3. Hidden leverage: the kind you never asked for

Risk 4: Leverage

Many of the investors who are ruined by leverage never ticked a box saying leverage. They signed no credit agreement, they never saw a line of interest on their statement and they would have sworn in good faith that they were trading with their own money alone. Leverage is not a product you sign up for: it is a property of your balance sheet as a whole.

It is a ratio, not a box

Go back to the definition in the first module: multiple equals exposure divided by capital. Nothing in that definition mentions a loan, a broker or any particular product. If you have 100,000 euros of net worth and the market value of what moves with you comes to 250,000, you are leveraged 2.5 times, regardless of the route by which you got there.

Out of that idea come two measures worth telling apart. Net exposure adds the long positions and subtracts the short ones: it says how much you are affected by the market rising or falling. Gross exposure adds the absolute values of all of them: it says how much you have at stake. A portfolio with 100% net exposure and 300% gross looks prudent in the first number and is nothing of the sort in the second, because three different positions can be wrong at the same time.

Where the leverage that carries no label lives

• Futures. A contract with a notional of 45,000 euros exposes that entire amount even if you have only put down 4,000 of margin. If your account holds 200,000 euros, that contract is a small position; if it holds 30,000, you are at 1.5 times. The contract does not define your multiple: your net worth does.
• Bought options. You pay a capped premium, but the effective directional exposure can be many times that premium: with a sensitivity to the underlying of one half on a notional of 20,000 euros, you are carrying some 10,000 having paid a few hundred. The loss is indeed limited; the exposure is not.
• Short positions with the cash reinvested. Selling short generates cash. If you use it to buy more, your gross exposure shoots up even though the net figure looks contained.
• Products with debt inside them. Funds that track more than they hold in cash, structured notes with a multiplied participation, listed property vehicles with debt at 40% or 50% of their assets, or private equity where the debt lives inside the companies bought.
• The mortgage while you invest. It is the most invisible of the lot and few people look at it.

The household balance sheet: the mortgage counts

Somebody with 60,000 euros invested in shares, a home worth 300,000 and 240,000 outstanding on the mortgage has a net worth of 120,000 euros and assets of 360,000. His balance-sheet multiple is 3, even though his broker demands not a single euro of collateral and he says in all sincerity that he uses no leverage.

The qualification matters and it has to be given in full: an ordinary residential mortgage is not callable against your portfolio, it generally carries a lower rate and it has a long, predictable schedule. It is not the same thing as a margin account, not remotely, and the next module explains why that difference changes almost everything. But the exposure is amplified all the same: if the home falls 20%, your net worth falls by 60,000 euros, half of what you had.

The companies in your portfolio come leveraged from the factory

Here is the leverage you carry even if your portfolio is cash equities with no debt at all. Imagine a company with operating assets valued at 1,000 million, debt of 700 and therefore equity of 300. The shareholder owns the difference, and the debt does not move when the business goes worse.

If the value of the assets falls 15%, 150 million is lost. The 700 of debt is still 700, so the equity goes from 300 to 150: the shareholder has lost half. A 30% fall in the assets wipes it out completely. The shareholder of a heavily indebted company holds, without knowing it, a position leveraged more than three times on the business.

This explains why in every credit crisis there are whole sectors (airlines, property developers, telecoms with loaded balance sheets, companies bought with debt) that fall 70% while the index falls 25%. It is not that their business got three times worse. It is that their capital structure multiplied the blow.

How to measure your own without any tools

• Add up the market value of everything that moves with you, using the notional of futures and the effective exposure of options, not the premiums.
• Add up the debt: margin, consumer credit, mortgage and any product that finances a purchase.
• Divide the first by your real net worth. That number, and not the names of the products, is your multiple.
• Look inside the funds: if the prospectus allows exposure above net assets, that exposure is yours.
• Estimate the debt of the companies you own: a portfolio concentrated in indebted companies carries an implicit multiple even if you owe nothing.

Case study: Archegos, March 2021

Archegos Capital Management was Bill Hwang's family office, without the disclosure obligations of a fund open to the public. It built enormous, highly concentrated positions in a handful of shares, but not by buying them: through total return swaps with several investment banks. Formally, the owner of the shares was each bank; economically, the exposure belonged to Archegos.

Here is the part that matters. Each lender saw its own exposure, demanded reasonable collateral for it and had no way of seeing the total against the same client. Consolidated gross exposure, according to later reconstructions, reached tens of billions of dollars on a far smaller capital base. When the shares fell in March 2021, the margin calls arrived all at once and the capital evaporated in days.

The lenders' losses were public: Credit Suisse acknowledged around 5.5 billion dollars and Nomura put its impact at around 2.9 billion. Each of them measured its own slice properly. Nobody measured the whole. And leverage only means anything when it is measured on the total.