Many are watching with horror as venerable financial institutions in our country collapse one by one due to the demise of the sub-prime lending industry. But this is nothing new, though perhaps bigger more public names are being dragged down. The financial world regularly flirts with this kind of disaster because they’re drawn like moths to the flame of using leverage to deliver increased returns. It’s their business, but it’s a dangerous one.
When an industry makes its revenue collecting “Golden Crumbs” (I love that line from Bonfire of the Vanities), it takes extremely large transaction volume for the crumbs to amount to much. The only way to achieve those volumes is through ridiculous amounts of leverage. It starts with the financial firms needing the leverage before the spread on extremely low interest rates adds up to interesting revenue. It moves on from there to extending leverage to allow customers to do more and larger transactions so the market can grow further. Pretty soon the PhD quants have analyzed it, bought the appropriate derivatives with more leverage, and decided there is no way to lose, even the Nobel prize winners like Long Term Capital (which precipitated a crisis involving major bank bailouts in 1998). Eventually these enterprises become indistinguishable from a garden variety Pyramid Scheme if enough capital is leveraged.
“Dear Customer, if you’ll give us your banking information we’d like to deposit a large sum of money there that you may use to buy a valuable asset.” Hmmm, I get something very similar from Nigeria that is outright fraud.
People think it is incredibly reckless to buy stocks on the margin. Yet, part of this crisis involved buying an asset with ridiculously more margin (right up to 100% margined zero money down). Worse, it’s an asset you have to own if you want a roof over your head. As we all remember from discussion of stock market margin, the margin compounds our losses. It magnifies them, just as it magnified profit for the financial institutions. If we could not afford to put much money down on a house (because we bought a ridiculously expensive house thinking you can’t lose on real estate in a time when the stock market has been fickle), how can we afford those losses?
So now we have a problem fixing it. There are too many snared in the web to just make it go away any time soon without lots of casualties on both the customer and vendor side. Wealth is being destroyed much faster than it was created. It’s a non-linear system that can dish out results much worse than a zero sum game. In a zero sum game, somebody gets to keep the wealth, it’s just a matter of who plays the game well enough. In this game, the wealth simply evaporates.
Meanwhile, I like Fred Wilson’s “Leave Wall Street, Joins a Startup” post.