Discourse on the Great Recession – Leverage

Discourse on the Great Recession – Leverage

Leverage refers to the use of credit to increase returns on a given amount of equity. If one holds $10 in equity – invests it and makes a dollar they have garnered a 10% return; if one uses that same $10 to borrow $100 and invests the $100 and makes $10 – the $10 of equity has garnered a 100% return. This is better, at least, until there is an equal decline in value then losses are as dramatic.

In the Stock market, people have provisioned the ability to borrow using stocks as collateral, when a brokerage (or a provisionary of funds) sees a decline in stock price, their security for the loan, they make a margin call – requiring the borrower to pay back funds. When there is a widespread crisis of confidence, margin calls can generate a cascading event, where, as people liquidate their positions to satisfy margin calls – the value of stock decreases – prompting more margin calls. This transpired at the beginning of the Great Recession and was part of the complex of causal events.

It was estimated in 2006 that the United States as a nation was levered at about 11 to 1 – an entire economy that had $1 of equity for every $11 of debt. When all the effects of the crisis of confidence occurred and people exited the field or were forced to – the value of assets decreased, however, the debt remained. It becomes very difficult to effect growth in an economy when people are holding large amounts of debt, and their ability acquires or appetite for more, debt is curtailed. Worse than the immediate effects of this debt, is that it weighs on economic growth for a long time. For the average person, when their house value drops and their mortgage stays the same, their ability to borrow more money and purchase goods are curtailed.

There is a phenomenon that occurs in the presence of credit; in real estate, it is common to have a 10-acre piece of land worth more per acre than a 100-acre piece of land. The reason is that when the hundred-acre piece of land is subdivided into 10 pieces there are more people who can afford the 10-acre piece of land than the 100-acre piece of land, effecting an increase in demand for the small parcel of land relative to the larger parcel – the increase in relative value between the more expensive asset and the least expensive is referred to as a “liquidity premium”. Credit in general and credit configuration has this same effect – by making assets more affordable by amortizing their cost over years you increase the pool of available buyers and exert upward pressure on all assets value.  This is true also of credit configuration, by extending amortization periods you have the effect of making an asset more available – hence increasing demand and exerting upward pressure on price.

It was the extended period of well-rewarded leverage and credit availability that effected an overvaluation of stocks and related products. It was the availability of credit and credit configuration that effected massive secular inflation and the resulting bubble in the housing sector.