Will Leverage Cause The Financial World to Blow Up?

Will Leverage Cause

The Financial World to Blow Up?

By Martin A. Armstrong

Copyright October 9th, 1998

Princeton Economic Institute

There has always been the question of leverage that enters into the process of any financial panic. The degree of leverage within the system is a key factor in determining just how severe the panic will become. However, the degree of leverage may also have a neutralizing impact upon government’s ability to manage and control the economic forces at work. In short, even if government reduces interest rates, increases the money supply and passes sumptuary laws to deal with the effects of leverage, all such efforts may have little impact upon the short-term while increasing the amplitude of the next business cycle. It has always been the degree of leverage that ultimately dictates the fate of mankind and his political economy. Today’s financial turmoil has shown precious little evidence to suggest anything otherwise.

The amount of leverage within the system has always dictated the degree of the overall decline in combination with the desire to move toward liquidity. Whenever these two forces move together, the degree of panic is raised exponentially. For example, let us say that we have a lending ratio of 16:1, as was the case during the Great Depression. If the desire to move toward liquidity causes a contraction in leverage from 16:1 down to say 8:1 in combination with at least a 25% decline in asset values, the net effect of these forces upon an economy are magnified considerably. If a central bank seeks to reduce interest rates, there will be little or no effect during a period where the desire to move toward liquidity dominates the trend. A reduction in interest rates will ONLY have a positive impact upon the marketplace if there is a credit crunch and NOT a desire to simply liquidate positions.

If we assume an overall leverage of 16:1 on the actual money supply through the course of bank lending, then a contraction in leverage will tend to be more than the ability of any government to implement counter-trend measures. If the money supply were $1 trillion, which has been leveraged, into $16 trillion, then a modest contraction back to 10:1 becomes a reverse leverage of 600:1 insofar as the destruction of paper wealth is concerned. Therefore, even if the central bank doubles the money supply, such an increase will not be sufficient to overcome the deliveraging effect. This is the situation we currently find ourselves in as some of the big hedge funds liquidate positions in an attempt to meet margin calls.

We have warned that intervention is a dangerous game. It has been used by politicians in recent years to support their own agendas that have been counter-trend to the free markets. In the case of massive liquidation that is causing a panic within the currency of a nation, this is perhaps the only justification for government intervention to sell back its own currency. The failure to do so on the part of Japan now may put at risk the entire world economy thanks to the hedge funds. There will be no way to stop the effects that will now spread due to the shock in the currency markets. Yet over time, governments will attempt to intervene in the process by controls, regulation and sumptuary laws. All such efforts will risk a further contraction in economic activity raising the risk of a prolonged global meltdown.

The large hedge funds have placed vast sums of leveraged cash on the line in trades that they thought were liquid, such as dollar/yen and mark/yen. The problem that we are currently experiencing has to do with the crisis in liquidity and not a flight to quality. There is a subtle difference. A flight to quality is where capital is rushing from one investment to another. What we are witnessing is a crisis in liquidity caused by the liquidation of positions seeking to move to cash. While hedge funds like Tiger have made no public comment on their losses, they continue to make the headlines of even the evening ABC national news. The manner in which these positions are being liquidated is amatureistic at best because they are being thrown on the funeral fires in a manner that says, “just get me out!” However, if we assume that these portfolio managers are NOT amateurs, then the only explanation for such massive and relentless selling must be due to the fact that they are under the gun in order to meet margin calls or face forced liquidation by banks.

In any event, liquidation by one fund causes action to be taken by others. We have argued for decades that ALL Panics are NOT caused by short selling but by long liquidation. This is precisely what is taking place and it is perhaps more visible now because those funds that are liquidating are so few. As liquidation begins, others are also forced to liquidate. The danger, is when this vast leveraged hoard of cash forces normal economic flows to take action. In this manner, the deflationary influences expand rapidly spreading from economy to economy until the entire world is engulfed in financial pain. The low comes about only when the liquidation finally ends.

The damage now caused by the liquidation of yen positions against the German mark and US dollar filter over beyond the mere currency markets. This sudden drop in the dollar means that whatever profits the Japanese banks did have on their foreign investments was just wiped out in 2 days. There cannot possibly be many Japanese banks that have a remote possibility of earning a yen. The higher yen results in a collapse of the Nikkei as foreign holders of Japanese equities rush to take immediate profits in the face of a sudden 10% gain in currency. Domestic Japanese selling comes in due to those who now see any earnings of the corporates vanishing due to foreign exchange. Everything begins to feed upon itself with one domino pushing into the next.

The US bond market was sent rushing upward due to Long Term Capital Management (LTCM) who had a big bet on higher interest rates. Their rush to cover positions sent the bonds from 125 to 135. However, the collapse in the bonds most likely came from others like Tiger Management selling in an effort to meet alleged margin calls on yen and equity positions. A third hedge fund is said to have 30,000 long positions in the S&P 500 futures. If that is true, then this liquidation panic can also crush the stock markets. We have already seen relentless selling of the European markets earlier without the slightest sustainable rally while the US market held its ground. This was caused by other hedge funds, perhaps including LTCM, who had been betting aggressively on the coming Euro. They were long European markets and short the US market.

The Euro has effectively been wiped off the face of the earth. LTCM was the biggest player on the Euro. They were short the German mark against just about every Euro currency through the bond markets. LTCM was responsible for the miracle convergence throughout Europe. Now the trade appears to be long marks and short ECUs as the ERM simply blows up. In reality, Europe was a giant emerging market play as fund managers were betting on coming reforms to bring about “Euroland” as it was being called.

From here, this plague of liquidation appears to be spreading around the world. We are witnessing the massive deleveraging of our global financial economy. The degree of leverage is not known at this point and we certainly cannot see any relaxation in confusion or volatility. We can say that each market appears to be turning on its own investors with the intent of creating as much havoc as our human capacity for endurance can take. This means that the stock market decline is NOT over. We will see a rally first as the market attempts to squeeze out all the short positions. However, lacking fresh buying, the markets will then turn south with the speed of a thunderous crash. There will be NO flight to quality trades that survive in the global mess short-term. Forget about rushing into the metals. As reported on Reuters today, the new German government will no longer oppose IMF gold sales due to the fact that they need their own cash for home. This will lead to more selling from additional central banks as well as they themselves become caught up in the global liquidation crisis.

Even the silver market fell like a stone today. Selling in the cash market of more than 12 million ounces already has sent silver down from $5.45 to $4.76. Those who have taken issue with our computer models on this market will curse the day they ever bought silver. Dealers continue to talk about possible Buffett selling. Tiger Management has also been a big player in the metals markets, which could now lead turn into another wave of liquidation. Everyone is now running out and buying puts on metals for fear that the next wholesale liquidation will hit this group sparing no one around the financial world.

There is no place to hide other than cash for the moment. We are in the final stages of a global liquidity crisis and not a flight to quality crisis. In this atmosphere, cash rules.