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Here's an example of how that leverage works: Assume a hedge fund has $20 of real capital. If a bank allows it to leverage five times its capital, the fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Now assume the assets fall by 10% in value, or $10. The hedge fund's leverage suddenly increases to nine times -- that's $10 of equity (the original amount less the loss) and $80 of debt now supporting $90 of assets.
If the permitted leverage stays constant at five times, then the hedge fund must sell $50 of assets, or 50% of its holdings. If lenders more realistically reduce permissible leverage to three times the loss, then the hedge fund must then sell $70 of assets, or 70% of its holdings. This process is bad enough in normal markets, but when buyers are scarce, prices of these involuntary sales are knocked down to levels that can wipe out the fund.
This scenario continues to play out across the global economy with occasional timeouts. As hedge funds deleverage in fits and starts, much of their inventory is going back to bank balance sheets. This is known in the banking business as involuntary asset growth, and it isn't good. It forces banks to issue more new equity to comply with international capitalization rules, further undermining current shareholders.
Deleveraging is going on among corporations and individuals as well, leading to less buying power for both. That leaves less money available for homes, cars, televisions and travel, further leading to the sort of buyers strike characteristic of long periods of slow or stagnant economic growth.
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In sum, it's easy to get carried away with the idea that stocks can levitate from extreme lows as greed kicks in and kindles buyers' interest for bargains. But the borrowed money that previously bulled stocks toward last year's high is gone, and so is the earnings-growth confidence that's necessary to push price-earnings multiples higher.
It appears that a real secular, or structural, change has occurred that makes our past understanding of how banks perform outdated. So Das suggests you enjoy occasional two- to three-month advances as the speculative opportunities that they are, but don't be surprised if permanent improvement is much more elusive as financial stocks remain under pressure for at least an additional year or two, and possibly longer.
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The biggest threat to our standard of livingToday's state of the U.S. economy may not seem apocalyptic, but a slow and steady economic beating could prove disastrous, MSN Money's Jim Jubak says.
Still, anytime there's so much hand-wringing about a sector, there are bound to be opportunities for speculators. Want to try your hand? Here's an idea, courtesy of Rich Gula, a veteran analyst and portfolio manager. Back in the early days of Batterymarch, a pioneering quantitative fund where he started, managers would buy an equal-weighted sector portfolio in which at least half the stocks were in horrible downtrends and half were neutral or positive.
Gula says you can expect a couple to go bankrupt, most to trade in line with the market and a couple to rise by 200% or more. On average, after two years, he says, it's likely to be a winning speculation. Here are my picks for the experiment:
| Company | Market cap | May 6 closing price | 1-yr. price change |
|---|---|---|---|
$3.6 billion | $9.84 | -56.4% | |
$3.9 billion | $6.17 | -83.1% | |
$3.9 billion | $8.00 | -67.1% | |
$10.7 billion | $22.94 | -57.8% | |
$17.7 billion | $27.33 | -59.2% | |
$8.1 billion | $40.86 | 52.6% | |
$9.9 billion | $19.15 | 44.5% | |
$7.8 billion | $82.14 | 46.3% | |
$13.7 billon | $116.27 | 58.9% | |
$12.0 billion | $53.89 | 63.1% |
Meet Markman at The Money Show
MSN Money's Jon Markman will be among more than 100 investment experts on hand for The Money Show in Las Vegas from May 12 to 15. You can hear from the experts in more than 250 free workshops while sharing tips and tricks with other active investors. Admission is free for MSN Money readers.Markman's presentation on "What I Am Trading Now" will be available via a live webcast from 2:15 to 3 p.m. Wednesday, May 14. To register in advance, click here.
To sign up, call 1-800-970-4355 and mention priority code No. 009552, or register online.
At the time of publication, Jon Markman did not own or control shares of any company mentioned in this column.
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