(Almost) Everyone Loves Leverage
Danny DeVito’s character, Larry the Liquidator, in the 1991 film Other People’s Money confessed, “I love money more than the things it can buy….but what I love more than money is other people's money.” As it turns out, Larry the Liquidator was a little ahead of his time, because these days, everyone it seems loves leverage – the tool that allows investors to make large investments using other people’s money.
Fueled by investment banks who have invented new leveraging tools such as derivatives and the success achieved by leverage pioneers such as hedge funds and leveraged-buyout funds, the use of leverage has now reached mainstream America. Retirement funds and mutual-fund companies alike are investing heavily in derivatives. Public companies are loading up on debt to improve returns. Even individuals have entered the fray, borrowing a record $300 billion in March 2007 alone from brokerage firms to buy stocks. Industry experts estimate that borrowing by hedge funds, leverage at major securities firms, and margin loans to individuals totaled $4.9 trillion in 2006, compared with $1.8 trillion in 2002.
But not quite everyone sees leverage as a good thing. One often outspoken critic of the use of leverage is billionaire investor Warren Buffett, who has warned for years that the widespread use of derivatives – which he once referred to as “financial weapons of mass destruction” – and excessive borrowing by investors are endangering the financial system.
Regulators too have become concerned. Both the Fed and the SEC have attempted to gauge the risk of leverage on the market over the past several months by gathering information from hedge funds and Wall Street firms. Although regulators have not yet made the results of their continuing investigation public, regulators have reportedly become concerned that, among other things, Wall Street firms are not getting enough information from hedge funds to assess risk and are accepting too little collateral in exchange for borrowed funds.
One issue regulators and other industry insiders are concerned about regarding the wide-spread use of leverage is that no one really knows what will happen in the event the market takes a serious downturn. The obvious guess is that if (or when) the market turns bad, leverage will create a snowball effect. As market prices fall, lenders will demand more collateral, investors will have to dump additional stocks and bonds to raise cash, which will cause market prices to drop further, which will cause additional losses, which will cause more selling, and so on. In fact, this is essentially what occurred following the 1929 stock-market crash, when it was common for investors to purchase stocks with as much as 90% borrowed money. Once the market began to nose dive, investors had to sell shares to keep their debt below 90%, which in turn caused market prices to dip even lower and eventually led to wide-spread market panic.
