There’s widespread recognition that leverage has been encouraged to grow exponentially in recent years; what’s less well understood is the fact that it’s a new kind of leverage. As Will Rogers drolly observed: “You can't say that civilization don't advance; for in every war they kill you a new way.”

Traditional leverage -- borrowing and lending -- remains important, to be sure - particularly in the form of collateralized lending, in which holders sell assets against the agreement to re-purchase them later. The borrower posts an initial margin, or “haircut” (a small sum of money), and promises to post more cash if the value of the asset declines.

Favorable regulatory rules, an optimistic view of liquidity (the collateral must be sold if the borrower fails to pay) and faith in the models used to set the initial margin are driving aggressive use of collateral, increasing available liquidity and leverage. The growth of hedge funds and prime brokers have further fueled explosive growth in collateral and expanded the range of assets against which funding can be raised, complementing the long-established government bond repo markets.

Derivatives have contributed to the sharp rise in leverage in two ways: the “derivatization” of lending and embedded loss leverage. Total return swap (TRS) is an example of derivatization: Under the terms of the swap, a trader can purchase $10 million worth of shares, which would ordinarily require cash, by paying only the cost of holding them (price decreases and the dealer’s funding cost). TRS requires no funds other than any collateral required by the dealer - substantially less than the $10 million at which the shares are valued. The trader therefore has the same exposure, and receives the same dividends, that he would if he bought the shares - but leverage increases his return.

Total Return Swap Structure

Click to enlarge

In effect, the loan to the investor has been repackaged as a derivative transaction, which enhances the leverage.

In embedded loss leverage, you increase your potential gain or loss for a given event. Two examples -- digital options (a common form of exotic derivative) and credit leverage in collateralized debt obligations (“CDOs”) -- illustrate this idea.

Under a normal option to buy shares at $100 (the strike), the gain is equal to the share price at the time of expiry minus $100 (assuming the price has increased). If the share price is $110, then the purchaser of the option makes $10 and the seller loses $10. In a digital or binary option, however, the parties might agree that the option payoff will be $25, irrespective of whether the final share price is $100.01 or $300.

In effect, for a relatively small move in the share price (from $100 to $100.01), the buyer gains and the seller loses $25 (25% of the value of the share) - effectively embedding tremendous sensitivity -- leverage -- to price movements. Declining market volatility in recent years has meant that traders generate larger premiums by increasing the size of their wagers.

In credit markets, CDOs provide loss leverage. In a $1 billion CDO portfolio made up of $10 million exposure to 100 corporations, the equity investor assumes the first 2% ($20 million) of the portfolio’s losses. Assuming a $6 million loss if any corporation defaults (since recovery rates are 40%), the equity investor takes on the risk of the first three defaults. In contrast, three defaults in a $20 million portfolio ($200,000 per corporation) would result in the investor losing $0.36 million ($120,000 per company). For three losses, the equity tranche investor’s leverage to defaults is 56 times (if there were 3 losses, then the investor loses the entire $20 million invested in the CDO equity against $0.36 million in the diversified portfolio). By reducing the “tranche width” (the size of the equity tranche), the credit leverage can be increased over 83 times!

Increasing the amount of potential gain or loss for a given event is now routinely used to create leverage, but these techniques are poorly understood. They don’t show up in traditional leverage measurements, but the additional liquidity and leverage create complex chains of risk and moral hazard in markets - chains which may prove problematic when prices correct.

It’s another unknown unknown of modern markets: As Wells Fargo (WFC) CEO John Stumpf observed: “It’s puzzling why bankers have come up with these new ways to lose money when the old ways were working so well.