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.   

Discourse on the Great Recession – Trading Systems

Discourse on the Great Recession – Trading Systems

Trading is the most primal of human exchanges, even in the most primitive societies comparative advantage prompted trading – the excellent hunter made a deal with the excellent arrowhead maker. The challenge in modern trading systems is the degree of abstraction that has evolved – there is no clear connection between actual human endeavour and trading – trading then hinges on the perception of value, rather than a perception of value anchored in relative human action. Absent a concrete attachment to a service or product, the “castle of the mind” plays a massive role; confidence or the lack of it determines value.

 

One of the initiating factors of the Great Recession and also the key factor in the prolonged state of uncertainty, was the inability to quantify exposure for individuals and governments due to opaque trading systems. Many of the new financial instruments were without a public forum to trade; the various assets CMO, CDO, many other Asset-Backed Securities and Credit Default Swaps without a public trading forum to make public their volume and tempo of exchange or their value, the condition of the market was indiscernible by governments and individuals – there was no ability to qualify the exposure; this effected a widespread state of unease. Lending institutions with no clear assessment of other institutions' exposure were hesitant to lend to one another regardless of the interbank rate determined by central banks or other factors – this caused serious consternation and retarded the availability of capital. Many of these “products” became valueless, even though the underlying assets had value, due to the uncertainty of the underlying asset’s value – there were no tangible means to assess value and no open trading system to manage sentiment.

 

When you contrast these assets’ price behaviour and ambient sentiment through the crisis with publicly traded products – stocks, exchange-traded funds and the related derivatives – one noticed a more favourable circumstance evolved with the transparent trading system. The ability to assess the value of the underlying assets due to generally accepted and regulated accounting and reporting systems and the presence of an open trading system together allowed a floor to form on the value of openly traded assets sooner than in opaque trading environments and the general market confidence in this space recovered more quickly.

 

Credit Default Swaps (effectively bond insurance) – for example – the sum total of the asset represent was less the total amount of “insured” value – the equivalent of a $100 asset being insured for $100,000 – default is then a favourable circumstance for the holder of swaps – the challenge of course is, the issuers of swaps often take the asset back from the entity the swap has been issued to. One can see in this circumstance how challenging it can be to assess one's exposure absent any “open” trading modality; once again negatively affecting general confidence.

 

There will always be “private agreements” between people and companies, however, when public entities are at play – publicly traded companies - as a matter of regulation concern public companies must be obligated to have the capacity to accurately disclose the value of assets they hold – this should preclude them from trading inside opaque systems with “products” that have no clear expression of value and no means to handle the realities of market sentiment.