Effor.com

I was responding to some comments to a post I made to www.seekingalpha.com a few minutes ago, when I said something that I think needs to be explained further.  I mentioned “leverage” and since that’s been in the news (especially regarding financial stocks) quite a lot over the past few months, I decided to expound on it a bit.

In the comment I referenced above, I said “Let’s say you have $1 million equity in your house, and you take it out in a HELOC. You take that $1 million and put 10% down on 10 other $1 million properties - and you depend on the renters to make your payments.“

That’s leverage.  I just took $1 million in assets (my home equity) and used it to gain control on $10 million in assets.  I used the words “gain control” rather than saying “to buy” because I don’t actually own them - the bank I borrowed the other $9 million from actually owns those properties.

It’s an important distinction, because what happens to my $10 million in assets if just one renter falls behind on their payments?  Suddenly I can’t make my mortgage payments.  It’s only 10% less income, but it causes me to suddenly have to sell the whole $10 million in leveraged assets - because I can’t make the payments.

That’s what happened to Bear Stearns.  They had some assets which they leveraged (borrowed against) in order to buy (with other peoples money) other assets.  When one small part of the initial asset didn’t make their payment, the whole house of cards fell.

In my example, I used a leverage ratio of 10 to 1.  Bear Stearns was leveraged over 30 to 1.  I’ve sen some arguments from pundits (including Ben Stein) where they say the markets have over reacted; that a 10 percent jump in the rate of defaults doesn’t warrant a 20 or 30 percent drop in the stock price of financial companies. 

They’re wrong.  And they’re wrong for the reason above.  When you’re that highly leveraged; when you have 20 (or more) dollars of debt for every dollar of assets; you are hosed when just one percent of the underlying assets doesn’t pay up.

Suddenly you can’t make your payments on all the debt you’ve borrowed.  And since you really didn’t make much of a down payment anyway, you have no equity in the investment.  If you had some equity, you’d have a little breathing room.

But you don’t.  You need every dollar that you’ve counted on to make those payments - because you’ve leveraged your equity. 

And what happens when the value of thoseleveraged assets turns out to be too high?  You’re fucked.  Not only are you highly leveraged, but the base value of thoseassets has dropped, so now you are more leveraged than you were just a monthago.  And so you’re even more vulnerable when there’s a small rise in loan defaults and bankruptcies.

It’s a wild, wild world right now.  I can’t think of a single bank or REIT that I’d touch with a 10 foot pole.  Go ahead and Google the news results for the 3rd quarter of last year.  Check out all the stories that claimed that the 4th quarter was the “kitchen sink” quarter.  Be sure to read how damn near everyone thought that the banks and investment houses have finally fessed up and come clean.

Now watch the headlines during the week ahead.  Let’s se how many additional write-downs there are.  A lot of people have written me saying that I’m overestimating the impact of the sub prime stuff.  Many have told me that all of those losses for the upcoming rate adjustments (for the Option ARM’s and ARM’s written in 2005 through 2007) have been accounted for, and that there’s no where to go but up.

They may be right, but I don’t think so.  I don’t think people truly understand the impact of leverage.  I don’t think they truly understand that just a 3 or 4 percent drop in the base asset (mortgages) can cause a company to disappear.  

I’m not putting my money back into the market until I’m sure that risk has been priced in.  Given the (in my view) extremely optimistic earnings forecasts for 2008 and 2009, that risk is being ignored right now.  I may be wrong (I often am!) but I think I’ll be getting 2 or 3 percent in my money market funds while the optimists are losing 10 to 20 percent (or more) trying to bottom fish the market.

Any questions?

gk

Nice article in the NY Times today about some of the problems in the financial world.  I hate to say I told you so (not really, but it’s sounds slightly less smug) but I’ve said all of this before.  Despite Mr. Krugman’s pessimism, he is still underestimating the size of the problem. 

For example he says “But what worries me more is that the move seems trivial compared with the size of the problem: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.”

By comparing the size of the Fed bailout to the amount of outstanding mortgages, I think he’s missing the bigger picture - the derivatives that are using that $11 trillion as leverage.  (To be fair, probably less than 10% of the mortgages will default, but that’s still about $1 trillion.)  

I don’t remember right now where I read this, but the average leverage is something like 20 to 1.  That means that the $1 trillion in eventual defaults will lead to more like $20 trillion in losses.  That’s where the problem lies.  That’s why companies are getting margin calls.  That’s why they aren’t able to meet those margin calls.  And that’s why many of them will not be around next year at this time.

Who will be the first big name to disappear?  If I knew that, I’d be getting paid some big bucks for the info!  But rumour has it that Bear Stearns and Washington Mutual are very highly leveraged.  And for what it’s worth, Citigroup has been talking a lot lately about how much they have in reserve.  Me thinks they protest too much….   I have no position in any of these, just giving my opinion.

gk

Interesting daily update from The Daily Reckoning.com.au today.  The Mogambo Guru said (in part!):

I know what will happen in a crisis, because I know what the crisis is, which is that derivative holders will not be getting the money they were supposed to be getting, because the guys who owe them the money are already bankrupt, because they didn’t get the money they were supposed to get from guys who were bankrupt because the guys who owed them money were bankrupt, and they are all bankrupt because they put up a lousy $3 of their own money, and borrowed another $97 to buy an asset worth $100, and now that asset is worth only $90!

That’s what basically happens when someone defaults on a loan.  It’s a whole chain of people going bankrupt - or at the least taking huge write-downs - because a sub-prime borrower can’t make his payments.  The elephant in the room is the amount of money involved.  According to Wikipedia, it’s over $500 TRILLION!

To put that $500 trillion number into perspective, the total GWP (Gross World Product) of the entire world is estimated to be about $65 trillion.  The total market value of all the publicly traded shares in the world is about $44 trillion.  (These numbers are from The CIA World Factbook.)  And according to Wikipedia, the total value of all the property in the developed countries in world is about $62 trillion.

In other words, the money in derivatives total about three times the total of all the above values - combined.  That’s what happens when you leverage real property multiple times.  And when the property that the whole house of cards is built on drops in value by just a little bit, guess what happens to the chain. 

Does a derivative crash make any sound?  We’re getting ready to find out….

gk