A De-Leveraging Date with Destiny

To understand today's market you only needed information from 230 B.C.

Give me a lever long enough and a place to stand, and
I will move the world.


For investing consumers of financial media there has been a parade of posturing pundits.  All are happy to explain the same three things:

  1. Our financial system had excessive leverage;
  2. We are in the process of wringing it out of the system — a "Great Unwind", if you will;
  3. This is going to take a lot longer and it will involve much pain.

Most of the pundits want to opine about who made the mistakes that caused this problem.  The typical argument is that some politician was too stupid or too biased to act intelligently.  For those interested in the public policy implications, there will be plenty of government hearings in the next year or so, and maybe a few criminal trials.  Meanwhile, the best and most balanced coverage has come from one of our featured sites, Barry Ritholtz at The Big Picture.  This article, which I have already sent to a number of my friends from academic circles, is a good starting point.

What Is Missing?

While we are all interested in affixing blame and making the world a better place, there is an immediate question for investors:  What should an investor do right now?  Put another way, the key question is as follows:

How much further must this de-leveraging process go on?

The Significance

Leverage is the most important question.  The punditry has plenty to say, but little understanding.  Here is the acid test, which a reader should use every time the subject is raised.

Whenever you see the subject of leverage raised, ask two questions?

  1. What is the appropriate amount of leverage?  How does it vary by type of institution?  If the answer is "no leverage" or "match obligations to assets" the responder is dodging.  The financial system has never worked that way, and it never will.  Get real!!
  2. What is the right leverage ratio for various institutions, like regional banks?  How close are we to that ratio?  How long will it take to get there?

The Question of "Hoarding"

Every day seems to launch a new series of challenges to the "Rescue Plan."  Today's message from financial media focused on financial institutions that were hitting the TARP plan, but not expanding lending.  They were improving  balance sheets or looking to buy other banks.

This variant of investigative reporting lacks objectivity.  First, it relies on anecdotal evidence rather than data. Bill Rempel astutely notes some actual reporting of lending, which has not declined at the level suggested by the doomsayers.

These issues are significant because the markdowns in assets happen so quickly that some even challenge whether the Treasury can add enough capital to meet the write downs in mortgage securities.

The Biggest Variable You Do Not Already Know

The amount of leverage depends upon the amount of current assets.  For a typical bank, if you force it to mark down assets by $10 million, you reduce lending power by $100 million.  If the bank's assets are truly impaired, this is capitalism in action.  If the write-down is not an accurate assessment, then the de-leveraging has already gone too far.  Anyone who does not have a good answer to this, is dodging the key question.

What to Look For

The big story tomorrow will be the roundtable discussion sponsored by the SEC, working on their report about mark-to-market accounting.  Colin Barr, one of our featured sources, has been writing recently for the mother ship rather than his excellent blog, one of our featured sites.  This nice article captures the key elements.  Our only complaint is that he awarded our "trademarked" death spiral analysis to someone else!  We were on this subject in January and before, using the Death Spiral terminology.

Colin points out the SEC meeting, the first of two, and the significance.  It is something to watch tomorrow.  If the SEC finds that the FAS 157 moves were, as we have suggested, a good idea that was implemented poorly, the game could change.  The spiral might end.

We will not get the final Congressionally-mandated SEC report until January 2nd, but the discussion will highlight the issues.  You can watch the webcast tomorrow on the SEC site, or you can follow the coverage on CNBC.

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  • Rob October 29, 2008  

    The problem with Barry’s analysis is that he has his own axe to grind–the primary reason I came to this website (and no longer go to his) in the first place. So when he says the whole subprime mess wasn’t Clinton, or this or that, I’m already remembering back to his previous partisanship and rolling my eyes. Not that I would defend Bush the younger and his psuedo-conservative domestic record…
    I’m still wondering how a problem caused by bad policy and big government is going to be solved by questionable policy and big government.

  • VennData October 30, 2008  

    The tiny percentage of subprime mortgages (2% of all mortgages) post-Clinton pales in comparison to the ramp up once the tethers were off the leveraged ibanks rising to 30%-plus in 2004 and beyond.
    You may not want to believe it – and buy the GOP media machine’s talking points to deflect the blame from Bush et al – but check out econobrowser and others to get the facts straight. To deny the facts put forth by BR and others may be emotionally satisfying, but it’s wrong.
    It’s so simple to say “…I’m still wondering how a problem caused by bad policy and big government is going to be solved by questionable policy and big government…” but that’s what the GOP is hoping you tune into emotionally. And emotionally-satisfying palliatives are what this blogs eschews.

  • Rob October 30, 2008  

    I don’t know how to make a water heater, and I bet you don’t either. The point I was trying to make was that in our economy, we all play very specialized roles, and rely on experts to fill in the gaps (that might almost be a verbatim quote from this blog!) Like the partisan who cried “Wolf!”, it’s difficult to see when Barry hits the mark (and almost irrational to try). I don’t go to poorandstupid.com anymore, either.
    Sorry I made you so upset. For what it’s worth, take my comment, or leave it…
    Call me a skeptic, or call me “emotional”, but I’ll call myself a seeker, and one who doesn’t appreciate distractions in my already busy life.