extra $25.
The reason one can only borrow 50% of the value of the XYZ corporation from the broker is that the government limits how much one can leverage in buying stocks. These sorts of limits permeate the financial system, but not completely. The hedge funds have figured out how to avoid those limits and in many ways the hedge funds are simply unregulated. So they borrow great sums and in very complicated ways, using "derivatives" to engineer the leverage. The very large returns that the hedge funds have enjoyed in the past several years have interested pension funds and public companies in their approach, according to the WSJ, and they are now on the bandwagon as well. (The WSJ reports, for example, that "garden-products maker Scotts Miracle-Gro Co . . . [has] loaded up on on debt to improve returns.")
The WSJ calls it a "leveraging binge", and you can tell that its editors are worried because they put their article on the front page of Monday's edition. The article states in part:
No one is sure what will happen to this complex brew in the event of a serious market downturn. When markets turn bad, leverage can create a snowball effect. Lenders and derivatives dealers demand that investors provide them with more collateral - the stocks, cash or other assets they pledge to cover potential losses. Sometimes, investors dump stocks and bonds to raise cash. Prices drop more, losses accelerate, and more selling ensues. Some Wall Street analysis have taken to referring to a nightmare version of this scenario as "The Great Unwind.
Not having a pension plan provided by a big corporation, government agency, or union, I am like a lot of my peers and have saved using IRAs and 401K plans. The financial markets are about the only place one can invest such savings. So I have been buying stocks and bonds over the years, but quite a large proportion of stocks. (I have never bought anything on margin. Except for my house.) That approach has done reasonably well, but I am so worried about this that I am significantly reducing my exposure to stocks, and I started doing that in earnest earlier this week. I will continue to do so, until I feel comfortable. Yes, the stock market continues to go up, and hit record highs. But it worries me.
Let's go back to our XYZ company illustration. Let's assume that in one year its value goes down 10%. At the end of the year, then, the investor's position is worth $900. He sells the stock and pays the broker back the $500 he borrowed, plus $50 of interest. That leaves our investor $350. He lost $150 on the deal or 30% of his investment. As you can see, leverage works the other way too. And in these illustrations I am assuming relatively benign price movements. But things seem to be different in the financial markets. The price movements may not be so benign when the Great Unwind begins.