Wall Street Journal describes "fears of reckoning" over use of credit - 1-May-07 - Generational Dynamics

"Thanks to advances in financial engineering, investors have never had so many different ways to make commitments that exceed their bankrolls. And never before has leverage wormed its way into so many nooks of the financial world.

We're living on planet leverage, and regulators and market gurus are growing nervous.

How did this happen? For starters, hedge funds and leveraged-buyout funds have proliferated. They're pioneers in boosting returns using borrowed money, the most traditional form of leverage. Also, investment banks are pumping out newfangled leveraging tools such as derivatives, complex securities that allow hedge funds and other investors to add leverage without borrowing money.

Finally, mainstream America has gotten into the act. Once-conservative institutions are copying hedge-fund tactics. The Pennsylvania State Employees' Retirement System has begun dabbling in derivatives. Mutual-fund companies such as Easton Vance Corp. and Federated Investors Inc. have launched funds that rely heavily on derivatives. Garden-products maker Scotts Miracle-Gro Co. and other public companies have loaded up on debt to improve returns."

What's being described today is the same manic credit debauchery that I've described many times.

People today look back at the Tulipomania bubble of the 1630s, when investors borrowed money to pay astronomical prices for tulips. And even worse, an investor would sell his home and tap his friends to pay an astronomical price in the fall for a certificate giving him the right to a certain tulip to be grown the following spring. When the tulip market crashed on February 3, 1637, investors lost everything. How could they have been so stupid as to think that the price of tulips would keep going up forever?

Well, they're just as stupid today. I've been saying it for years, but now it's gotten so bad that even the Wall Street Journal is expressing concern in a front page article.

We're seeing the same abuse of credit that was seen just before the crash of 1929, just before the 1637 crash of the Tulipomania bubble, just before the South Sea bubble of the 1710s-20s, just before the bankruptcy of the French monarchy in the 1789, and just before the Panic of 1857.

And notice this sentence in the first paragraph above: "And never before has leverage wormed its way into so many nooks of the financial world."

This is an interesting sentence, because it captures part of the generational concept. Generational Dynamics does not analyze the attitudes and behaviors of one person or a group of politicians. Generational Dynamics analyzes the attitudes and behaviors of large masses of people, entire generations of people.

The fact that leverage has "wormed its way into so many nooks of the financial world" makes it clear that what's going on today is not being caused by one crook or one category of financier. What's going on today is endemic, throughout the population, throughout the world. There is no fear today of borrowing, of credit, of unlimited credit.

Let's read some more of the WSJ article to see how far the "leveraging binge" has progressed:

"This leveraging binge has regulators and others worried. In the first place, no one knows how much leverage there is. Much of it is hidden, because investors aren't just juicing returns with borrowed money, but with derivatives, which are harder for regulators to track.

No one is sure what will happen to this complex brew in the event of a serious market downturn. When markets turn bad, leverage can create a snowball effect. Lenders and derivatives dealers demand that investors provide them with more collateral -- the stocks, cash or other assets they pledge to cover potential losses. Sometimes, investors dump stocks and bonds to raise cash. Prices drop more, losses accelerate, and more selling ensues. Some Wall Street analysts have taken to referring to a nightmare version of this scenario as "The Great Unwind."

That's where the mania is today. It's not just borrowed money that's messed up; it's the interlocking use of derivatives, using one kind of overpriced derivative as collateral to pay for more overpriced derivatives.

As bad as it is in America, it's much, much worse in China, where they don't have the vaguest idea what's going to hit them. "College students are putting their tuition money into the market...stroke-stricken retirees get wheeled into branches of securities firms to trade." This is from star economist Andy Xie, formerly of Morgan Stanley investment firm, in warning of a coming crash in China.

(This shows why well-known economists can't tell the truth even if they know it -- they get fired. Fortunately, you have me, dear reader, because I'll never fire myself.)

Compare this to what John Kenneth Galbraith describes in his 1954 book, The Great Crash - 1929:

"[The] amount of speculation was rising very fast in 1928. Early in the twenties the volume of brokers' loans -- because of their liquidity they are often referred to as call loans or loans in the call market -- varied from a billion to a billion and a half dollars. ... Brokers' loans reached four billion on the first of June 1928, five billion on the first of November, and by the end of the year they were well along to six billion. Never had there been anything like it before. ...

People were swarming to buy stocks on margin -- in other words, to have the increase in price without the costs of ownership. This cost was being assumed, in the first instance, by the New York banks, but they, in turn, were rapidly becoming the agents for lenders the country over the and even the world around. There is no mystery as to why so many wished to lend so much in New York. One of the paradoxes of speculation in securities is that the loans that underwrite it are among the safest of all investments. They are protected by stocks which under all ordinary circumstances are instantly salable, and by a cash margin as well. The money, as noted, can be retrieved on demand. ...

However, there were many ways of making money in 1928. Never had there been a better time to get rich, and people knew it. 1928, indeed, was the last year in which Americans were buoyant, uninhibited, and utterly happy. It wasn't that 1928 was too good to last; it was only that it didn't last. [pp. 20-22]"

"America has been a nation of debtors for years. Prior to the 1929 stock-market crash, brokers allowed customers to buy stocks with as much as 90% borrowed money -- called margin debt. When the market began sliding, investors had to dump shares to keep their debt levels below 90%, igniting market panic. Nowadays, the SEC limits margin borrowing by most investors to 50% of a stock's purchase price. ...

But those limits don't apply to all of the derivatives and other financial instruments that now pack the portfolios of hedge funds and other big investors. Estimates by analysts of leverage at major securities firms, borrowing by hedge funds and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002. Hedge-fund borrowing and other financing tools were valued at $1.46 trillion last year, up from $177 billion in 2002, according to estimates by Bridgewater Associates Inc., a Westport, Conn., hedge-fund company."

Galbraith's book also provides the response to those nutcakes who still think that the wide use of hedge funds and derivatives will save the market because they'll spread the risk so that people will only get hurt a little. In fact, former Fed Chairman Alan Greenspan often spoke of how great derivatives are, because they spread the risk. What we're going to see is that hedge funds and derivatives and will make things MUCH worse.

In 1929, the instrument corresponding to hedge funds was the "investment trust." Here's how Galbraith describes what happened to them:

"The stablizing effects of the huge cash resources of the investment trusts had also proved a mirage. In the early autumn the cash and liquid resources of the investment trusts were large. Many trusts had been attracted by the handsome returns in the call market. (The speculative circle had been closed. People who speculated in the stock of investment trusts were in effect investing in comnpanies which provided the funds to finance their own speculation.) But now, as reverse leverage did its work, investment trust managements were much more concerned over the collapse in the value of their own stock than in the adverse movements in the stock list as a whole. The investment trusts had invested heavily in each other. As a result the fall in Blue Ridge hit Shenandoah, and the resulting collapse in Shenandoah was even more horrible for the Goldman Sachs Trading Corporation." (p. 124)

This kind of chain reaction continued. Thus, said Galbraith, "The great investment trust boom had ended in a unique manifestation of Gresham's Law in which the bad stocks were driving out the good."

Warren Buffett says that leveraging in derivative trading today "makes a mockery of margin requirements," and that it the leverage that preceded the 1929 crash "look like a Sunday-school picnic," according to the article.

La Valse à Mille Temps

Writing for this web site for five years has made me acutely aware of the utter craziness going on, as the world appears increasingly to be spinning out of control. And I even mean "spinning" literally, in the sense that leveraging goes around in circles, with investors using hedge fund A as collateral for B, and another investor uses B as collateral for A. In the end they're both worth nothing.

Last year I suggested a comparison to the Jacques Brel song "La Valse à Mille Temps" or "Carousel" in the English version. Play the MP3 version of the song and sing along:

Generational Dynamics Web Log for 1-May-07
Wall Street Journal describes "fears of reckoning" over use of credit

La Valse à Mille Temps

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Generational Dynamics Web Log for 1-May-07 Wall Street Journal describes "fears of reckoning" over use of credit

La Valse à Mille Temps

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Generational Dynamics Web Log for 1-May-07
Wall Street Journal describes "fears of reckoning" over use of credit