Money & Markets: Financial institutions are addicted to leverage

Archimedes said, as I’m sure you recall, ‘Give me a big enough lever and a place to stand and I will move the world’. What he did not note was that in the process he might throw the planet off its orbit with a catastrophic result. He certainly used levers to upend the Romans.

In markets it is simple: ‘Leverage kills.’

If you lever up your position 1,000 per cent, a 10 per cent move against you will lose you everything. A 10 per cent move in your direction will double your money. Greed is, of course, the one side of the trading coin that this risk/reward ratio speaks to most loudly. It is a trap set for anyone foolhardy enough to reach for more returns than are usual.

Markets wobble. They do so because the process of markets is noisy. Leverage amplifies that noise and noise is power law distributed, or enough in that zone that at some point a burst of noise will strike and give most people a bad day, month or year. With leverage that nasty burst of noise is amplified and will wreck anyone with any sort of leverage at all.

Leverage, however, is irresistible, and no matter the number of people wrecked by it, over however long, recorded history lets you find examples; financial participants are lured down the slippery slope of leverage until there is no escape and all is lost.

There is an idea in markets and in gambling of ‘gambler’s ruin.’ This is the point where the player has lost all their money and cannot go back into the game to recoup losses because they simply have nothing to stake anymore. Anyone who has played a slot machine or pumped 2p pieces into a waterfall coin-op in an arcade will know the feeling. Once you have no money to play, the fun stops.

This gambler’s ruin is massively accelerated by leverage. You can visualise gambler’s ruin as a cliff that once you fall from, it is your lot. An investor or trader stands some distance from this cliff and the randomness of the market and its power function wobbles the participant backwards and forwards to and from that cliff. Leverage increases that distance of travel until it is only a matter of time before the individual and their positions are sent into the abyss. Leverage and financial destruction is a function of time.

This is, time and again, the underlying cause of financial crisis. Tulip bulbs, 1929, the global financial crisis of 2007-2009, all were built on volcanic leverage.

You would think that in these days of legions of regulators that venerable financial institutions would avoid much leverage or have it made clear they should steer well clear of it or else.

So this September the UK’s sovereign debt went into free fall and along came the Bank of England and bailed us all out. It seems that it isn’t understood by many that the whole UK economy nearly came off the rails and what that would have meant.

What had happened was, pension funds had levered up their government bond holding five, seven, perhaps even 10 times. When interest rates spiked these leveraged positions imploded and forced their holders to sell assets to make up the deposit on their leverage that allowed them to go massively in debt to buy giant piles of government debt bonds. As they began liquidating their positions it forced rates to rise, forcing more liquidations, and a doom loop was created that only the Bank of England was big enough to stop.

The Bank of England bailed out these positions and by inference bailed out the pension holders who were about to lose their pension companies and their pensions along with it. In effect, the Bank of England ultimately wrote a check to pensioners for £20bn. If they hadn’t, the UK’s sovereign debt would have imploded and that really would have had the plus-sized soprano on stage.

The whole point of pushing pension funds away from equities to bonds back in the early noughties was so that pension funds would be more ‘safe’. (Obviously pushing pension savers’ cash into government coffers would never have been the real reason.) As such this ‘emergency’ underlines many fundamental problems with the financial industry, the core one being the financial services industry herd must rush for the cliff edge in any event as it is forced by the most negligent, dishonest, deluded or aggressive member desperate to be ahead of the rest of the stampeding flock. As the CEO of Citi said of the cause of the global financial crisis: "As long as the music is playing you have got to get up and dance." He also roughly said: "When the music stops things get complicated." Things are getting complicated.

So the real question is: how much of this is still out there in the UK, Europe, the US etc? Is this just a one-off situation or the beginning of something big?

Banks on the edge of default like in 2007-2008 is one thing, but whole countries is another scale entirely. Those folks at the central banks are going to have to pull off another tight-rope walk because the positive TINA ('there is no alternative') thinking the market is grasping right now could prove as fatal as asking a Roman soldier not to mess with your circles.