Thursday, August 1, 2013
Leverage destroys. Just ask Robert Citron.
In 1993, Citron was a hero. He was a public servant who discovered a way to earn high returns in a declining-interest-rate environment. While other municipal treasurers were struggling to earn any sort of return at all, Citron was cleaning up. The gains on his investments made up for any shortfalls in his county budget, kept several county government programs alive, and eliminated any talk of raising taxes.
Citron's strategy wasn't all that complicated. He put county money into Reverse Purchase Agreements (RPAs) and Floating Rate Notes (FRNs) that were designed to increase in yield as interest rates fell. He juiced the yields even more by leveraging up (borrowing money) to invest in these securities. After all, if he could borrow funds at 3% and generate a 6% return, leverage was a good thing.
Citron was so successful that neighboring municipalities entrusted him with their funds in the hopes of receiving equally high returns. And they did... for a while.
But in February 1994, the Federal Reserve Board raised short-term interest rates by 0.25%. Liquidity disappeared from the RPA and FRN markets... And Citron's investment portfolio blew up.
Many of his securities lost 60%-80% of their value.
Citron was convinced that if he could just hold on until conditions returned to normal, everything would work out all right. But he didn't have the luxury of time. You see, he had borrowed money to make those investments. The sudden drop in value made his lenders nervous, and they wanted Citron to either put up more collateral or liquidate enough of the securities to pay off the loans.
His county didn't have any more collateral. So Citron was forced to liquidate for pennies on the dollar. The money he received wasn't even enough to pay off the loans against the portfolio.
A few months later, Citron resigned as Treasurer of Orange County, California. And Orange County became known as the largest municipal bankruptcy ever in the United States.
But here's the thing...
Citron was right. Within a few months of the bankruptcy, interest rates started to fall again, liquidity returned to the RPA and FRN markets, and almost all the securities Orange County sold for pennies on the dollar were trading near par. If he could have held on, everything would have been all right.
It wasn't the investments that destroyed Orange County. It was the leverage.
By borrowing money to buy securities, Citron put Orange County at the mercy of its lenders. Lenders don't care if you make a good or bad investment decision. They only care about getting their money back. When they fear their money is at risk, lenders will call in the loan. If you don't have the money to back it up, you can be forced to sell depressed assets in illiquid conditions. That's the nature of a "margin call."
It's what destroyed Orange County... It's what brought down Lehman Brothers... And it was at the heart of the 2008 financial crisis.
Leverage exacerbated the stock market crash of 1987. It led to the extreme stock valuations in 2000. It accelerated the decline from the market top in 2007.
And leverage is what every investor ought to be worried about today.
You see, NYSE margin debt is at an all-time high. Investors are borrowing money to buy stocks. So as the market rallies to new highs, investors are now more leveraged than at any other time in history.
History tells us this is a bad thing.
In March 2000, margin debt on the New York Stock Exchange climbed to more than $278 million for the first time ever. Then it started falling. Four months later, the S&P 500 peaked above 1,500 and entered a severe bear market. The index lost 45% of its value over the next two years.
In July 2007, margin debt set a new all-time high above $381 million. Then it started to fall. Two months later, the S&P 500 set a new record above 1,550. Eighteen months later, it traded as low as 667.
Last April, margin debt rose above $384 million – another new all-time high, the first since 2007. True to form, the S&P 500 rallied to a new high last month. But margin debt has been declining since hitting its high in April.
If the historic trend persists, that's a bad sign for stock prices.
Best regards and good trading,
"Leverage is financial crack," Jeff writes. "The first hit feels good. It's a trader's high... We want more of it. So we use it again, and again, and again – until we're addicted." Eventually, though, "it kills us." Learn more here: Wall Street's Favorite Drug Will Kill the Stock Market.
Detroit recently usurped Orange Country's place as the largest municipal bankruptcy ever in the U.S. "Detroit is a living case study of why government efforts to redistribute wealth don't work," Porter Stansberry writes. "But instead of recognizing any of the lessons of the catastrophe, OBAMA! promises more of the same." And Porter says our country is headed for a far worse end than Detroit. Get all the details here.
Bonds continue to fall... big Treasury bond fund TLT breaks down to a 22-month low.
U.S. consumers are spending... retail fund XRT soars to a new all-time high.
The "stealth" biotech uptrend continues... biotech funds IBB and XBI jump to fresh all-time highs.
Big U.S. conglomerate 3M hits a fresh high... investors are up 43% over the past two years, including dividends.