Sunday, April 26, 2009

Leverage: The Genesis of the Global Financial Turmoil

Credit, the lifeblood of capitalism, is now virtually non-existent. A lack of credit affects businesses from high tech giants to stay-home-moms to all manner of consumers. With credit unavailable, economic paralysis ensues, and conditions just get worse and worse.

In the most severe recession since World War II, the global economy is projected to shrink by 1.3 percent in 2009, with a slow recovery expected to take hold next year, according to the IMF’s April World Economic Outlook.

Without naming countries, Dominique Strauss-Kahn, the IMF's managing director said, “obviously the crisis comes from an important regulatory and supervisory failure in advanced countries . . . and a failure in market discipline mechanisms."

At the heart of the global financial crisis is the American housing bubble. This bubble has impelled an historic crisis of capitalism. So we think.

In an expanding bubble, belief or confidence in the profit potential was indomitable. Everybody was winning borrowers and lenders, brokers and investors, home flippers, home builders and home buyers, credit-rating agencies and bond salesmen, appraisers, realtors and municipalities, and, far from least, politicians.

The credit performance of mortgage loans was good, with very low delinquencies, defaults, and losses. More debt seemed better. House prices could never come down. Did anybody believe that? The bubble was out of control. The United States is now two and a half years into the deflation of the housing bubble with accompanying defaults, foreclosures, and massive losses to lenders and borrowers, as well as home builders and investors.

This is a monumental crisis, one that will have deep, long and complex consequences. Many theories will be advanced to explain how we got here. One theory that I find most persuasive is by Simon Johnson in an essay titled “The Quiet Coup” in The Atlantic.

Johnson examines the rising power of corporate profits between 1973 and this decade. He observes that domestic corporate profits rose from 16 percent in the 70s and 80s to 20-30 percent in the 90s to a record 41 percent in this decade.

Wall Street was awash with money. Wall Street's political power soared. Wall Street and Washington merged. Enabling legislation was designed to enhance freedom and power of corporate finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

Given that in the buildup to the recent global economic meltdown hedge funds had been leveraging their deals by ratios of 30-to-1 i.e. borrowing $30 for every $1 of their own that they put in. It must seem obvious that massive leverage was a major driver of the financial turmoil.

Stefan Thurner, an econophysicist and director of the complex systems research group at the Medical University of Vienna, Austria, and colleagues say their model shows that many of the distinctive statistical properties of financial markets emerge together as rates of leverage climb.

The lure of the Gaussian function- a bell curve that gives little probability to large swings (risk)-gave finance whizzes the illusion that they could accurately calculate risks. But high leverages increased the likelihood of large swings than most bankers understood. In reality, the distribution has “fat tails” that make large swings possible. Thurner and colleagues have developed an “agent-based model” of a market. In their model, if they forbade leverage, the market behaved largely as classical economics would predict.

In a Wall Street Journal article titled “Is This the End of Capitalism?” Daniel Henninger thinks the crisis has less to do with capitalism than with psychosis, a mental dis-ease that dispossess bankers, borrowers and regulators of their capacity to meet life's everyday demands. For sensible bankers, that includes due diligence and risk management.

Capitalism did not torpedo the U.S. economy. Overbuilt housing did. Overbuilt housing tanked the economies of the U.K. and Ireland and Spain. If little else, we've learned that artificially cheap housing sets loose limitless moral hazard.

Two signal events in history are shaping the politics of the current economic crisis: the Great Depression, Reaganomics/Thatcherism.

The Great Depression touched off a raging tension between public and private sectors over who determines the course of a nation’s economy. After 50 years of public sector dominance, Reagan's presidency tipped the scales in favour of free-market enterprise.

The Great Recession of 2009 is a chance for the public sector to control the agenda and reinstate public-sector power. And President Obama recognizes that his administration has a responsibility to “create rules that punish shortcuts” on Wall Street.

It is disappointing that rather than fixing just what the mortgage crisis broke, the G-20 suddenly became a musing on the "future of capitalism."

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