Thursday, June 12, 2008

What is Leverage, and "Deleveraging"??

S&P500 2-Year Chart
2007 US Equity Market The US equity market can be described as a tale of two halves. During the first quarter, economic growth was flat, and most believed the Fed would lower rates to stimulate the economy. This sentiment turned in the 2Q when companies reported better than expected numbers. The Fed did not lower rates, but in fact held them steady, as expectations of a rate cut all but disappeared in the Fed Funds futures market.

Bear Stearns’s Hedge Fund Losses Fast forward to July, when rumors began to surface about Bear Stearns’ two hedge funds. Losses were to be staggering, and what would later be the precipitating event of the “credit crisis”, most in the know understood that if the rumors were true, that these two funds were bankrupt, then all of the contrarian sentiment that we were in an unsustainable housing bubble could ultimately be true. These two hedge funds had large positions in sub-prime, mortgage backed securities. The rumors bore out, and the credit crisis began.

Tech Bubble Burst, the Fed, and Speculation To fully appreciate US market’s decline during the second half of 2007, you have to appreciate the momentum driven market that the US had been in during the past 5 years since the bottom in 2002. The cost of money was basically free, since the Fed wanted to re-stimulate growth after the Tech Bubble burst. Stock prices simply represent the intrinsic value of a company’s future cash flows, discounted back to the present. To oversimplify, the excess money created demand for companies that may have been purely speculative, pushing their respective stock prices higher. It was no different than when companies were apparently worth more than real companies selling real products during the Tech bubble. Please see this graph I posted earlier, showing the S&P500 during the housing/credit bubble as compared to the Tech Bubble.


The Hedge Funds “De-leverage” OK, so presumably you know the backdrop, maybe because you checked your 401k, etc. and saw how much you may have lost if you hadn't moved to stable value before the unwind. Many of the talking heads in the press kept stating that hedge funds, private equity, etc. were in the process of a massive “de-leveraging” that once started, contributed to the downward momentum of all prices of all stocks in the market. The inevitable question for the average person is “what is de-leveraging” and did it really play the key role in the market’s decline?

What is Leverage? A Simple Example To understand de-leveraging, you have to understand what “leverage” is. Here’s a simple example, where you initally want to make a 10% return on 10 dollars.

1. You could take your $10 and buy a widget for the $10, and hope you can sell it for $11 so that it makes you a $1 ($1/$10 = 10% return).

2. Or you could use $1 and borrow $9 from a buddy. Then you buy the widget with your $1 and your buddy’s $9 for $10. You then sell this widget for $11 to someone else who wants it for $11. You just made a 100% return using leverage. That is, you turned your $1 into $1, for a return of 100%. The diagram below shows the familiar diagram for a lever. A lever is a multiplier of power; "with little effort or force, we exert power."

In this example, from a financial perspective, using borrowed money, or leverage, produces a return of 100%, versus the boring 10% return using 100% of our own money. If you understand this, you’ll understand the next post. The hint is to ask “what happens in both situations if the price for the asset your return depends upon falls to $9 instead of $11?