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The trouble with leverage

Agriculture.com Staff 10/10/2008 @ 11:39am

Problems with the world economy are driving the grain markets more than fundamentals. Even with today's bearish report, there would still be the chance for grain prices to go up if the psychology in the equity markets were not so negative. These panic markets have happened before. It is always a time of intense emotional price moves.

Webster defines leverage as "the intensified speculative effect of market fluctuations….". Farmers are all too familiar with the principle because of experience with margin calls in futures accounts. Buying or selling on margin means you get a multiplier effect on any capital put down to guarantee a position. Being on the wrong side of a big move can quickly wipe out more than the amount initially invested.

Buying stocks on margin was one of the big reasons for the stock market crash of 1929. During the prosperity of the 1920's the stock market seemed to go only one direction. Investors made huge paper profits as prices soared. They borrowed against these paper profits to buy more shares, some times putting down only five percent of the cost. When prices did finally drop, the whole scheme fell apart very quickly. Regulation of the stock market to limit buying on margin and short selling followed. That solved most of the inherent problems at that time. The best year ever percentage wise in the stock market followed in the early 1930's.

The crash in October 1987 was also caused by leverage. By then options were in common use in the equity markets. There had been a long period of relatively stable growth in stock prices. Sharp investors saw this and realized that when prices go up, put options lose value and expire worthless. Selling put options in a rising market is a simple and easy way to generate income. The problem is that the seller becomes the insurance company, guaranteeing that stock prices will not drop below the strike price. Any short options position must be margined. When the stock drops, the seller must add money to the account. The leverage with this system means that the initial money and any additional capital can quickly disappear. The seller must continue to raise margin money or go bankrupt. The risks in this system are somewhat controlled by government regulation.

Fast forward to the twenty first century. A new tool appeared on the scene called "swaps". This tool provided businesses a way to lay off various risks by having an agreement with another business to make a payment if certain things happened adversely affecting the profitability of the first company. For instance, the company might pay a premium to the second company for the second company to guarantee that a customer would not default on an outstanding loan. All terms of the swap contract would be completely negotiable between the two companies.

Because swaps are between two individuals or companies and are not traded on an exchange, the government does not regulate transactions. This is similar to the unregulated HTA crisis in the 1996 corn market. It means that there is no one watching to see that the seller has adequate capital available to guarantee performance. It also means that there is no one watching to see that the number of swaps is reasonable in relation to the size of the overall risk to the economy. If the players in this game are not competent to watch their risks, the whole thing becomes a crap shoot with only the courts to referee.

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