Deleveraging, or: Why the Disaster is Deepening

Wednesday, October 08, 2008
10 months ago, I asked on my little Facebook blog: is there going to be another Great Depression? The thing troubling me most was the amount of leverage in the financial system.

Excessive leverage caused the crash in 1929. The best example of leverage is margin buying. In the 20s, it was a fad to borrow money from a bank, turn around, and invest the loan in the stock market. This is dangerous: it encourages risky stock buying (people tend to take bigger risks with borrowed money).

Margin buying triggered the recent crashes on the Russian stock exchange and elsewhere, according to the reports I've read.

It's only one type of leverage. The more convoluted type works like this: an investment firm will take out, say, a $1 million loan, and then it'll put that loan toward collateral on another loan, and then that loan will be put toward collateral on another loan, and so on. This is called 'gearing up.' In the 20s, investment trusts geared up hundreds of times over.

Hedge funds are leveraged like this. Hedge funds are secretive firms, which employ computer models and supposedly brilliant investment gurus to manage stock portfolios. Hedge funds are not regulated in any way; but they hold trillions of dollars and they can control the stock market with sheer force. For years they've been bringing their customers 30 percent returns. Now, it's rumored most hedge funds are floundering or going bankrupt.

The present-day financial system is leveraged to an extent unseen since the 20s. The leverage goes back to the booms in the 1990s. Of late, we're seeing the unwinding of that leverage. The term 'deleveraging' is becoming a common phrase on the financial news wires. Just this week, the president of Credit Suisse said he expects deleveraging to continue into the rest of the year.

Deleveraging is the process of loans being called in. Here's what it looks like. Let's say an investment firm has borrowed 20 billion dollars to invest in the stock market. Suddenly, the bank that loaned it the money gets uneasy and sends out a margin call: it wants its loan back, or it wants another down payment on the loan. So, the investment firm, to pay off the loan, has to sell off its stock. This is how sell offs get started. This is why the international stock market is tanking.

(Lehman Bros., the bankrupt investment firm, was leveraged 30-1. It had borrowed 30 dollars for every one dollar it owned. And its situation was not unique. They all did it, and it's all coming down.)

Now, for my prediction: the markets are going to get much, much worse. Here's why.

For the past few months, the Fed has been loaning hundreds of billions of dollars to banks and other institutions. Just this week, it airdropped 600 billion dollars into the systems. And I'm not talking about the bailout bill. This 600 billion dollar dollop was a separate thing. It was auctioned off to banks at extremely low interest rates.

I can't tell you how catastrophic this will be - for the Fed is simply adding leverage to the system. The banks are being loaned money; they're not being given it. As the crisis spirals, I presume they'll be unable pay back the money they owe to the Federal Government.

At which point the U.S. fill face the prospect of defaulting on its debt.

The effects will not be abstract. and they'll be immediate. The only reason Americans can charge to their credit cards like they have is because America has the most trusted government in the world, with a AAA credit rating. When the Saudis and Chinese turn off the credit spigots, credit cards won't work. It's that simple.

People in the know say this scenario is almost unthinkable. China and Saudi Arabia are too dependent on the U.S. economy to let it crumble, they say. Right. But it's already happening. This week, the Chinese government discretely ordered its banks to stop lending to U.S. banks.

Welcome to the Great Crash of the Zeroes. As I've said before: There Will Be Blood. In fact, that was the whole point of the movie. Did you notice the last scene took place in 1927?

It ended with an oilman killing a preacher.