Massive Leverage Strikes Again In The Stock Market

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Too much leverage strikes again in the stock market!

It’s at least the second time in 2021 that investors using leverage to enhance their returns has sent the market into turmoil.

The first example came with GameStop GME , the beleaguered video game retailer. An army of individual investors used borrowed money to pile into the stock sending shares in the struggling company skyrocketing. You can read more GameStop and how margin debt works in a WSJ story I wrote here. Margin debt adds financial leverage to stocks positions, meaning that investors stand to make far greater profits if the stock moves as anticipated and suffer far greater losses if the stock price goes the other way.

The rally in the stock of a company barely-getting-by had observers and regulators concerned that the markets might be unstable and/or being manipulated. Neither of those things is considered good for investors.

But the yo-yo-ing GameStop stock seemed to be forgotten quickly as a mere quirk in the markets.

More Hedge Fund Pain

Now something bigger has happened and major banks are feeling some financial pain. Just like with GameStop the issue is the use of leverage to enhance investment returns. A large hedge fund, Archegos Capital, was trading securities using derivatives. But it seems that the trade went against the fund and the banks decided to force the sale of the remaining stock positions.

While few people would care about a hedge fund taking a large loss, the same cannot be said when it comes to the banks. Japanese bank Nomura, said it would take a potential $2 billion loss, while Swiss bank Credit Suisse CS , says the losses could be substantial. As we saw a dozen years ago, banks, even the big ones that look robust, can be fragile. Losses by a major bank tend to get transmitted across the financial system and the real economy with speed.

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No Surprise

Events like this forced liquidation should be no surprise to investors. The Federal Reserve and other central banks have made sure that borrowing costs are ultra low, and at the same time they have engaged in unprecedented money printing program. All this means there is a lot of cash floating around the banking system looking for a home.

With what essentially amounts to free money, why wouldn’t hedge fund companies borrow massively or leverage their positions to the hilt with the hope of achieving huge financial gain?

There is plenty of upside for them. If the trade turns out well, then the principals of the company will get rich(er.) If the trade goes badly the fund can be wound up and the principals can start another company. It’s heads I win, tails you lose. In other words, hedge funders have an incentive to gamble.

The bigger problem for the market as a whole is that heavily levered investing can become tantamount to gambling, and it can cause unstable markets, which the tends to scare at least some investors away. That in turn will hurt the real economy.