FedUpUSA

Leverage: Just Don’t

Leverage

How to spit your coffee early on a Monday morning…U.S. Should Show Some Ambition on Bank Leverage:

This week, Federal Reserve officials are expected to vote on new rules for bank capital — shareholders’ equity and other forms of financing that, as opposed to debt, can absorb losses and prevent insolvency in times of trouble. According to Bloomberg News, U.S. authorities have been considering increasing the requirement to $6 in capital for every $100 in assets, a “leverage ratio” of 6 percent. That’s double the international minimum set by global regulators in Basel, Switzerland. The current U.S. minimum is 4 percent.

Oh, so it’s 4% eh?  Really?  Including all derivative and off-balance sheet (such as SIV) exposures?

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Supposedly, if you read that article, the current “big banks” have only 3.4% in equity — so how is that possible if the minimum in the US is current 4%?

Well, first you have to assume that even that set of so-called “accounting standards” are accurate (they’re not) because nothing is being hidden (it is.)

The problem rests here:

For 30 years we have lived in a world of increasing leverage made possible by broadly-declining interest rates.  There is nobody currently in the banking or investing world under the age of 50 who has ever lived in a different environment — and that’s a fact.  Most who are older and still working knew only the pain trade from the rapid rise in interest rates following the Arab Oil shocks.  Those with an actual understanding of how markets and leverage work in a rising rate environment are all dead.

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Here’s reality for you — when rates are declining it is effectively a “free carry” to increase leverage.  It is damn near risk-free and as long as you can ride out the small counter-trend moves because you don’t get too far out over your skis you’re fine.  You print money by turning the crank and there appears to be no downside — or end — in doing so.

The problem comes when this trend changes.  When it flattens out then turning the crank simply increases risk, and we’ve now had four years of that.

But when the rate environment shifts to one of increasing rates then leverage is death and the more you turn the crank the faster you bleed out.  There is no way to get in front of it by trying to back off, because backing out of your leverage means taking the losses that accumulate at an exponentially-increasing rate and you drive the rate environment higher as you do so, exactly as you drove it lower when it was trending the other way.

Nobody in business or government presently has lived in this environment and learned how to prosper in it.  You prosper in it by not having leverage on and picking up the pieces from others who fail.

There have been a few instances where this has been possible over the last 30 years but they have been isolated.  Recessions always provide these opportunities for those with actual capital, but there are usually few of those people because on balance this is not a strategy many employ.

However, this is going to become the dominant winning strategy instead of a sideshow in the coming years, where the opportunities to “turn the crank” will be the exceptions rather than the rule. 

Indeed, it will be those with little or no leverage who have the advantage, and this trend too, like the last, is likely to persist for decades.

If you’re not thinking about this here and now, and positioning for it, you’re going to be in trouble.

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