Lesson 1 of 25 · 8 min

How to read a deleveraging episode: the sequence, not the villain

Every collapse has the same skeleton, and the last step is always a sale that deepens the fall.

A deleveraging episode is usually retold as a story about someone who got something wrong. That retelling is the least useful part of it. Every episode in this track has the same skeleton, and the skeleton is arithmetic: a position, a financing arrangement, a price move, a collateral demand with a deadline, and a cure that required selling the thing that was falling.

The episodes here run from 1993 to 2022. They differ in instrument, in venue and in scale — a single industrial hedge, a fund with a balance sheet reported in the hundreds of billions, a retail account with a few thousand in it. What repeats is the order of events. Once the order is visible, a new episode stops being a surprise and becomes a variation.

Two conventions hold throughout. Reported magnitudes are given as rounded approximations, labelled as what was widely reported at the time, because a precise figure is often contested and a rounded one rarely is. Every worked example is invented by contrast: an explicitly illustrative, scaled-down version of the mechanism, small enough to follow line by line, and never a claim about the reported amount.

A third convention is about naming. The entity at the centre of an episode is named where that is public record. Firms that financed it, cleared for it or lent to it are not, because a counterparty's identity adds nothing to the mechanism. No individual is named. Nothing here describes what anyone wanted, believed or deserved; the subject is positions, prices, dates and outcomes.

The five steps, in the order they occur in every episode that follows:

A position that is concentrated, correlated, or both.
Financing whose full size is visible to at most one party.
A price move that is ordinary by the standards of the asset.
A collateral demand on a deadline set by somebody else.
A cure that requires selling into the move that caused it.

The villain is optional and usually decorative. The sequence is not. Remove any one of the five steps and the episode does not occur.

Key terms

Deleveraging: Reducing borrowing relative to assets. Done voluntarily it is a decision; done under a collateral demand it is a sale at whatever price exists that day.
Forced sale: A sale whose size and timing are set by a collateral requirement rather than by the holder. Track 1 lesson 9 works through why it cures less than it raises.
Illustrative figure: An invented number used to make a mechanism followable. Every figure in this track's worked examples is one, and none is a reported amount.

Worked example

The five steps, with invented figures

Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts of any episode. A position of $2,400,000 funded with $1,800,000 of borrowing and $600,000 of equity, under a rule requiring equity of at least 20 percent of value.

Leverage at the start: 4.0x
Position after a 12 percent fall: $2,112,000
Equity after the fall: $312,000
Leverage after the fall: 6.77x
Equity the rule now requires: $422,400
Sale needed to cure it: $552,000

A 12 percent price fall produced a demand to sell 26.1 percent of the position. That ratio, not the size of the fall, is what every episode in this track is about.

Check yourself

A position worth $860,000 is funded with $645,000 of borrowing. It falls 15 percent, and the financing requires equity of at least 20 percent of value. What is the shortfall, and how much must be sold to cure it?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.