Today's word is leverage. Lev-er-age. Leverage is a magic word faintly redolent of new bills pressed into warm palms. The root of leverage, "lever," goes back to the 13th century in Middle English (Latin root: levare, to lighten) and had a long history among the mechanical engineering set before settling into finance in the '50s. There's a story there, but for another day. Archimedes, for instance, knew all about leverage when he theorized that he could move the world if he positioned himself correctly, say somewhere beyond the moon. Michael Milken introduced the same concept using junk bonds and an office on Wilshire Boulevard. Like so many magical words, "leverage" has taken on many meanings: from the action of a lever to the ability to influence people and events to — wake up, this is the test question — the use of small amounts of borrowed funds to gain high returns or to control much larger investments. Margin is leverage; junk bonds, repos, leveraged loans can be too. Financial leverage is like a carburetor in the days when cars had carburetors: Open it up wide, and markets race; shut it down, and things slow down or stall. Question: Does leverage work with fuel injection?
Most of you know all this, except perhaps for the 13th-century part. Our subject this week is leverage and private equity. Leverage may stem from mechanics, but its magic — its ability to amplify effort and thus returns — makes it powerful, even ubiquitous in finance. In fact, without financial leverage, we might as well move into the cave with Osama. Mostly, since we're really not ready for cave life, we view leverage as good. But like cholesterol, there's good leverage and there's bad leverage. Leverage on the upside can make an ordinary investment look nifty. Leverage on the downside, as the options gang knows full well, can blow a hole in a portfolio big enough to alert the nuclear seismographs. The Great Depression was not caused by promiscuous margin lending on stocks; but the stock market crash that informed us that happy days were temporarily over was certainly exacerbated by excessive borrowing to buy New Era shares. In the '30s, fairly strict margin rules were promulgated. But as the financial system expanded and became more complex, much of that evolution was driven by the desire to use leverage in new and legal ways. The finance crowd proved exceedingly clever. While there are still margin calls — day traders live on them — there are many more sophisticated ways to tap into widely available leverage, like options or derivatives. Indeed, Wall Street couldn't open for business in the morning if it didn't spend much of the evening jacking up its leverage.
Our cover story this week, by Vyvyan Tenorio and David Carey, focuses on that very issue: When does good leverage become bad leverage? The metaphor they examine — actually it was raised by a buyout executive — involves Eve, the apple and the serpent; there they are on the cover. Whose fault is it if markets make potentially dangerous leverage available at seductive terms? How can you turn down what's freely available? In a competitive world, how can you reject what everyone else is gobbling up happily? Well, obviously, the serpent's offer has been widely accepted recently — fact is, that temptation lies at the heart of our markets system — although it's hard to tell what the consequences might be. Is divine retribution lurking around the corner? Or is Eve a grown-up young lady perfectly capable of handling what she consumes? Might markets occasionally be completely wrong, morally, economically or otherwise? Who is responsible, who takes the hit, if the apple turns out rotten: Eve, the snake or the other critters of Greater Eden?
Then, of course, there's Adam, who's been whispering to Eve to munch the damned apple so they can move out of the cave (hey, this is my story). Biblically speaking, of course, the tiniest taste of the apple is enough to send the pair packing. In our fallen world, there are subtleties and gradations of possibility that are extremely difficult, for the serpent or Eve, to anticipate. Contrary to media moralists, who always know, the line between market good and evil is extremely hazy, even ambiguous. On one side of that shifting border, there's a world of trouble that only downside leverage can wreak. A few feet away, however, glistens the heavenly rewards of upside leverage. That's the game; that's the risk; that's the reward. No wonder we overeat at Thanksgiving.—Robert Teitelman
