Leverage versus debt


Europe, Japan and America are printing money at an extraordinary rate. It has reduced the cost of debt to negligible levels. Usually this is explained with reference to what is happening in the conventional economy, but I suspect there may be another explanation. The systemic effects of the bizarre financial system that we have created, which is based on leverage. That leverage, which is thought of as debt, is not really what we mean by debt.

One of the features of the explosion of derivatives in the last 15 years, the rise of “meta money”, is that it was achieved through the creation of massive amounts of leverage. When Long Term Capital Management nearly destroyed the world financial system in 1998, it was done through a highly leveraged play on the rouble. LTCM was brought undone when Russia defaulted on its bonds.

Nothing was learned, and the creation of this meta money was encouraged rather than stopped. Derivatives are now more than twice the capital stock of the world. Oh what fools these mortals be.

The reason so much leverage is used is that the investment plays can be quite small, based on fairly incremental changes in price. But those small changes can be amplified using huge levels of debt/leverage.

Leverage is technically debt, but it is very different from, for want of a better phrase, “normal” forms of debt. The shortest type of debt in the money markets is the overnight cash rate, a period of 24 hours. That is an aeon in the current financial markets. Leverage games, especially in the high frequency trading arena, can occur in micro-seconds, perhaps even nano-seconds.

This means that the interest rate on the debt is rendered fairly meaningless. If the debt has, say, a 7% interest rate, that is the return over a year. If you incur that debt for only a few minutes, or even a day, the interest costs are so negligible as to be unimportant. All that matters is what happens to the price of the asset that is the subject of the investment play.

There is thus a crucial difference between conventional debt, such as a mortgage on a house that takes decades to pay off, and leverage in the meta money markets. Conventional debt is subject to the tyranny of compound interest. Meta money leverage is not. They are very different types of transactions.

It occurs to me that the evaporation of interest rates across the major developed economies, which represents the disappearance of the cost of capital, may be the consequence of the “meta money” leverage becoming so dominant. This new form of debt-like transaction in the meta money markets, in which interest rates are largely redundant, is having an effect on what is happening to interest rates in the more customary forms of debt.

The situation is certainly very strange, even bizarre. The threat in the developed world, especially in Japan, seems to be deflation. Central banks are printing money with furious intensity, which seems to imply a shortage of money.

Yet when we look at the world of meta money, there is definitely no shortage of capital, indeed quite the opposite. Derivatives are twice the capital stock of the world. Admittedly this is not “money” in the conventional way, it is gambles that net out to much smaller amounts. But it is a type of transaction, and money in the end is only transactions.

They are meant to be parallel universes, “real” markets at one level and “meta money” markets at another. But as we saw in 2008 when the meta money nearly destroyed the US banking system, they are not parallel, they intersect. Meta money is increasingly affecting what is happening in the more familiar capital markets: bonds, bank debt, equities. That is the price of the recklessness of allowing these crazy markets to emerge.

Banking crises are not new, but usually it is bankers working within government stipulated rules to exploit everyone else, and that exploitation has wreaked damage on the overall system.

This time it is different. Governments have given over the rule making to private actors. Unsurprisingly, those private actors have invented a myriad of rules to benefit themselves. And equally unsurprisingly that is creating a chaotic system that governments are struggling to manage in any way. I am reminded of Keyne’s comment:

“Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.”

I am also reminded of Goya’s famous image of Saturn devouring its children, a massive painting depicting self destruction. Capitalism, I suspect, is doing its best to follow communism into the grave yard. Its strength was that it was not an ideology, just a practice – markets, after all, have been around for thousands of years. But the capitalist ideology of “financial deregulation” whose fruits are now so evident, the worship of markets as the solution to everything, is threatening the system itself.

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  1. I read the cause-effect somewhat differently.

    As the world has become increasingly saturated with (private) debt, the ability of bankers to maximise profits using their foundational debt Ponzi leverage play — i.e., fractional reserve lending as leverage on their root profit source, Net Interest Income — so their ability to maximise that NII via “high” interest rates on loans to a debt-soaked populace has been gradually reduced.

    Thus, the rise and rise of the multiplicity of “meta-money” leverage instruments.

    The fact that meta-money is a means for banksters to make profits by largely eliminating the importance (i.e., to them) of base NII, would tend to support my interpretation.

    Ban usury — in all forms — and there is nothing for bankers to leverage. No matter how fast the technology allows them to “trade”.

    • As interest rates fall, their ability to get net interest income would fall too, one assumes. And interest rates are pretty negligible in most parts of the developed world. I don’t disagree with your point, but it seems to me that it is a problem that has existed for a very long time, whereas this problem is rather more novel. And if we are to ban usury, we are going to need a new definition of it: meta usury, perhaps.

      • “As interest rates fall, their ability to get net interest income would fall too, one assumes.”

        Apparently not.

        Here is a chart I just constructed from the StLouisFed FRED data. It shows US banks’ net interest margin (NIM), vs the Effective Federal Funds Rate (FEDFUNDS), since 1984 –

        The banks’ NIM has varied surprisingly little, across 3 decades; only 170 basis points max. difference between the peak (4.91%, 1994) and today, with the FEDFUNDS rate at 0.14.

  2. “this time it’s different….”

    I would add that there is also something called a credibility trap. This is when (and I quote Jesse here at http://jessescrossroadscafe.blogspot.com.au/)

    “a condition wherein the financial, political and informational functions of a society have been compromised by corruption and fraud, so that the leadership cannot effectively reform, or even honestly address, the problems of that system without impairing and implicating, at least incidentally, a broad swath of the power structure, including themselves.”

    I am looking at Cap’n Glenn here. And others.

    So not only have we handed over all control to Finance/Capital/etc but then we still expect markets to operate as normal. We have not modified our theories of how economics works to take in the “new normal” of practically unlimited QE, unlimited government purchase of stocks and bonds to support price, unlimited recapitalisation of insolvent banks, etc. I avoid most comment that either explicitly, implicitly, by ignorance or lack of interest discounts or ignores the above “new normal” influences in the world/local/national economies.

  3. Regards the Alice in Wonderland world which is “derivatives markets”, Janet Tavakoli explains how these instruments work in plain words. One example:


    How any reasonable person can think the lack of regulation which enables the control fraud that permeates these “meta money” markets (as you call them) is in the public interest is beyond me. But these of course are the very same bankster/vampire squids which own politics now (China an obvious exception there).

  4. The global financial crisis was caused by an old fashion overly bullish property market falling with far too much leverage, it has happened before. I recall in the early 90s in Australia with little or no so called meta money, the property market failed and the banking sector almost failed, unemployment 11%. Just an old fashion banking sector crisis.
    And for Europe the crisis had nothing to do with meta money, it was related to over borrowing by governments and lending by banks who didn’t appreciate the risk of second tier European sovereigns. Sounds vaguely similar to the state crisis we had in the early 90s. I cant see the so called meta money relationship.

    • the rate of leverage was around 52 on rmbs derivatives. so $52 in meta money forevery $1 of actual mortgage.
      i was this that fits for lehmans.

  5. Ronin8317MEMBER

    The financial market is the mechanism that allows the West to obtain goods and resources from the rest of the world. One upon a time, to exploit a country requires invasion and enslaving the population. With global finance, you only have to show them numbers on a computer screen!! Don’t look at the “numbers”. Instead, look at the flow of goods and services, and you’ll get a better picture of how the world functions today.

    In general, investment is a ‘black box’ with an unknown content to be delivered in the future. What is inside may be very valuable, or it may be rubbish, but you won’t know until the time to open it. The role of the financial market is to find and sell those ‘black boxes’ to investors. As long as the total value inside those ‘black boxes’ exceed the losses incurred, society in general will benefit.

    After a while, the financial market got so good at selling, they ran out of investments opportunities. So the first ‘meta-money’ is invented (CDS). They created a casino so people can bet on ‘what is in the box’. To prevent themselves from ‘losing their shirt’, each bet is matched by a counter-bet to limit the losses. The insanity occur when hedgefunds decide to borrow vast amount of money (at 30:1 leverage) to gamble, because their mathematics model says they can win. LCTM is a case where a hedge fund run by Nobel Prize winning economists borrowed a lot of money to gamble, and lost. Still, when one side loses, the ‘counterparty’ would win, so the net effect is zero. You have to question the sanity of banks who are willing to lend at 30:1 ratio though.

    The bigger problem occur after 2000. As gambling creates winner and losers, the financial market contorted a scheme where they will always win. They will place the bet, then put the ‘betting slips’ into a ‘black box’ (CDO) and call it an ‘investments’. Betting is never an investment, and it’s the rating agency’s role to prevent this, but all 3 major global agency got bought off, so the ‘betting slips’ are assigned a ‘AAA’ ratings. This allowed the financial market to create artificial ‘AAA CDO’ on demand, even when the original ‘investment’ consist of lending money to people with no income, job or asset (NINJA loans). When those loan went sour, all the “AAA rated CDO” imploded, which caused investors to lose faith in all ‘black boxes’. The financial market won, the general public lost.

    An investment should creates wealth instead of shifting wealth between parties. Gambling shifts money from one party to another, so it’s not an investment. Buying/selling a house is similar (as oppose to building a house, which does create value). When it gets to the point where buying/selling “meta-money” generates a better return than producing goods and services, the system is no longer functioning .

    • LabrynthMEMBER

      This is the best post I have seen to date that explains what caused the GFC.

      The following line accurately sums up our residential property market:

      ” When it gets to the point where buying/selling “houses” generates a better return than producing goods and services, the system is no longer functioning .”

  6. Nice. I especially like the point about capitalism and markets.
    Markets have been around for a long time and so has debt. Every economy that includes debt has had to deal with the associated problems. Those that found a good solution lasted longer and prospered.
    We have invested new forms of debt and devolved regulating debt to bankers. Unsurprisingly this has not gone well for us.

    Something I discovered during the GFC was that most economists did not understand the crisis, the cause the effect or the solution. The people who did understand were a few Economists on the fringe (several bloggers here) and historians.
    Students of historical economic trends could predict the crisis and the forces behind it because similar things have happened before. Our technology just allowed it to be bigger and global.

    Political Economy had a better grasp of reality because unlike modern Economics it didn’t pretend ideology wasn’t relevant. And history can teach us as much Economics as it can politics.