Leverage

Often when a problem is revealed there is tendency of government to over react and the cure is worse than the disease. This is the reason why adequate investigation into solutions is necessary and it concerns me that there is a rush into passing financial reform.

Some even suggest that derivatives be outlawed which would be a disaster for most businesses. For example, take farming which is big business throughout the Midwest and most of us are familiar. Typically a farmer has a pretty good idea of what his crop will produce but he is not as sure about the price. In the spring it is a common practice for a farmer to purchase a contract to sell his crop at a set price in the fall. He knows that he needs three dollar wheat to make a living so he buys a contract that guarantees he can sell his wheat in the fall for three dollars. This contract is a derivative, a kind of insurance policy to help him stay in business. This is how derivatives first started, as a way to satisfy a need.

Let’s say that the farmer anticipates, based on past years, that he will have an 80,000 bushel harvest so he purchases a contract that guarantees that some buyer will pay him $3 per bushel for his crop. If there is a shortage of rainfall and he only harvests 60,000 bushels he will have to go out into the open market and purchase 20,000 bushels at the current price to satisfy his contract. This may work to his advantage if the price is lower than $3 or to his disadvantage if the price is higher than $3. This is a straight contract with wheat to back up the deal. Now bring in the concept of leverage and see how things change. Suppose he buys a contract to sell 800,000 bushels of wheat and he uses a bank loan to pay for it. He is now betting that wheat will be higher than $3 so he can make a big profit. He is now leveraged 10 to 1 which is pretty darn risky. If he guesses right a big profit but if he guesses wrong he might have to sell his farm to pay off the bank.

The reason I offer this example is that I heard on the news today that some of the banks who were dealing in the mortgage derivatives were leveraged at 33,000 to 1. You see when you’re betting with other people’s money you tend to take bigger risk. The big insurance company that was backing up these bets (AIG) was leveraged even more.

Even the big life insurance company that I worked for, Equitable of New York, had two billion of assets to back up 100 billion in insurance policies. At 50 to 1 this seems high but what are the chances of all 10 million of their clients dying at one time.

John/Jack