Saturday, September 20, 2008

The great de-leveraging

Four years ago, SEC rule changes allowed the big investment banks to take on more debt. Predictably, leverage ratios increased from 12 to 1 to over 30 to 1. When the markets are going up, increased leverage is profitable, but exposes banks to more risk should they go down. But de-leveraging (selling assets to pay back lenders) is difficult in the face of so much uncertainty.
Nobody understands who owes what to whom — or whether they have the ability to pay. Counterparties have become afraid to trade with each other. Sovereign wealth funds are no longer willing to supply badly needed capital because they no longer know what they are investing in. The crisis continues because nobody knows what anything is worth. You simply cannot have a functioning market under such circumstances.
Everyone I ask says that this is going to take about two years to occur. But when everyone says that, I suspect that no one really knows. If I did, I wouldn't be teaching school, and I certainly wouldn't tell you.

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