What the Hell Is That?!? (Vol. 1)

For the next week... I'll break down all the things that make this financial system both fascinating and dangerous...

Editor’s Note: I’ll be on the road, so to streamline my editorial, I’m going to focus on one single topic… written largely stream of consciousness… to define the things we discuss and why they are so important…

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Dear Fellow Traveler,

Over the past week, I've discussed “leverage.”

This word usually only surfaces in the media when something bad has already happened.

Reporters mention it when hedge funds blow up. Regulators warn about it in reports nobody reads.

But what the hell IS leverage?

Let me explain.

Can’t Read My… Poker Face

Right now… you're at a poker table with $100 in your pocket.

You could play it safe and only bet what you have.

Or you could convince your drunk friend to lend you $400 more.

Now you're playing with $500 total…

If you win the hand, you keep all the winnings.

If you lose, well... you still owe that $400 you borrowed.

That's leverage in a nutshell.

You're using borrowed money to amplify your bets.

When you win, you win big.

When you lose, you lose bigger.

The financial world operates similarly to this poker game, except that instead of cards, people bet on stocks, bonds, and other assets.

For example, if you think Apple stock is going up.

You have $1,000 to invest.

Without leverage, you buy $1,000 worth of Apple stock.

If Apple goes up 10%, you make $100.

That’s not life-changing money, but you’ve got $100 extra bucks in your pocket - minus whatever the government takes from you…

With leverage, your broker lets you borrow another $1,000.

Now you can buy $2,000 worth of Apple stock with your original $1,000.

This is called "2-to-1 leverage" because you control $2 for every $1 you’ve got.

When Apple goes up 10%, you make $200 instead of $100. You doubled your gains…

However, if Apple's stock price drops 10%, you lose $200.

That's 20% of your original money gone in one trade.

The math gets scary fast.

With 5-to-1 leverage, a 20% drop in Apple would wipe out your entire $1,000.

You'd still owe the broker money on top of losing everything you started with.

Where Can I Get This Borrowed Money?

I met Michael Lewis three years ago at a conference.

One of the things he always bemoaned is the fact that he wrote his book “Liar’s Poker” as a warning about Wall Street.

However, he has come to find that many other people have used it as a “how-to” guide.

So… don’t make me regret explaining leverage… okay?

Banks and brokers are happy to lend money for these bets because they charge interest, and they hold your investments as collateral.

It's like a pawn shop for stocks.

The most basic way is called a margin loan.

Your broker looks at your portfolio..,

Then, because he knows you’re probably a gambler, he says: "I'll lend you money to buy more stocks, and if you can't pay us back, we'll just sell your stocks to cover what you owe."

That’s pretty basic.

But the going gets weird when we start cranking up the leverage through a topic I’ll explain this weekend.

I’m talking about what’s called a "repo agreement.”

This may sound complicated, but it's essentially just overnight borrowing.

You sell your Treasury bills or other safe collateral to a bank and promise to buy them back tomorrow for a slight increase in price.

This gives you cash to buy more stocks today… (or to roll existing trades, depending on the fund’s strategy.)

Then tomorrow you do it again.

And again.

Each time you're piling on more borrowed money.

Think of it like using credit cards to pay off other credit cards, except instead of buying groceries, you're buying stocks.

Now… THIS IS IMPORTANT

Here's where it gets tricky…

What I’m about to explain is how hedge funds trick everyone, including themselves.

Let's go back to our poker analogy.

Say you're at two different poker tables at the same time.

At table one, you bet $300 that you'll win.

At table two, you bet $200 that your opponent will win.

If we count your total exposure, you've got $500 in bets riding on poker games.

But if we count your net exposure, you're only risking $100 because one bet partially cancels out the other.

Wall Street refers to these as "gross leverage" versus "net leverage."

Gross leverage counts everything you're exposed to, period.

Net leverage only counts your actual directional bet after you subtract out the hedges.

So, a hedge fund might tell you it has only 3-to-1 net leverage…

Doesn’t sound dangerous… right?

What they don't mention is that they have a 20-to-1 gross leverage ratio because they're making numerous offsetting bets and have borrowed a ton of money...

This sounds smart until you realize that in a crisis, all bets tend to go the same direction.

DOWN… And fast.

When bonds and stocks fall at the same time… things get ugly…

Your "hedge" at table two doesn't help when both poker games get raided by a stick up crew...

How to Turn $100 Million into a Four-Sigma Event

Let me demonstrate how this works in the real world, using the exact same tools that any hedge fund can access today.

Say you start with $100 million.

That's your poker bankroll.

First, you take $60 million and buy the safest possible investment: U.S. Treasury bills.

These are basically IOUs from the U.S. government.

Everyone thinks they're safe collateral.

Then the magic happens.

You take those Treasury bills to a bank and say you need money for the Treasury bills as collateral.

The bank gives you $59.4 million cash and holds your T-bills.

You use that cash to buy more Treasury bills.

Then you go to the bank again and repeat the process.

It's like taking your car to a pawn shop, getting cash, buying another car, taking that car to another pawn shop, getting more cash, and so on.

Except instead of cars, it's Treasury bills, and instead of pawn shops, it's some of the biggest banks on Wall Street.

After doing this, you end up with a massive amount of leverage.

Now you take your remaining $40 million and buy stocks.

But not just any stocks - you use something called "portfolio margin" which lets you borrow way more money than normal margin loans.

Instead of the usual 2-to-1 leverage, maybe you can get about 6.7-to-1 leverage if you buy the right mix of stocks (based on historical volatility and correlation figures that seem to always break down under stress.)

So your $40 million becomes a massive amount of stock positions… well in the hundreds of millions.

But wait, there's more.

You can sell "covered calls" on those stocks, which means you sell someone the right to buy your stocks at a higher price.

They pay you about $10 million for this right.

You free up $10 million through Treasury recycling or repo trades. You buy call options on other stocks.

Dizzy yet?

When you add it all up, your $100 million ballooned over $1 billion in exposure…

However, here's the kicker - if your positions are structured as hedges, your net leverage might only appear to be 3-to-1 or 4-to-1 on paper.

You appear to be a well-managed conservative fund.

You’re not…

When Conservative Becomes A Problem

This is where the story gets scary.

In normal times, this whole contraption works beautifully.

Your Treasury positions provide steady returns.

Your stock positions hedge against each other.

Your options decay predictably.

You're making nice, steady returns with what appears to be modest risk.

Then something like March 2020 happens.

Suddenly, Treasury markets freeze up.

The "safest" investments in the world become impossible to trade. Your stock hedges don't work because everything crashes together. Your options become worthless overnight.

Remember our poker analogy?

If Omar Little raids both poker games at the same time, and suddenly your hedge at table two doesn't help you at all.

Your 3-to-1 net leverage has just become 18-to-1 leverage, pointed straight down.

The banks that lent you money start calling.

They want their money back NOW.

But you can't sell your positions because the markets are frozen.

So, you're forced to sell whatever you can at fire-sale prices, which drives prices down even further, triggering more margin calls, which in turn force more selling.

This exact scenario has played out repeatedly.

Long-Term Capital Management in 1998. Hundreds of hedge funds in 2008.

The repo crisis in 2019. The Treasury market freeze in March 2020.

And it happened again in April 2025.

Why You Should Care About This

You might be thinking "I don't run a hedge fund."

But here's the thing - as an investor in America… you technically do…

This affects everyone.

Your retirement fund probably invests with hedge funds using these exact strategies.

The banks lending this money are the same banks that hold your deposits.

When these leverage machines break down, they don't just hurt hedge fund managers.

They can freeze up entire markets.

When that happens, guess who comes to the rescue?

The Federal Reserve (and you).

They print money and buy up all the stuff nobody else wants to buy.

They bail out the system.

And who ultimately pays for that?

You.

The Real Danger

The thing is… the problem isn't leverage itself.

Leverage is just a tool, like a chainsaw.

In skilled hands, it's incredibly useful.

In the wrong hands, it's deadly.

The danger is when everyone uses similar leverage strategies, borrows from the same banks, and makes bets on the same popular investments.

When something goes wrong, everyone tries to exit at the same time.

Your "reasonable" leverage becomes unreasonable very quickly.

Think of it like a crowded movie theater.

Having exits is great.

Having emergency exits is smart planning.

But when someone yells "fire" and everyone rushes for the same exit at the same time, people get trampled.

The next financial crisis won't come from one rogue fund using 100-to-1 leverage.

It'll come from hundreds of funds using "sensible" 15-to-20-to-1 leverage that all goes wrong at the same time.

And when that happens, the Fed will fire up the money printer to clean up the mess.

Again.

The leverage machine continues because it's profitable for everyone involved.

Hedge funds need leverage to generate returns.

Banks need the fee income.

Regulators can claim they've imposed safety rules.

Everyone wins until the music stops.

When it does stop, the Federal Reserve and ultimately taxpayers end up holding the bag.

Stay positive,

Garrett Baldwin

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Next up in "What the Hell is That...": Derivatives…