INVESTING: Process of deleveraging creating lots of carnage

The deleveraging of America continues with unpleasant consequences for consumers and investors who are overextended. One problem with a mass deleveraging is that the repeated selling of an asset to repay a debt burden leads to further declines in the price of that asset. That, in turn, forces others to sell, as the lower asset values no longer support their debt obligations. It’s otherwise known as a vicious circle.

The Federal Reserve, the U.S. Treasury and Congress are scrambling to come up with plans to stem the skyrocketing home-foreclosure rate. Ideas floated include lowering contractual mortgage interest rates, or even forgiving a portion of the mortgage principal balance-in effect creating an equity cushion for homeowners on the verge of default.

None of these solutions would be easy to implement. And they certainly aren’t palatable to the banks that would take the hit, many of which already are dealing with huge losses in their security portfolios.

States and municipalities also are being forced to deal with problems created by this deleveraging. Municipal bondholders are balking at reinvesting in “auction rate” securities, which are really long-term bonds that function like short-term debt via periodic auctions.

About 70 percent of these auctions are now failing, which leaves a bondholder with an illiquid security. For the municipality, its borrowing costs can rise dramatically depending on the terms of the bond contract. In one dramatic case, bonds for the Port Authority of New York had interest rates reset from 4.7 percent to 20 percent after an auction failed.

To deal with this problem, many municipalities are preparing to issue up to $166 billion of new bonds, in what one observer described as a “supply tsunami.”

The deleveraging drama played out spectacularly with the recent failure of the London-based Peloton Partners hedge fund. The $3 billion fund had just logged a wallet-fattening 87-percent return in 2007. Now, in merely the first 45 days of 2008, Peloton may be worth nothing.

Peloton, like many hedge funds, used borrowed money to leverage portfolio holdings. During 2007, the fund’s managers correctly bet that subprime mortgages would decline in value. In addition to the gains earned by their investors, Peloton doled out tens of millions of dollars in performance fees to its managers for these investment results.

The end for Peloton came with a new bet by the fund that higher-quality mortgages would rise in value. That promptly proved disastrous after those securities dropped 15 percent this year. The investment banks that lent Peloton the money to leverage its portfolio began calling back that money in one giant margin call, which Peloton could not meet.

A 15-percent decline normally is not catastrophic, but it can be when combined with heavy leverage.

It all unraveled quickly. Yet this, in a nutshell, is what ails the markets today-leveraged, illiquid assets in a slowing economy.