Leverage: The Meltdown Amplifier

Someone on another blog, SeekingAlpha, wrote an article in which he asked, "Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage?"

The answer is actually quite simple: leverage. Leverage creates losses that are multiples of the original amount of capital that was put at risk. In short, people borrow to buy assets that end up losing tremendous value, and then those people are left with the debt and no assets to sell to cover it. For example, low margin requirements amplified the losses associated with the 1929 crash, making the fallout much more severe than the typical market correction. Investors were required to put up only 10% of the cost of the stock when they purchased it. When the stocks lost most of their value, the investors still owed a remaining 90% of the original cost. Where was that money going to come from? Certainly not from selling the stock. So, the stock investors of 1929 defaulted on their margin debt and left the banks holding the bag. This is the same situation today, except that we're talking about inflated home values and defaulted mortgage debt.

Complicating the mortgage default problem is the destruction caused by the casino-like activities in the unregulated credit default swaps market. The likes of Goldman Sachs put up pennies on the dollar to buy swaps (again, the use of leverage), most notoriously from AIG, and left AIG with losses of 30-50 times of what Goldman paid. Because our brainiacs in Washington decided to bail AIG out, the public will now be paying for those losses for decades, thus putting a stranglehold on the economy for years.

Most economic crises have not involved substantial leverage. The dot-com crisis is a good example. Trillions were lost in that crisis on dot-com stocks, but those stocks had not been purchased with leverage. Money was transferred from one party to another, but there was no change in the amount of money in circulation within the economy. In other words, although the dot-com stocks took a beating, the economy as a whole was net neutral. Hence, the recovery was fairly swift, given the magnitude of the disaster.

Today, in contrast, we borrowed to create inflated asset values. Indeed, the credit amplified the inflation, as buyers who weren't required to put cash on the table became desensitized to the prices they were paying. Those assets have now declined in value by half, but the debt remains. Hence, the economy as a whole is in a net loss position (technically speaking, insolvent), whereas it wasn't following dot-com mania. It is much more difficult to recover from such losses.

Our government is borrowing money to pay off the debts that are left over from the housing bubble, thus socializing the losses from the housing market and Wall Street's excesses. However, replacing one debt with another debt does nothing to get the economy out of its net loss position. Only the generation of profits and the systematic and disciplined repayment of debt from those profits can do that.