William Wallace. Yes we all know him - Braveheart fame. Great movie - enchanting music. And the movie talks about the Battle of Falkirk. So why do I want to talk about it?
Highly Leveraged!
Yes my dear friends William Wallace's army was leveraged more than he could handle - and he did not anticipate the market (or in his case - his allies) to turn on him.
What was that? Step back a little? OK so let's see if I make any sense at all.
What is 'Leverage'?
In a very general sense 'Leverage' means - to reinvest debt for a greater return than the cost of borrowing.
So how was Wallace highly leveraged? He depended on allies (borrowed forces), which he wanted to reinvest in the battle against King Edward I (Longshanks). If he won he would have achieved a greater return than the what he invested in having allies swear allegiance to him.
Oh but the mind is a 'tabula rasa' - "Et Tu Locke!" - Wallace must have muttered for I would chance to believe he did not know anything about empiricism. I digress - What I meant was that Wallace was 'blank' (tabula rasa = blank slate or with no experience - coined by Locke) to the experience whatsoever of working with leveraged positions.
Wallace's newly befriended allies kicked his behind and instead swore allegiance to King Edward I in return for nobility. Inevitably, Wallace lost the battle of Falkirk. In being dependent - or in our language - leveraged - he was exposed to:
1. His allies giving him the middle-finger salute.
2. His own men/forces being outnumbered and outflanked by Edward's army - and eventually slaughtered.
So let me try to make sense of this in terms that are closer home for us finance junkies.
I'm talking about positions where firms like LTCM (my recent obsession) were highly leveraged. LTCM used debt/loans/credit extensions to finance their strategies around derivatives/emerging markets/IR swaps/volatility etc. Their exposure in leveraged positions was twofold:
a) Exposure to risk in the investment/arbitrage opportunity itself.
b) Exposure to risk in the investment/arbitrage positions and having to repay loans after they booked losses on their positions.
This is but the simplest explanation and 'leverage' is not the criminal here - nor the crime. In fact, leverage is important for market participants to trade actively. However, keeping in mind the Credit Exposure and mark-to-market principles - a highly leveraged position may be extremely risky in case of a very volatile market or even a loss of liquidity in the market.
I have a very skewed perception of analogy. Inspite of the insanity and almost incoherent post above - I hope I have been able to manifest William Wallace and the Battle of Falkirk into the rabid and complex world of debt/leverage and most importantly - structured finance - which I will delve into soon after I get some sleep and someone to make me breakfast in the morning. Goodnight you princes of loans, you kings of subprime.
I can't wait for all you warriors out there to leave me hate-comments for this post.
An aside: I can't believe the Tigers beat Seminoles! "Riverboat Gambler" - when will you catch up with Joe Paterno? I believe in you. Go Noles!
