(as found in everything from your common or garden mortgage to major investment bank funds)
“Give me a place to stand and a lever long enough and I will move the world”, said Archimedes.
And he was right. Although the Earth would have to be orbitally stationary relative to his position, and it would have to stop rotating, and he’d have to be in a spacesuit, and the lever would have to be made from something immensely more light and strong than even carbon nanotubes, and the pivot would have to be frictionless, and wherever he was standing would have to have sufficient mass to counteract his exertions, and…
In fact the whole thing’s daft, really.
But you can see what he meant: little movements can have a big effect if you have the right leverage. And, just as you can shift a heavy boulder with the aid of a small rock and a big stick, so you can shift a lot of money on the back of geared loans secured upon bricks and mortar.
Because that’s what a mortgage is; a form of leverage. Most people can’t afford to buy their house outright, so they put down a deposit (usually) and take out a loan for the rest. For the sake of argument, let’s say that Mr and Mrs Average put down £20,000 on a £200,000 house, borrowing the remaining £180,000. They now have a leveraged ‘investment’ - sometimes rather quaintly known as a ‘home’ - with a gearing factor of 10.
What this means is that if house prices go up by 50% - i.e. their house becomes worth £300,000 - they don’t just make 50% on their initial investment: they make 500% profit (once they sell, that is, and not counting mortgage interest payments, solicitors’ fees and so on).
Conversely, if house prices should drop by just 10%, their entire deposit would be wiped out. And if prices should drop further, our not-so savvy investors will be in negative equity, owing the bank more than the current value of their house.
This, then, is the fundamental characteristic of leverage - it is risky. When things are going well, a leveraged investment can make huge returns relative to the initial stake. But if things go wrong, it can very quickly wipe out all your gains and perhaps leave you with significant losses, too.
Why does this matter so much at the moment? Well, stepping aside from the UK’s housing market for a moment, with its various “will they, won’t they” pontifications about price falls, leveraged investments are incredibly popular in the wider financial world. In fact they are probably the most common type of investment.
While it’s perfectly possible to invest without leverage - simply by buying shares, for example - most forms of investment offer leverage, because everyone wants to make money quickly. You can use a spread-betting account to ‘buy’ (or sell) shares using leverage. You can use a currency trading account to trade on differences in exchange rates and interest rates using leverage. You can use exchange traded funds (ETFs) to invest in commodities using leverage. In fact, if you know where to look, you can invest in almost anything using leverage. You put down pennies, you make pounds.
And many people have done so. In particular, many investment banks, hedge funds and other institutional investors have done so, making phenomenally good returns over the last five years or so. Recently, however, those leveraged investments (and some non-leveraged ones), particularly those based on pesky old sub-prime mortgages, have started to go awry. Instead of profits, many investors have been hit by significant losses.
In a global economy, effects in one area of investment can quickly spread to others. So when institutional investors started to lose money on collateralised debt obligations (CDOs) and residential mortgage-backed securities (RMBSs) because of the US sub-prime crisis, they quickly liquidised other investments in order to cover their losses.
For example, some of them shifted cash out of the carry trade (in which money borrowed in low-interest currencies such as the Yen is invested in higher interest currencies such as the Pound), causing the Yen to rapidly appreciate and leading to a whole slew of currency investors losing money on their leveraged positions. These currency investors in turn had to find the money to cover their losses, perhaps by selling gold, temporarily shifting the gold price downwards and causing a tranche of leveraged gold investors to lose their shirts. And so it went on, and continues to go on.
Nobody knows the total amount of leveraged investment in the world, but it has been estimated to be many multiples of global GDP. Some rather alarmist commentators have said that more money is owed on leveraged investments than actually exists in the world, which is an odd state of affairs.
In fact the whole thing’s daft, really.
But in actual fact, it’s not necessarily as bad as it sounds. For example, our property owning couple put down £20,000 and have a debt of £180,000. As long as they sell before the value of the asset becomes less than the value of the debt, they don’t have a problem. The £180,000 debt sounds big, but while it’s secured on an asset that’s worth at least that much, all that’s actually at risk is £20,000.
So it is with other leveraged investments. A 1% leveraged investment of £10,000 in any particular market gives a headline exposure of £1,000,000, which sounds rather scary. But in fact, as long as there are stop-losses in place at the right points, all that’s actually at risk is the £10,000.
And yet… what if you can’t set a stop-loss because your asset isn’t liquid enough? What if there’s suddenly no market for what you’re trying to sell? What if everyone is so scared that nobody wants to put a price on what you’re selling, for fear that it’s too low and will in turn cause them to lose vast amounts of money too, because they hold similar investments?
That’s pretty much where we are now, and it’s why there’s such a concerted effort among central banks to lend money to commercial banks, taking even the tainted mortgage-backed securities as collateral. The hope is that by accepting these investments at face value (i.e. “Let’s pretend these pieces of paper are worth something”), central banks will release the credit blockage and get the global economy moving again.
Time will tell if it actually works, and we probably won’t have long to wait.
© Alex Cruickshank 2007
The author hopes, somewhat forlornly, that his pension fund doesn’t hold too many leveraged investments.
