When the definitive history of this financial crisis is written, the role of leverage should get a hard look. In the ailing credit markets, leverage turned what should have been chest pains into a full-blown heart attack. The “seize up" metaphor became especially apt.
Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.
The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.
Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.
Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.
When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.