Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [80]
Since Peloton liked bicycle analogies, this simplified one may help explain its problem with leverage. Suppose Peloton’s assets consist of a fleet of uninsured bikes originally worth $1 million purchased with $200,000 of its investors’ money and $800,000 of money borrowed from an investment bank. The investment bank says that at all times, Peloton must keep a balance of pledged assets—any assets—against the $800 million loan of $1 million in value. The extra $200,000 is margin collateral for the loan, a cushion for the investment bank making it unlikely that the investment bank will lose money. Initially, Peloton pledges the entire $1 million fleet of bikes as collateral for the $800,000 loan with the investment bank. If Peloton damaged 5 percent of its bikes due to rough riding, the assets would only be worth $950,000, and the bank would ask Peloton for another $50,000 in collateral to maintain the cushion. This is known as a margin call. If Peloton has enough cash on hand there is no problem. But if Peloton does not have enough cash (or liquidity) to meet the investment bank’s demand, it will have to liquidate the assets—sell the bicycles and unwind the position—to pay back the bank. Since the bikes are worth $950,000, the bank is paid its $800,000 in full, but the original investment of $200,000 is now only worth $150,000 for a 25 percent loss on the investors’ original capital.That’s the downside of leverage on fixed assets.
Now suppose that 25 percent of Peloton’s bikes round Dead Man’s Curve and skid off a steep cliff. One quarter, or $250,000, of the value of the fleet disappears. Peloton loses the investors’ entire original $200,000. More than that, if the bank repossesses the fleet and sells it—known as unwinding the position—it will not get back the full amount of the $800,000 since the $200,000 cash cushion the investors provided has been used up.The bank loses $50,000 and only gets back $750,000 of its original $800,000 loan. The investors lose 100 percent of their initial equity; the investors are wiped out. But the investment bank, the creditor, loses 6.25 percent of the original principal on its loan.
Bear Stearns’s shareholders and creditors had Peloton’s demise fresh in their minds when, a couple of weeks later, a confluence of events raised questions about Bear Stearns’s solvency. If Peloton were an investment bank, shareholders would be wiped out, and only the bond-holders and other creditors would recover some (or all) of the original amount of the debt.That is the power of leverage.When things are going your way, everyone is euphoric and gasping with delight. When things do not go your way, shareholders can be wiped out. The results can be dramatic and swift, and instead of gasping with delight, shareholders are gasping for air.
Funds that leverage risky debt assets without sufficient liquidity are doomed to collapse. Yet, time and again, bankers extended credit lines to funds using fully priced tranches of collateralized debt obligations, turning a blind eye to the unwind potential.
When we first met, Warren explained that he evaluates the underlying collateral: its probability of default and its probable recovery value. He avoids leverage and looks for a risk premium payment to cover potential losses and more. Peloton was about as far away from Warren Buffett’s philosophy as one can get.
Peloton’s problem with making leveraged bets on fixed-income securities was that they had little or no upside, and the securities underlying the ABX index were overpriced when Peloton put on the trade even though they had already dropped from par to prices ranging from 90 to 95.The downward price swing was due to irreversible damage in the underlying collateral, and unlike a manufacturing company, there is no source of future earnings to make up for the lost cash.9
In January 2008, when Beller accepted