Why does Warren Buffet think that "leverage is a weapon of mass destruction in the economic sense"?
Did someone say Lehman Brothers? Or are you too young to remember the 2008 financial meltdown?
If you didn't get a chance to read the primer on how the centralized derivatives issuers make their money, please read here. If you already read it, you already formed the base for what I am about to share next with you.
Remember, the most important element that derivatives issuers need to address in order to make money is to manage their own counterparty risk from exposure through the derivative contracts that they have sold.
Different issuers follow different protocols for managing this exposure risk. Some are disciplined and try to balance their risk as much as possible along a single underlying asset. Others will try and manage a bit more complex risk matrix on a portfolio of underlying assets that are similar. For example, all derivatives on all stock indexes. In the end regardless of how disciplined they are in keeping many narrow risk silos or if they prefer to pile up their risks in a large bag of similar assets, they all need to be good at managing these risks.
Its when they fail to manage the risk exposure from a large number of highly leveraged trades that may go against the position they took, that the whole institution feels the pain.
This failure to manage their risk exposure can occur for various reasons based on timing, overarching blind beliefs or simply contractual obligations. Let's say the issuer has an automated portal for selling the derivative contract copies and they put all contracts up for sale on a seemingly stable day. Then a news breaks that simply puts all traders in the most positive frame of mind and before the system could react a huge amount of call options are picked up by the market. The issuer then has very limited ability to balance a risk in the short term as no one is willing to buy a put or downside contract regardless of how enticing the issuer tries to make it.
In another situation it may just well be that an entire institution has a very high sense of conviction in going after a future state of the economy that they put a very confidence level on. In the case of Lehman this was based on their conviction that the sub-prime swaps and contracts will hold their own for a considerable amount of time and that they have all the information they needed to make huge profits from seemingly highly leveraged trades. In this situation it is quite possible that a seemingly impossible future state becomes a reality, and the institute is caught up on the wrong side of the trade, which they simply cannot fill with the money at hand. It is when a systemic failure like this occurs that the centralized issuer cannot honour the contracts they sold due to lack of liquidity pools that the organisation though they had but have vanished due to higher risk and then the organisation collapses. Get enough number of such centralized institutes in the same position and it is likely that an entire economy could collapse.
Its not just banks or derivative issuers that get into such positions. Remember when Leicester won the English Premier League and a bunch of sports betting providers were caught out by the high odds of 20000/1 that they had put out for Leicester? There weren't enough punters that took up that bet, else it is possible that one or more of the betting houses may well have collapsed.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
