Friday, October 10, 2008


An over-simple look at leverage and risk

The financial mess is, as they say, complicated. With all the interrelationships among the institutions and the instruments and the investments, and with the different market mechanisms and other such things involved, it’s hard to understand it all. But there are two aspects that I do understand, and that, put together, explain a great deal of how it happened.

Excessive “leverage”

When you have to move a large stone that you don’t have the strength to budge by hand, you can use a lever, one of our basic tools, to make it possible. A pry bar gives you an advantage that your strength alone doesn’t.

In finance, leverage has a similar purpose: it allows you to buy something you don’t have the assets to buy.

Notice I said “assets”, not “money”. Most of us buy things on simple credit all the time. When we buy houses, we usually get mortgages, secured by a combination of the house itself and our regular income. The bank is reasonably confident that our incomes are adequate to let us make the payments, and if we fail, they can take the house and get most of their money back (possibly all, possibly more).

But suppose I should want to buy a $300,000 worth of stock in company X, but I only have $100,000 to spend. And suppose I have all this other business going on, my reputation is good, and I can convince you to sell me the stock for the money I don’t have. Or I can buy a $5 billion company when I only have $1 billion to put into it. That’s an oversimplification of leverage.

It’s the way the financial industry works. Very often, money is just moving around on paper, and isn’t really being transferred as money. And it works in part because of the other aspect:

Assumption of independence of risk

A company that sells insurance on houses all over the country can weather a storm in Florida, because even though it might have a lot of claims from there during hurricane season, it makes enough money from the rest of the country — and during years without bad storms — to cover it. The chances that there’d be a large number of claims from Florida, New York, Kansas, and California all at the same time are extremely small. But a company that only insured houses in Florida would have a much worse situation.

In the financial industry there are certainly independent risks as well. But with so many companies investing in the same things — and in each other’s success — the assumption of independence goes out the window. If company B puts money into “safe” instruments that depend on company A’s success, company C does the same with company B, and company D does it with company C... if company A falls, the others will go down in turn.

There’s also a related assumption at play:

Assumption of constant risk over time

Obviously, the longer a company insures your house, the more likely it is that you’ll make a claim over the life of the policy. But the chances of a claim from you in any given year is about the same from year to year — or, at least, any increase in risk that owes to the aging of the structure is known.

What happened here, though, was that as companies used their leverage to pile on more and more financial obligations that they couldn’t meet, the risk of failure went up dramatically. In addition, they piled on investments that were riskier to start with, having the dual effect of increasing the risk of the overall portfolio directly, and of increasing the risk of the other investments indirectly.

So: Everyone owes everyone else far too much, which means that their financial successes are too intertwined. They underestimate the risk involved because of invalid assumptions about the independence of the risks from each other and over time.

Can $700 billion of government money thrown into the system fix that? And prevent it from happening again in a few years?

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