Megan Skiendel: Franco Modigliani and Merton Miller published the framework for financial leverage in 1958. That's the foundation. And we still had 2008.
Zara Reyes: Wait — say more about that gap.
Megan Skiendel: Look, the math is not hidden. REITs lost 67% of their value in 2008 while the underlying properties — the actual real estate — declined maybe 15%. You don't need a Nobel Prize to see what's happening there. Leverage is amplifying the move. Same tool, same formula, different direction.
Zara Reyes: No but that's the thing that gets me — it's not a different tool in a downturn. Like, the ROE formula doesn't switch modes. r_A drops below r_D, and the same math that was building you up just — runs in reverse.
Megan Skiendel: Exactly. And yet Long-Term Capital Management had a trillion dollars in notional exposure in 1998. Brilliant people. Elegant models.
Zara Reyes: And still needed the Fed to come in and hold the system together. So — why does leverage keep convincing smart people? That's actually the question.
Megan Skiendel: Honestly, picture this. You put in fifty thousand dollars of your own money, borrow another fifty thousand at a fixed rate, and now you're playing with a hundred thousand in assets. That whole asset pool earns ten percent — that's ten thousand dollars. You pay two thousand in interest. You walk away with eight thousand net on your fifty thousand stake. That's sixteen percent Return on Equity. Not ten. Sixteen. That's the whole trick.
Zara Reyes: So the Debt/Equity ratio is literally the dial.
Megan Skiendel: It's the dial. ROE equals r_A plus the spread between r_A and r_D, multiplied by your D/E ratio. Turn the dial up, the spread gets louder — in both directions.
Zara Reyes: Okay but — what happens when r_A flips negative?
Megan Skiendel: The interest bill does not flip with it. That's — actually, that's the thing people miss. The asset return is variable. It moves with the market. The debt cost is contractual. Fixed. It just keeps going. So you're losing on the asset and still paying the interest, and your equity base is absorbing all of it.
Zara Reyes: The formula looks symmetric on paper.
Megan Skiendel: Completely symmetric on paper. But the lived experience is not — because losses can exceed a hundred percent of your equity. Total wipeout. Insolvency. The upside is theoretically unlimited but practically there's a ceiling. The downside has a floor called zero and then a trapdoor. That asymmetry isn't in the formula. It's what the formula doesn't show you.
Zara Reyes: And that trapdoor is exactly what I keep thinking about — because imagine you're not a hedge fund. You're a retail investor who borrowed to buy an index basket on Robinhood. Tuesday morning, market drops eight percent. Margin call. You're forced to sell.
Megan Skiendel: While the hedge fund PM is on the phone with their prime broker negotiating a soft landing.
Zara Reyes: Same math. Radically different Tuesday.
Megan Skiendel: And that forced sale — that's not just your problem. Because when you sell, prices drop further, which triggers the next margin call, for someone else, and honestly — that's the spiral. That's the actual mechanism. Forced selling depresses the price, which erodes someone else's equity, which triggers their margin call. It compounds.
Zara Reyes: Which is exactly what Long-Term Capital Management was sitting on top of in 1998. A trillion dollars in notional exposure — wait, against what equity base?
Megan Skiendel: Thin. Genuinely thin. And when markets moved against them, that forced deleveraging spiral threatened to cascade — I mean, the Federal Reserve had to coordinate a private-sector bailout. Not because LTCM deserved saving. Because the contagion vector ran through every counterparty they touched. Unleveraged participants. People who never made that bet.
Zara Reyes: So was LTCM a failure of discipline — or is that just what leverage does at scale? Like, was it always going to end that way?
Megan Skiendel: Both, I think. And that's the honest answer. LTCM's leverage was individually rational — the models said the spreads would converge. The problem is that every counterparty had similar positions. So when it unwound, it unwound everywhere at once. The Office of Financial Research has actually written about this — how aggregate leverage creates fragility that no single actor can see from inside their own book.
Zara Reyes: I just can't get past that.
Megan Skiendel: Leverage is risk transfer as much as it's risk amplification. The equity holder takes first loss, fine. But at systemic scale — you're moving that risk to counterparties, to unleveraged participants, eventually to taxpayers. The math stays neutral. The pain doesn't land where the bet was made.
Zara Reyes: Which is — lowkey — exactly what Modigliani and Miller couldn't account for in 1958. Like, their framework assumes frictionless markets. No cascades. No Tuesday margin calls.
Megan Skiendel: Frictionless markets. Right.
Zara Reyes: So leverage is neutral on paper — the ROE formula genuinely has no directional bias built in — and I keep turning that over, because if it's neutral, then the question of who holds it and who gets liquidated isn't a math problem. It's a design problem. And I don't think we've decided what we actually want to design.
