The importance of not leveraging too much
Posted in Finance on November 3rd, 2008 by Sacha PeterWhen the markets are stable, and incomes are increasing along with asset values, people tend to reach out a little too far and eventually they will get nailed.
You will start to see that with a lot of residential real estate mortgages coming up – not necessarily residents, but speculative investors will get hit badly. Most people, if they owned a single residence, will make necessary budget allocations to ensure the mortgage keeps getting paid off, but people that have invested in multiple condominium units will face the grim decision of either having to sell off the units at a loss, or decide to rent out the units and leak cash for the years ahead (this is even assuming that the property values will increase within the 5 year time frame that most speculators suddenly develop when they can’t flip the properties for a quick profit).
You also see this happening in the stock market – people confident of $200 oil over-invest in one particular sector and they get hit. This happens to small investors and large investors – the most tragic example was when the CEO of Chesapeake Energy (a major energy company in the US) was forced to sell most of his holdings in his own company. You can see from the insider transactions that it amounted to about 31.5 million shares, or about 5.4% of the company. Incidentially it took the company’s stock price down from about $20 to $12 as institutions scrambled to pick up cheap shares. You can easily see it in the following stock chart:
Instead of receiving $620 million for an orderly liquidation of stock, he received about $400 million, so the price of liquidity was about $220 million. So when people are forced to make financial decisions, they will have to pay the price for doing so.
The CEO statement was the following:
I am very disappointed to have been required to sell substantially all of my shares of Chesapeake. These involuntary and unexpected sales were precipitated by the extraordinary circumstances of the worldwide financial crisis. In no way do these sales reflect my view of the company’s financial position or my view of Chesapeake’s future performance potential. I have been the company’s largest individual shareholder for the past three years and frequently purchased additional shares of stock on margin as an expression of my complete confidence in the value of the company’s strategy and assets. My confidence in Chesapeake remains undiminished, and I look forward to rebuilding my ownership position in the company in the months and years ahead.
“Margin” is financial lingo for “loaned money”. The only way this person is going to be able to afford “rebuilding his ownership position” in the company is through stock option grants and salaries/bonuses, both of which will be paid for by the shareholders of the company.
Some might think this would represent the best buying opportunity – cashing in on the misfortune of somebody’s financial errors. Unfortunately in the case of Chesapeake, the last company I would want to invest in would have a CEO that got caught by a massive forced liquidation like this one – first of all, his incentive to perform well has just disappeared (having no more equity stake in the company) and secondly, one would wonder whether he’d make a similar miscalculation with the company’s finances.
That said, the company is in good financial shape and has excellent energy assets, but in the hands of a reckless leader, that value can easily be destroyed in short order – just like the hole in the wallet of the aforementioned CEO.
Now, I don’t have $400 million dollars to worry about, but in the much more microscopic realm of personal finance, the important rule is that excessive leverage (in the form of debt) is very dangerous because it forces people to do stupid things. Your relative performance will suffer in periods of good times, but it will be more than made up for when the over-leveraged people get liquidated in circumstances like these.