The Wall Street Journal Worries About Excessive Leverage

The paper offers a perspective on the buildup of wild speculation with little potential for governmental regulation — a recipe for disaster.Smith, Randall and Susan Pulliam. 2007. “As Funds Leverage Up, Fears of Reckoning Rise.” Wall Street Journal (30 April): p. A 1

“Estimates by analysts of leverage at major securities firms, borrowing by hedge funds and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002. Hedge-fund borrowing and other financing tools were valued at $1.46 trillion last year, up from $177 billion in 2002, according to estimates by Bridgewater Associates Inc., a Westport, Conn., hedge-fund company.”

“Private-equity firms, investment funds that often buy entire companies, also are contributing to the leverage buildup. Loans to companies bought by private-equity firms rose to $317.3 billion in 2006 from $51.5 billion in 2002, according to Reuters Loan Pricing Corp. That’s partly a function of more and bigger deals. But borrowing has also risen relative to cash generated by companies the funds buy.”

“Individual investors have been moving in the same direction. Their margin debt — the amount they borrowed from brokerage firms to buy stocks — totaled $293.2 billion in March, the third straight month it exceeded the record set during the high-tech bubble in 2000, according to the New York Stock Exchange. That’s up from $134.58 billion in 2002.”

“There’s leverage everywhere — whether at corporations or broker dealers or hedge funds or private-equity funds,” says senior credit analyst Tanya Azarchs, who follows U.S. banks and brokers at Standard & Poor’s Corp. “It sort of feels like something’s got to give.”

“In 2006, the Federal Reserve estimated there was $20.6 trillion worth of corporate stock outstanding, up 73% from 2002.”

“Suppose a hedge fund wants to bet that IBM stock will rise. Under the SEC rule governing margin lending, the fund couldn’t borrow more than $50 for every $100 of IBM stock it buys. A “total-return swap” on $100 of IBM shares would cost $5 or less for many hedge funds, at least initially. If IBM shares were to rise, the return per invested dollar would be better than if the hedge fund bought the IBM shares outright using a margin loan. If IBM shares were to fall, however, the derivative leverage would work in reverse: The hedge fund would have to pay the counterparty an amount equal to the decline in share value — plus the agreed-upon fee. Mr. Buffett contends that the proliferation of such swaps is dangerous. “Total-return swaps make a mockery of margin requirements,” he says. The widespread use of swaps, he maintains, makes the leverage that preceded the 1929 crash “look like a Sunday-school picnic”.”

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