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LEVERAGE
Published: 8/16/07

The recent market turmoil is often traced to sub prime mortgages, no-doc loans, hedge funds, CDOs, and a myriad of other villains. Although this etiology is not incorrect, it may miss a larger culprit. To compare: was the inner city kid responsible for the robbery or was the rough neighborhood to blame? I am not advocating we allow the felon to walk away, but we may want to find the root cause of the criminality if we hope to prevent a crime wave.

For years investment banks have used a simple trick to magnify their trades: leverage. Borrow money and double or triple your bet. Anyone who has traded futures understands this risk/reward dynamic. Hedge funds have taken this concept to the next level by magnifying their bets to even greater multiples. How else did you think they such produce huge returns? Borrowing money is not a crime in non Muslim cultures, however, nor should it be. We all borrow to buy our houses and cars and seem to be very comfortable with this system.

This leverage or borrowing actually magnifies the number of dollars, euros, and yen in the market. Thus, the whole financial system is greatly amplified even from just a few years ago. This produces an environment of enormous volatility both overall and intraday. It also necessarily creates bubbles and extremes. In other words, we now have a more dangerous neighborhood than ever before.

We all try to avoid bad areas in our lives and in our investments, but you cannot stay home all day every day. You must venture out and enjoy your life. Likewise you must buy a stock or bond or mutual fund if you ever want your assets to grow. And you should.

Now how do we correct this situation? Well, flooding a neighborhood with police is only a temporary amelioration. The root cause of the crime is socioeconomic and the root cause of our present contagion is too easy credit. Inevitably, the market will instill discipline on these unruly borrowers although not without collateral damage. This pain will force the easy money into a bunker. Henry Kaughman, the well known Wall Street economist, argues no one will learn their lesson if the Federal Reserve continues to bail out the perpetrators. Personally, I disagree; there is enough pain and suffering already to change much of the irresponsible activities. It is time for the Federal Reserve to intervene. Wall Street is greedy, but not stupid. Behavior will change at least for the near term.

For most of us we should maintain the same approach as always. Stay diversified, as much as possible, and avoid unsafe neighborhoods whenever unnecessary. However, if you never take any risk, you do not really experience all life has to offer.

Written by: Marty Gallagher

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