4. the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s own liability for any loss.
For an investor, margin is a blessing and a curse. When you’re trading on margin, your returns can be very high, but it only takes small losses to wipe you out completely. It’s the problem of leverage. If you invest $1000 but your brokerage is giving you 5-to-1 margin, you effectively invest $5000 instead of $1000. Thus, a 20% return nets you $1000 profit instead of $200. But it’s a problem in the opposite direction too. A 20% loss loses you $1000. You now have a $4000 loan from the brokerage, and the total position of your holdings– if liquidated to pay off your loan in a margin call– will leave your position wiped out.
Margin, for an individual brokerage and an individual investor, can be a very useful tool. Yes, it’s a big risk, but it carries big rewards. It allows the investor to play a large position with a limited exposure, and allows the brokerage to make very liquid loans when they have excess capital.
When margin requirements get very loose, though, and the practice becomes widespread, it becomes scary. Gains happen quickly, as the money moving in the market gain velocity. Losses are worse. If a brokerage has a lot of investors working on margin, a bear market may force them to initiate a margin call on a lot of investors, and their exit of the market can further reduce demand and drive down prices. Thus, each brokerage is in a race to exit the market, and the market crashes — as we saw in 1929.
Leverage is not a bad thing. Without leverage, most people couldn’t afford a house. We don’t save the full price of the house, we save a modest down payment, borrow the rest, and then watch as our 10% down payment reaps the rewards of 100% of the gains of the house price. In a down market, because houses rarely drop more than 10% or 20% in a down market, it’s rare that a price will drop enough in a short period of time to liquidate our down payment…
Enter subprime and alt-A. When lending standards decline, offering houses to people with no money down, the leverage becomes nearly infinite. If I can buy a $400K house with no down payment– only covering closing costs– I now have the ability to make a huge reward with very little risk of my own. It doesn’t take a 10% drop in housing prices for me to be underwater on my investment, but a 10% increase on that house is $40K in profit.
Leverage increases the rate of gain as well as loss. When subprime lending became widespread, everyone was buying on margin and bidding up the prices of homes to obscene levels. The market was crowded not only by homeowners, but by speculators looking to “flip” houses for a quick profit. The rapidly escalating prices was a false signal to homebuilders, who believed that demand had shot up and tried to build houses to meet the demand. The market went up with no signs of stopping — and then it stopped.
As all bubbles do, eventually the perma-bulls have nobody to sell assets to except other perma-bulls. The market can go nowhere but down. At that point, everyone who is leveraged is in big, big trouble. In this case, the market was leveraged top to bottom, and we’re looking at a financial catastrophe unlike few people today living have ever seen.
I said we were leveraged top to bottom, but so far I’ve only spoken about the homebuyers and lenders. It goes far deeper than that. Investors lending out their own money have a responsibility to ensure that they’re lending to creditworthy borrowers. Even if it’s not “their own” money, they usually have to carry those profits and losses on their own balance sheet, and thus it’s their responsibility (often with their job on the line) to ensure the money is handled responsibly. But in this case, the incentive of the lenders was to “churn” loans, because every loan was carried by someone else. The loans were packaged into CDOs– Collateralized Debt Obligations– securities grouping these toxic loans into equities sold to institutional investors who were far more liquid than the banks or the homebuyers.
Even worse, many of those institutional investors were working on their own version of margin, CDSs– Credit Default Swaps. A CDS is an insurance policy against default. If I buy $1B worth of securities, with a worry about losing my entire position in a big default, I can insure my position against default for a much smaller amount. I can then assume that my $1B investment is no longer “exposed”, and go out making another billion dollar investment as if the first billion doesn’t even exist. I’m covered — as long as my counterparty selling me the CDS can remain solvent.
So everyone’s leveraged to the max, top to bottom. How did it get this way? This post isn’t intended to assign blame, but as I’m sure many of you know, I think the government deserves quite a bit of responsibility for its easy-money policies, Fannie and Freddie, and the CRA. Then, of course, there were a lot of investors who got swept up in the “good times” thinking nothing could go wrong, and many of their technical investing brethren who assumed that the new CDO and CDS products would work to improve stability instead of just allowing the bubble to reach historic proportions before bursting. And there’s the old-fashioned greed, by lenders who want to refinance everyone they meet and homebuyers who either bought more than they could afford or treated their homes like ATMs. This one’s big enough that there’s plenty of blame to go around.
So what’s happening now? The global financial margin call. This leverage has to unwind, and the way that happens is going to cause a lot of pain no matter what happens. It would have been easier if everyone just held on through the crisis. But these financial institutions are in a prisoner’s dilemma writ large; if none of them write down the assets and try to de-leverage, they’re all able to weather the storm, but if any of them de-leverage, the firms to do it first get off the lightest. Plus, with mark-to-market rules forcing them to write down the losses, they’re hand is forced. We’re at the point where everyone’s in the process of trying to get out, and the whole system is nearly ready to come crashing down.
And why is the government stepping in? Because the credit markets are frozen. An institutional investor isn’t going to take a big risk right now if they can’t hedge that risk. They’d love to use a CDS to protect themselves, but nobody believes the counterparty selling a CDS is solvent enough to live up to its obligations. AIG is a perfect example. As the largest holder of these CDS contracts, there was no way they could effectively live up to their counterparty obligations, and allowing them to fail would unravel the whole egg in a very fast manner. Thus, the government stepped in and said that nobody has to worry, because if push comes to shove, the US Treasury will be that counterparty. And nothing’s more trustworthy than the US Dollar and the US Treasury, right?
There’s an old adage when it comes to economics: “If you owe the bank $5,000, that’s your problem. If you owe the banks $100,000,000, that’s the bank’s problem.” The problem with being “too big to fail” is that failing hurts the people you owe a lot more than it hurts you. This is where the bailout is coming from, because companies like AIG will cause so much havoc when they fail that we can barely understand the potential implications.
We can debate whether or not this bailout should or shouldn’t occur (for the record, I’m against it), but in an election year, there’s nothing that’s going to derail this monster. What’s important right now is to understand the potential implications. So here’s the possibilities:
Best Case: The whole point of the government intervention isn’t really to fix the situation. This situation can’t be “fixed” in that sense. The system is over-leveraged, and that has to work itself out. The issue is that if it occurs quickly, we’ll have a level of pain that this country is not ready for. If it occurs slowly, we might have a protracted recession and a dull nagging ache, but eventually the economy will grow its way out of the mess. We’re talking a 5-15 year process, but they may stave off double-digit unemployment and bread lines.
Worst Case: Government doesn’t solve the problem, and we still go into a depression. In order to get out of it, and to try to keep the economy moving, they inflate the dollar to try to give the appearance of growth, but America doesn’t buy it. The world abandons the dollar as a reserve currency, and we enter a hyperinflationary depression along the lines of 1920’s Germany.
Even the best case is not good, but the worst case is downright terrifying. But whether or not you support this bailout, I hope this post explains the underlying causes and issues at stake here. We’re in uncharted territory, and the Sword of Damocles is dangling just above. No politician wants to let that sword fall, but there’s a distinct chance that their intervention will destroy us first.