Monday, March 24, 2008

Credit Crunch Characters (9) - Kings of Leverage

In the end, the margin between 3% and 5% was just to small to sustain the life styles that bankers deserve, even after all the efforts to expand the margin by reducing risk. So they came up with one more trick. Many of the mortgage backed securities and CDOs were sold to hedge funds and sundry other investment vehicles. The trick was that these companies became highly leveraged by borrowing most of the money they used to buy these securities. By most, I mean about 95 percent.

The benefit of this high gearing is that the profits are multiplied by the degree of leveraging. In this case the margins are small. These institutions were able to squeeze a large profit from a low margin by being highly leveraged.

Here is an example. If is spend $1000 on a bond with a 4% percent yield, I get a return of $40 on my investment. I can increase my return by getting a loan of $3000 from my bank at 3 percent interest to buy more of the bonds with the 4% yield. The return is now (1000 x 0.04) + (3,000 x (0.04 - 0.03)) = 40 + 30 =70. This is a 7 percent return on my investment of 1000. The loan has nearly doubled my return, even with a gearing ration of 4 to 1.

If I increase my borrowing to $30,000. my return is (30,000 x (0.04 - 0.03)) = 40 + 300 =340. A leverage ratio of 30 to 1 increases the return on my investment of $1000 to 34%. You can see the appeal of high leveraging. A high return can be obtained, if the margin of the yield over the cost of funding is quite small.

High gearing is fine while the activity remains profitable. When losses strike, the leveraging works in the same way to amplify any losses. If in the last example, the value of the bonds that I have bought drop and my yield of 4% turns into a loss 10 percent, I have to deal with a loss of $3,000. My original capital is totally wiped out and I still have to pay $2,000. Not quite so nice.

This is what happened to several of hedge funds and investment vehicles. When the securities they had bought declined in value, their margin disappeared and turned in to a large loss.

These funds had borrowed the money they used to buy their securities from commercial banks, using their securities as collateral. When the value of the collateral decline, the banks demanded that they reduce the size of the loan or come up with more collateral. However, they could not produce more collateral, because their leveraged losses were chewing up their small capital.

High gearing is fine while an activity remains profitable. When losses strike, the leveraging works in the same way to amplify the losses. This is what happened to several of these funds. When the securities they had bought declined in value their margin disappeared and turned into a large loss.

Carlyle Capital fell into this trap. It controlled $21.7 billion in AAA rated mortgage debt issued by Freddie Mac and Fannie Mae. It had leveraged aggressively, borrowing $31 for each dollar of capital. When its investments lost value the banks started worrying about their debt exposure and demanded that Carlyle Capital put up more collateral for the loans. A $150 million credit line from its parent, the Carlyle Group, was not enough to keep it out of trouble and a couple of weeks ago it collapsed.

Bear Stearns got into trouble by lending money to two funds that it had set up to buy mortgage backed securities using bank debt. It then had to take the debt and the low-value securities back onto its own balance sheet. It never recovered.

Most investment banks are highly leveraged. According to the Wall Street Journal, Morgan Stanley, Bear Stearns and Lehman Brothers are also leveraged by more than 30 to 1 Merrill Lynch and Goldman Sachs are leveraged more than 25 to 1.

Sometimes the securities bought with leveraged capital are CDOs that already have some leverage built into their construction. In some cases the resulting effective leverage is over 50 to 1. This produces enormous profits in good times, but a drop of 2 percent in asset values can wipe out the capital of the investors.

High leverage amplifies profits, but it also amplifies the losses.

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