Fisher Investments MarketMinder: Pawning Stocks

Originally published by Fisher Investments MarketMinder on: 3/12/2008

Picture your average musician shuffling into a pawn shop with guitar in hand (maybe that prized sunburst Les Paul), taking a short-term loan to pay the rent when the credit card is maxed out and the paycheck from the last big gig is still in the mail.  It’s not fun to have to trade the trusty axe for cash, but the bills must be paid.

It’s easy to imagine some financial institutions in the same situation.

You may have recently heard the term “de-leveraging.” What exactly is de-leveraging?  It’s the process undertaken to reduce a company's financial leverage. Financial leverage (aka debt relative to equity) is the very basis for a financial institution to generate profits, but if it falls outside certain bounds set by regulators, it needs to be reduced back to “acceptable” levels in short order.

Many big financial institutions invested heavily in relatively obscure vehicles like mortgage-backed securities in recent years.  Following deterioration in their creditworthiness, the market for these securities is almost barren today.  Even small amounts of selling have lead to massive price drops due to a scarcity of bidders.  As the market value (marked-to-market sometimes based on guesswork) of these instruments decline, the leverage ratio of the investor goes up.  In the case of banks, brokers and insurance companies, regulatory requirements mandate leverage be reduced, forcing them to sell any available liquid assets.  In the case of hedge funds, margin calls or investor withdrawals can force the same.  In many instances, stocks have been the best candidate for selling, since they’re more liquid and less useful for capital adequacy requirements than other securities. The titans of Wall Street pawning their stocks to pay the rent! How sad . . . .

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