``Causa remota of the crisis is speculation and extended credit; causa proxima is some incident which snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move from commodities, stocks, real estate, bills of exchange, promissory notes, foreign exchange—whatever it may be—back into cash. In itself, causa proxima may be trivial: a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some borrower, some change of views which leads a significant actor to unload. Prices fall. Expectations are reversed. The movement picks up speed,”-Charles Kindleberger (1910-2003) historical economist, author of Manias, Panics and Crashes.
In the past we have noted of how the world financial markets have taken up way too much leverage to shore up asset values in the search for diminishing returns. And today, we are seeing much of this “leveraging” take place in private equity buy-outs, hedge funds to even margin debt taken up by mainstream or individual investors.
In the US, according to estimates by Bridgewater Associates Inc., a
Notwithstanding, loans to companies acquired by private-equity firms jumped by about 5 times to $317.3 billion in 2006 from $51.5 billion in 2002, according to Reuters Loan Pricing Corp.
Derivatives have been used largely by hedge funds and private investment pools for institutions and wealthy individuals to go around margin restrictions by mimicking the effect of purchasing stocks and bonds at lesser upfront capital. Of course derivatives come in myriad varieties not limited to stocks or bonds but also to commodities and even to the weather.
By taking up more leverage investor’s portfolios accentuate gains when the value of the underlying assets rises. However when the invested assets fall, unlike stocks holdings where losses could translate to floating paper losses, in swaps, the hedge funds or the counterparty of a derivatives dealer (usually investment banks) would be required to pay the equivalent amount of losses in value plus the agreed upon fee to underwrite the contract.
The danger lies when losing wagers would require investors to raise significant cash and by doing so unload illiquid assets that may create pressure on today’s highly correlated asset classes.
Aside, there is also the question of the erosion in lending practices that could lead dealers to relax on collateral requirements. As in the
According to Randall Smith and Susan Pulliam, writing for the Wall Street Journal (emphasis mine), ``Wall Street itself is one of the biggest users of leverage. Last year, the nation's four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders' equity, a leverage ratio of 25.5 to 1, according to research firm Sanford C. Bernstein & Co. In 2002, those same firms financed $1.59 trillion of assets with $72.7 billion of equity, a ratio of 21.9 to 1, it said.” At 25 to 1, a 5% decline in value is more than enough to eviscerate its entire equity capital.
Mr. Warren Buffett in last week’s Berkshire Hathaway’s annual stockholders meeting again reminded the public of the dangers of derivatives, Bloomberg quotes the Sage of Omaha (emphasis mine), ``The introduction of derivatives just made any regulation of leverage a joke. It's an anachronism,'' he said. Because of them, ``there will be some very unpleasant things that happen'' in the financial markets. ``We may not know exactly where exactly the danger begins and at what point it becomes a super danger.”
Figure 2: Bank of
The BoE warns, ``The changes are relatively modest, though several are judged to have edged up. Perhaps the most notable news is an increase in the interrelated low risk premia and corporate debt vulnerabilities, with signs of a further expansion of risk-taking in global capital markets. As conduits for much of this activity, the potential impacts of LCFI distress and infrastructure disruption are also assessed to be slightly higher. The likelihood of a disorderly unwinding of persistent global imbalances is judged to have fallen slightly since the July 2006 Report, as US domestic demand growth has eased and growth in the euro area has increased.”
On the other hand, the New York Federal Reserve sounded the alarm bells on the explosive growth of hedge funds which poses as the “biggest risk of a crisis since 1998”, notes the CNN (emphasis mine), ``Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.
``Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock," the economist Adrian wrote.
As the market climbs on concentrated levered positions, this heightens volatility risks as well as systemic risks.
Since we cannot control the macro environment, and can only work with our portfolios, it would be best to position only with the amount of risks we can sleep on and to tighten our stops (given the limited investing options in the Philippine market setting).
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