There's an interesting dynamic emering among would-be market seers: where the distinguished emeritus crowd sees relatively dark clouds on the horizon (prominent recent examples of which can be seen here and here), the bulk of the talking heads see the storm passing (illustrations of which can be seen here--or just about any time on CNBC).
Whatever the near- and medium-term future may hold, we still don't think market participants have fully come to grips with the source of our collective troubles. Strip away all the details, all the acronyms, and the recriminations, all the micro-level contributors. What's left? Excessive leverage.
Here's an excellent summary of this indispensable part of the broader story, from Woody Brock via John Mauldin:
Commentaries about and explanations of today's credit market implosion continue to roll in from luminaries everywhere. Martin Feldstein of Harvard (allegedly the most important macroeconomist in the world) concludes that blame lies with the failure of Fed regulators to properly supervise the banks within their purview. Others blame the incompetence of those charged with "risk assessment" for dramatically underestimating risk. They claim that the solution to today's troubles lies in instituting much more effective risk management procedures.
Still others call for greater market transparency, truth in lending, and incentives to guarantee more of both. Finally, there are repeated complaints about the extent of greed on Wall Street. Yes, we have all become shockingly greedy!
Yet almost no one singles out the distinctive role of excess leverage not only as the principal culprit, but perhaps the only variable than can and should be regulated by government--as it once was. Indeed, in his lengthy and much discussed March 17 Op-Ed piece in the Financial Times, former Fed Chairman Alan Greenspan never once cited the role of leverage in wreaking today's havoc. This oversight is as irresponsible as it was unbelievable, but it epitomizes the deficient analyses of consensus pundits.
Chapters II-IV of our February 2008 PROFILE report explained how excessive leverage has exacerbated today's crisis, and why leverage is the principal "control variable" that must be managed in the future. More specifically,
- The Fed has no direct control over institutions that now make over 70% of all loans. As Chairman Bernanke has stressed in recent months, the Fed's powers are thus limited in dealing with the kind of crisis now at hand.
- The risks that allegedly should be "properly assessed" are largely endogenous in nature. The joint probability distribution characterizing such risk is often non-knowable. Think Heisenberg Uncertainty Principle! Because of this non-knowability, glib assertions that recent happenings are "four sigma events" are wholly invalid. For to state that an event is four-sigma implies knowledge of an underlying probability distribution that in fact does not exist and thus cannot be assessed!
- Human nature never changes, and hoping that people will become less greedy and optimally transparent is unrealistic.
- Leverage, however, is controllable. Moreover, since it exponentially amplifies endogenous risk, and in doing so creates "perfect storms" like that of today, the regulation of leverage can accomplish a very great deal, at least in circumstances when such measures are called for.
Yet even in the case of the demise of the Carlyle Capital Corporation, the crucial role of a 31:1 leverage ratio has received scant attention. [We learned of this ratio in the financial press, but cannot vouch for it.] Yet it should have, since it was this excessive leverage that cost investors almost their entire investment.
To sum up, those writing about today's morass seem as ignorant of the reality that excess leverage is largely responsible for what has happened as they are that much reduced leverage is the appropriate remedy for the future.
Perhaps this oversight is no accident. After all, those who now run our major financial institutions increasingly owe their own fabled fortunes to the utilization of leverage subsidized by the public. Moreover, those financial economists who are handsomely paid to report today's developments happen almost exclusively to be employees of the very same institutions that have created, peddled and profited from toxic CDOs and SIVs.
In short, are we not forced to ask whether the foxes are finally guarding the chicken coop? If they are not, you would never know it. This author is frankly appalled by the failure of those who should know better to single out and stress the all-important role of excess leverage in creating today's crisis. Leverage will end up hurting millions of innocent bystanders far more than any other factor will have done. Hyman Minsky: Where are you when we need you most? And where for that matter are Wisdom and Common Sense?
In this regard, please recall that our final result in Chapter IV (op. cit) was the sketch of a proof of why excess leverage is bad for society: It is a non-market "externality" because it dramatically increases the riskiness of wealth growth over time, while failing to deliver any corresponding gain in aggregate societal wealth itself. That is to say, excess leverage creates an "inefficiency" since it generates more pain--but no more gain.
This is a deep observation that constitutes a paradox within the very foundations of modern financial theory: The irrationally high levels of leverage justified by the Efficient Market Theory via its dramatic underestimation of risk becomes the source of Economic Inefficiency in the precise and revolutionary sense first proposed by Kenneth Arrow in 1953: a misallocation of risk itself. [Recall the reason why the EMT necessarily underestimates risk: It implies zero endogenous risk.]
Yet just as Stein's Law predicts, this trend too has had its day. Stay tuned for that large-scale deleveraging of Wall Street and indeed of the consumer that is just commencing.
None of this should imply any particular short-term forecast for the financial markets. But it does suggest, quite strongly, that several years' accumulated leverage will take a while longer to unwind.
Sources
Woody Brock, "Five Delectable Examples of Stein's Law," John Mauldin's Outside the Box, April 14, 2008
