The sudden bloodletting that leveraged currency speculators experienced when the Swiss National Bank yanked the cap on the franc should have been a warning: central-bank promises that everything is under control are meaningless. And because of leverage, innumerable trading accounts blew up in a matter of moments.

Leverage acts like a powerful drug. It creates buying pressure and inflates asset prices further on the way up. But when asset prices sink, leverage begets forced selling, which drives down asset prices further, which begets more forced selling….

And stock-market leverage, encouraged by the Fed’s monetary policies that make nearly free money available to all sorts of speculators, has ballooned.

Some of it is closely watched, like margin debt. FINRA’s 4,000 member securities firms reported that their customers carried $496 billion in margin debt by the end of December, after a multi-year surge. Margin balances had peaked in September at $504 billion, by far the highest in absolute terms, and at 2.8% of GDP, the highest ever in relationship to the economy. Alas, the last two stock-market leverage bubbles ended in phenomenal crashes – the dotcom implosion and the Financial Crisis.

And corporations are issuing mountains of debt to buy back their own shares at peak prices – replacing equity with debt on their balance sheets, leveraging them up to the hilt, like others leverage up their brokerage accounts. In many cases, such as IBM, “tangible net worth” has turned negative, and stockholders are already under water.

Other forms of stock-market leverage are more difficult to quantify, like people borrowing against their home equity lines of credit or their credit cards to plow that moolah into stocks to make that quick buck that their neighbors have been bragging about.

This risk-taking with other people’s money works as long as stocks keep pushing relentlessly higher, powered by central-bank policies, ever more borrowing to buy ever more stocks, and a firm belief that everybody believes that stocks will continue to go up, thus creating momentum in the right direction.

But no form of stock-market leverage is riskier to the mostly unwitting public and taxpayers, and crazier in overall terms, than the leverage that desperate, underfunded public pension funds in cash-strapped states or municipalities take on to buy stocks.

Public pension funds have a problem: promises politicians have made to buy the votes of public employees and retirees, but that no one wants to pay for, neither these employees nor the already wheezing taxpayers. And forget cutting benefits. According to Moody’s Investors Service, the 25 largest public pension systems alone have $2 trillion in unfunded liabilities.

How are they trying to fill the holes? By borrowing money via pension obligation bonds and buying stocks with the proceeds. Leverage!

“It’s speculating the way I would have speculated in my bond position at Goldman Sachs,” explained Jon Corzine, ex-chairman of that venerable firm, at the time Governor of New Jersey which itself has a pension problem of mega proportions, and later CEO of MF Global which blew up spectacularly. It was the “dumbest idea” he’d ever heard of, he said.

This idea is that they can borrow at 4% or 5%, take some of the money to fill a current spending hole, and invest the remainder in stocks to ride the market into the stratosphere. These breath-taking gains will then pay for the interest and fill the remaining holes.

It doesn’t work out that way. Oakland, California, which was the first municipality to try to fix its pension problems that way in 1986, issued another set of pension obligation bonds in 1997 that ended up costing the city $250 million more than if it had paid into the pension system, according to an analysis by the city auditor. And how did the city fill the hole that the 1997 POBs left behind? By issuing another $210 million in POBs in 2012 that will cost another $105 million in interest over the next 14 years and expose the pension fund – and taxpayers – to even more risk.

If the city hadn’t issued the POBs, it would have had to pay $38.5 million – or nearly 10% of its general fund – to cover the pension expense for the year. The rest was invested, and since then, everyone has been praying that the stock market rally would last for 14 more years.

But leverage bites back. POBs played a big role in the bankruptcies of Detroit, Stockton, and San Bernardino – just like margin debt plays a big role when investors blow up their accounts. And holders of these bonds got their hide stripped off during the bankruptcies. POBs are risky for both sides.

It seems, lessons would be learned. But hey, this is the Fed’s America. The hunger for more stock-market leverage as savior is kicking off in earnest, now that everyone knows for sure that stocks can only go up.

In Kentucky, House Speaker Greg Stumbo, a Democrat, filed a bill in January that would authorize the state to issue $3.3 billion in POBs to paper over the $14 billion in unfunded liabilities of the Kentucky Teachers’ Retirement System. A House committee passed the bill to the State Senate. When the pension fund, currently funded at just over 50%, takes on $3.3 billion in new debt, a miracle happens: the funding level instantly jumps to 63%!

In Kansas, which is struggling with a budget crisis, Gov. Sam Brownback, a Republican, proposed to sell $1.5 billion in POBs to paper over the $9 billion hole in the Kansas Public Employees Retirement System. Last week, a committee in the House voted to move the legislation to a vote on the floor.

If examined at the perfect moment, POBs might look like acceptable deals: by 2014, with stocks at record bubble highs after years of QE and interest rate repression, they returned on average 1.5% – a mere 1.5%, after all this! But in 2009, according to a report cited by the Wall Street Journal, those POBs produced a net drain of on average 2.9%.

The POBs that Kansas intends to issue would pay a maximum of 5%, according to the State Treasurer. They expect that stocks will return 8% from today’s bubbly levels, year after year for 10 years without crash or fail – 115% in total.

What have these folks been smoking? If a hedge fund makes this kind of bet, OK. But a cash-strapped desperate state with a terribly underfunded pension fund?

Now there’s a mad scramble among politicians to take advantage of the Fed’s interest rate repression while it still lasts and leverage up pension funds. Intoxicated by the outsized stock market gains of the past few years that flew in the face of an utterly mediocre economy, politicians are going to borrow money on the backs of taxpayers, at a time when stock-market leverage is already at an all-time high, to wager this money on stocks after stocks have become enormously expensive. But hey, the Fed has this leverage bubble, the greatest of them all, firmly under control.

It’s tough out there for companies that have to deal with the over-indebted, under-employed, strung-out American consumers who’ve been on the other end of corporate cost-cutting for years. Read… Something Rotten Is Piling Up in this Economy

Enjoy reading WOLF STREET and want to support it? Using ad blockers – I totally get why – but want to support the site? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.