1/25/2009

A World Without Consequences?

Leverage:

"In finance, leverage is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Deleveraging is the action of reducing borrowings." Wikipeida

Why is the world shedding millions of jobs?

It's all about leverage, and as we are now seeing, deleveraging. The world is deleveraging. Deleveraging is a nice way of saying we are up to our eyeballs in debt and now we're screwed.

Getting into to debt takes very little time. Getting out of debt takes a very long time. If the world's economy was set up to service the demands of a leveraged society than we are going to need much less capacity to service the needs of a deleveraged society.

How did we get into this mess?

Did the world just want to increase its return on equity?

This leverage became the norm rather than the abnormal. No more $20 used couches, used cars, and ratty apartments for couples just starting out. No, we wanted everything new and now. Equity? We don't need no stinkin equity. No money down, no payments for 12 months, it's just that easy,

This went way beyond a return on equity.

We as a society have lost a respect, or fear, or knowledge, or something, about the dangers of leverage. People who should have known better also forgot, or never knew in the first place.

There is no industry that understands leverage better than the commodity futures business. All participants are well versed in the dangers of leverage. Leverage is what makes futures trading so lucrative and so dangerous. If you don't understand this you won't be in the business for long.

Maybe the banking industry could have learned something from their commodity brokerage peers, or in some cases subsidiaries. The commodity futures trading industry has been living with huge amounts of leverage for decades and as far as I know without too many problems.

Oh sure traders go broke all the time, lol, little traders and some very big traders but the industry, the backbone so to speak remains intact. That's what the banks could have learned from the commodity brokers. The banks took on the traders (home owners / speculators) risk. They took that risk and lost.

My commodity broker would never do that.

They monitor my position constantly, they monitor the volatility in the market, they change the amount of leverage available whenever they see fit, and they will sell my position out from under me if they see any possible risk to themselves.

They don't care if I make money, their only concern is that they don't lose money on my leverage. There is nothing wrong with that. They have to operate that way.

So what could the banks have learned from the commodity brokers?

They can't just up and sell your house if they feel threatened can they?

No.

They could have monitored their position though. Their position is held in trust by you the mortgagee living in their house. They need you to keep making those payments. They could monitor your bank account for any signs of decreased revenue, they could have monitored the market place to better determine value, they could have used sector caps (position sizing) to mitigate risk, they could have placed location caps on their portfolios, they could have done many things.

Why didn't they?

They felt secure, they had a mortgage, not a "risky" crude oil position on the books. They had insurance. Or so they thought, it turned out they only had a worthless "swap".

Risk management is a frame of mind, commodity brokers live with it every day, and traders live or die with it every day. It's a frame of mind that thinks along the lines of, capital is scarce, treat it as such. :)

Banks thought they understood this. They did not.

I think consumers, businesses, and banks all get it now.

Does your government?

Governments around the world believe that they can leverage themselves by the trillions to increase demand for products in order to keep the world employed.

They certainly have the ability to borrow, the question is what will they do next year, and the year after that. The world's consumers cannot deleverage in 1 or 2 years, it may take 5, 10, or 20 years.

Will governments just keep borrowing?

When will governments have to start deleveraging?

What will that do to the economy?

Is this a world without consequences?

I think not, we just keep delaying them.

Maybe we should just take our medicine now instead of passing it on to our kids.

2 comments:

Anonymous said...

The truly sad part is the CFTC tried to regulate the swaps market years ago and was shot down under pressure from the very investment banks that helped cause this disaster.

Solfest said...

All the more reason they should have been left to lie in the beds they made.

Cold, naked, and bankrupt.