Not all leverage is created equal. This is obvious from the lender side, because lending over different terms means different exposure to duration—if you make a floating-rate loan or continuously roll over a series of short-term loans, you run the risk that rates will decline and cut your income; dodge that risk by locking in rates over a long period, and the value of your credit asset gets more sensitive to rates.

Borrowers think about this a bit differently, because most of them aren't so much setting the terms as choosing from a menu, and that menu of options is partly a market-driven one and partly the result of a long series of legislative and business compromises. Consider the different forms of leverage available to someone who wants to be a levered speculator in equities and someone who wants to be a levered speculator in housing. In both cases, they can get some cheap borrowed money to juice returns, but it takes different forms. A stock market speculator is taking out a temporary loan, which is effectively renewed continuously every time prices change. If they're temporarily not in a position to fully collateralize the loan, their lender, i.e. their broker, can start chopping away positions until they have sufficient collateral. If the same speculator tries to get their leverage through futures rather than margin loans, the accounting details are different but the process is fundamentally similar: they get leverage, and if the market moves against them, they're out. The good news is that this means a levered speculator who continuously rebalances in order to keep their leverage is automatically running a momentum/trend-following strategy and picking up a bit of extra return. The bad news is that another way to phrase this is that they're systematically buying high and selling low.

A homeowner, by contrast, isn't continuously rebalancing. In the US, at least, they're typically locking in a fixed payment over a thirty-year period, with an option to refinance. This is an incredibly one-sided arrangement that wouldn't exist in anything remotely like its current form if it weren't promoted and subsidized by policy. It means that the speculator in question can be completely underwater on their loan and still not get hit with a margin call.¹ So they can ride out the volatility nicely on their own. Housing alone is not a great investment, but thanks to financial engineering it's much better than it otherwise would be.

For many investors, the cyclical nature of capital availability is just a fact of life. It's much easier to raise a lot of money to place levered bets on stocks when they're expensive but efficiently priced relative to one another, because the process of stocks going up and getting more efficiently priced produces good track records for the investors involved. And it's basically impossible to raise substantial funds when the market crashes and parts of it crash far harder than they should, and also quite difficult to get prime brokers excited about extending lots of credit in that situation. Some funds can even end up in a death spiral, where losses lead to redemptions and forced liquidations, which lead to more losses. It's slower-paced than a bank run or a purely leverage-driven collapse, but that's not all upside: it means that at exactly the time when the fund's managers should be focused on cutting the bets that aren't working and doubling down on the biggest opportunities, they're spending a lot of their day talking limited partners off a ledge.

So, they're responding: the biggest funds are giving their investors lower fees if they lock up their capital for longer periods; they want the kind of capital they could have raised in 2007 to support the trades they want to make in March of 2009. Other trading firms have issued bonds and term loans. They know that lenders who are in a position to stop lending when liquidity is scarce and risks are high will do so, and they're preempting them with some secure capital.²

Over time, strategies that generate alpha get commoditized, and the alpha turns into beta. This is an unavoidable consequence of competitive markets whose participants are always implicitly sharing some information every time they trade. One consequence of that is that for investors, a growing source of comparative advantage is the other side of the balance sheet—if your competitors can run similar strategies, or can poach your own people, having good strategies becomes a weaker source of edge—but being able to produce higher absolute returns from running a given strategy is a differentiator. In an environment where strategies have a short half-life, a big source of returns is being able to run those strategies at scale when competitors can't.

Read More in The Diff

We've talked about both sides of the balance sheet in The Diff many times. Good reads on this include:

• A review of Advanced Portfolio Management ($), a great book on how funds structure their bets and why some of their seemingly perverse strategies—like forcing traders to exit positions as soon as they start losing money—actually make sense.

• The biggest multistrategy funds are increasingly allocating their capital to other funds ($).

• Finance is fundamentally hard to decentralize, because systematic lending will always provide capital to people who can't get it based on a more qualitative assessment.

And correlations go to 1 in a crisis because a bear market in everything is just a bull market in dollars.

Join the discussion!

1  There are some obvious differences that make this work, of course. The transaction cost for selling out someone's Gamestop position are a lot lower than selling out their suburban four-bedroom, and because of that there's a form of invisible collateral that banks can't use to recoup the cost if the homeowner just hands them keys and leaves, but which reduces the odds of that happening: the transaction cost for exiting the loan and leaving the house is high for the homeowner, too!

2  One way to think about this is that selling bonds is a substitute for buying puts. Prop traders have a higher return than other investors do from buying out-of-the-money puts, because those put them in a position to continue making a market during a crash, when volume is high and spreads are, too. Since their revenue opportunity is very roughly a function of volume times spread, returns go nonlinear during a market meltdown, so it's good to have extra liquidity right around then. It also gives firms enough room to do favors for counterparties at a time when those counterparties really need a favor or two. Doing your hedging through an impersonal centrally-cleared venue and using it to do over-the-counter transactions is a good way to buy reputational capital when it's cheap.