Leverage: A Nasty Eight Letter Word

So much of what the credit markets are wrangling with is leverage. Fixed income strategist arbitrage small percentage differences between what they can borrow v. what they can earn. I think that is called positive carry. For those of you who followed along in MAR/APR 2007 in the discussion of the the paper, Hedge Funds and Systemic Risk, you will remember that the riskiest strategy, indeed the one that caused most hedge fund failures was Fixed Income.

Why? The answer is simple. When you lever up, small changes in the underlying investment can equal big losses. I prepared a very simplistic example.

If you are levered 5:1, then your investment gets wiped out with a 16.67% loss. But that is YOUR money. If you lose more than that, then you have borrowed money that you have to pay back. I heard someone say that the Carlysle affiliate invested in GSE's was levered 32:1.

As people are de-leveraging, either by choice or necessity, it feeds a cycle within the entire market causing prices to go down further and pulling more into the vortex of money going down the drain. Leverage ratios are based on the market market value of an investment. The market value of many of these credit products (and I'm not even talking about derivatives) is plunging. Price goes down; leverage ratio blows up; margin calls are made. I'm sure that there are many margin calls that are not being made satisfactorily.

This example is very simplistic, and I'm sure that I'm not telling you anything that you do not already know. But seeing it on paper is sobering. It is these credit events that levels out dynamic hedge fund strategies and causes previously non-correlated outcomes to correlate.

I have to say that I'm becoming gravely concerned about my money market accounts, and I may look to move money into something a little safer than Fidelity's FDRXX which is what they require my retirement money when not fully invested to be placed. I know that I sound like Chicken Little, and I've expressed that concern before. I don't think that it is a misplaced concern.