Thursday, July 8, 2010

Leverage, Still The Root Problem

As regular readers will know, FLG has come away from the financial crisis with the conclusion that we need to focus on leverage and pretty much only leverage. FLG found support in a quote in this post by Buttonwood:
Put another way, a period of excessive leverage is typically associated with exaggerated claims about the long-run growth rate of the economy. As a result, the net present value of expected future returns on assets ends up too high, leading to asset price bubbles which eventually burst as economic reality returns. Monetary and fiscal policy may be good enough to prevent a multi-year stagnation from turning into a great depression, but they are unlikely to be powerful enough to deliver a standard recovery in economic activity. Economic stagnation awaits those nations which, for too long, have been profligate.

That's really where FLG is sitting now -- too much leverage. FLG ties all the pieces of the crisis together with this one issue. Bankers' bonus structure and the Wall Street culture created incentives to leverage up for short-term gains because when the losses, in the long run, happened they wouldn't bear the costs. Financial innovation created instruments that we're on exchange/clearinghouses that required collateral. Thus, these new innovations created new leverage opportunities. Likewise, banks convinced regulators that they could correctly manage risk, when pretty much everybody except Goldman seems to have been piss poor. Worst of all, from FLG's perspective, is that normal people leveraged up because of the nature of the housing boom. Unlike the dot com bubble where most people put savings in and kept making more and more money which eventually went poof, people borrowed lots of money to buy houses. They borrowed it using exotic mortgages and liar loans. These leverage positions are going to take a while to unwind through short sales, foreclosures, and people bringing money to closing to sell their homes.

Anyway, leverage is really the issue. And what is leverage but borrowing? And what is borrowing but taking money now in the expectation that you will pay it back later? And what is taking money now and paying it back later but shifting your future cash flows forward? So, we've, in a very real way, burned our future cash flows. It's going to take a long time to untangle all that. A lot longer than dealing with the wealth effect of losing savings in a stock market bubble. If a lot of people had borrowed a ton of money to buy tech IPOs, then it would've been a much uglier recovery back then. Today, unfortunately, almost everybody borrowed a bunch of money to buy stuff. It really is all about leverage.

1 comment:

George Pal said...

Liar loans used to prop up liar loans at FHA – no end to unwinding in sight.

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