3 Ways Leverage Could Cause the Next Financial Meltdown

The ability to borrow money is one of the hallmarks of a successful financial system. But when too many people take advantage of the leverage available from borrowing, it can set the stage for dramatic financial collapses, wreaking havoc on the same financial system that made leverage possible in the first place.

Increased levels of leverage are showing up in several parts of the economy. Below, you'll learn more about three key areas where leverage has become increasingly important, but first, let's take a quick look at why this boom in borrowing is taking place.

Simple supply and demand
The financial system and its interplay between financial institutions and ordinary businesses and individuals can seem ridiculously complicated at times. But the financial system basically acts like a market in which money is a commodity, and supply-and-demand considerations govern money's use as much as that of any other commodity.


So with the Federal Reserve and central banks around the world having promoted low interest rates for years, it's no surprise that borrowers who can take advantage of low financing costs are taking advantage. Let's take a look at some of the big players involved.

Money managers are betting bigger
One troubling trend comes from money managers, which are taking on more leveraged bets in an effort to increase returns. In an effort to squeeze more yield from fixed-income investments, managers are turning to collateralized-loan obligations, borrowing money at relatively low rates in order to invest in higher-rate risky debt. As long as that higher-risk debt doesn't default, then the strategy locks in big profits for fund investors.

But what inevitably happens is that as positive returns entice more investors to copy the strategy, the quality of available debt degrades, raising the risk of default. Eventually, a debt default usually leads to a stampede for the exits, with asset values plunging as certain loans are exposed as toxic assets. At that point, undoing all the leverage becomes nearly impossible without massive disruptions to the financial system.

Mortgage REITs are still growing
Another area where leverage has led to big returns is in the mortgage REIT arena. Thanks to low borrowing rates, mortgage REITs have used mortgage-backed debt in much the same way that money managers are using other forms of loans, and balance sheets have soared in size. Industry leader Annaly Capital now sports $117 billion in liabilities compared to less than $60 billion three years ago. American Capital Agency has ramped up even more extensively, with its liabilities having risen nearly sevenfold in just two years.

Even more alarming is the pace at which newer entrants to the space have become huge players. ARMOUR Residential has gone from just $100 million in liabilities three years ago to more than $18.5 billion at the end of 2012. Invesco Mortgage Capital , meanwhile, has had liabilities jump 25 times since 2009 to more than $16 billion.

Most mortgage REITs have swaps in place to try to hedge interest-rate risk. But if short-term rates start to rise and spreads narrow, tighter credit markets could make leverage a lot harder to maintain, letting the air out of the dividend-producing balloon that mortgage REITs have given their shareholders.

Margin loans are on the rise
In any bull market, impatient investors start to borrow to try to reap greater rewards. Low rates have helped make margin debt -- where investors borrow against their stock holdings -- cheaper than ever, and margin levels are back near all-time highs.

As long as stocks rise, margin borrowers make out like bandits. But when markets fall, forced sales from margin loans exacerbate the decline, which can create a negative feedback loop.

Steer clear
The recent modest rise in interest rates has given investors a glimpse of what could happen in a leverage-driven world when higher rates truly start to take hold. As tempting as leveraged investments can be in good times, the risk involved makes them suitable only for those who know exactly what they're doing and what can happen when things go wrong.

There's no question Annaly Capital's double-digit dividend is eye-catching. But can investors count on that payout sticking around? With the Federal Reserve keeping interest rates at historically low levels, Annaly has had to scramble to defend its bottom line. In The Motley Fool's premium research report on Annaly, senior analysts Ilan Moscovitz and Matt Koppenheffer uncover the key challenges the company faces and divulge three reasons investors may consider buying it. Simply click here now to claim your copy today!

The article 3 Ways Leverage Could Cause the Next Financial Meltdown originally appeared on Fool.com.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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