HUMMONEY - The Crisis of our Confidence (Perspective)

--By Greg Lewin

 “Nothing is more dangerous than an idea, when it is the only one you have.”   Emile August Chartier

As the financial crisis unfolded and policy actions were chosen the mission was clear: increase economic activity, repair the housing market and get people back to work. Step One involved the transfer of many of the troubled assets (bad decisions) from the balance sheets of the banks to the balance sheets of the federal government. Step Two was to institute a series of stimulus measures which included numerous tax incentives and some make work projects. Step Three, called QE2, involves a two part process ultimately leading to the injection of money into the stock and commodity markets to create what is called the wealth effect in the hope of stimulating spending and therefore growth. We have written about these subjects in the past and encourage your review should you wish more detail. Although this story has been broadly reviewed, we suggest one important subtlety has often been overlooked - the use of leverage as a deliberate policy choice.

In Step One assets flowed from the banks to the government, thereby deleveraging the banks. Now as assets are flowing back to the banks in Step Three, in the form of cash, the banks are once again free to employ the leverage they were unable to use when burdened with troubled assets. Federal Reserve policies have essentially lowered interest rates to zero, forcing investors, including banks, to seek returns in more speculative assets, such as stocks and commodities, rather than fixed return instruments like bonds.  The basic business model of all banks is the liberal use of leverage, which has generally ranged from 10 to 30 times their capital bases.  So now after capital was recycled from the banks (who were burdened with troubled loans that could not sustain more leverage) to the government and back again to the banks essentially in the form of cash, the banks are able to back the deployment of this cash into the stock and commodity markets with their customary leverage.  As if by magic, leveraged capital is thrust back into the markets without repairing any of the problematic assets that were the genesis of our problems.  It should become a little clearer why the markets have exhibited such consistent strength since the inception of QE2. We have once again employed our traditional weapons of leverage and speculation to address our financial problems.

But the magic does not stop there.  The market operatives can apply a special sauce to effectively increase their leverage on market behavior to create the results they desire. One of the fascinating features of financial markets is the power of the marginal dollar. What does this mean? Let’s use the stock of IBM as an example. IBM has a market capitalization of over $200 billion and trades approximately 4 million shares per day. At a price of $160 per share that suggests 4x160 or $640 million of stock trades on an average day, or 0.032% of the total value of the company.  Yet consider how often you see IBM change well over 1% and on occasion as much as 5%.  This impact on the overall value of this gigantic fixture of American business is as much as 30 to 150 times greater than the proportional value of the shares traded. How can this happen? It is beyond rare that any single piece of information that could possibly arise on a given day could alter the destiny of such a large and great company to this degree. Because the vast majority of shares do not trade on any given day or for that matter series of days, the point being made is that marginally traded shares have incredible power over the fundamental value ascribed to businesses of any scale. Let me assure you our 30 to 150 times example gives us ample room to support our assertion should we be referencing days of unusually large volume. And this is by no means fictional value. The price of one’s shares can impact the cost of raising capital, the ease of recruiting and retaining employees and the ease of gathering new business as a strong stock price influences the perceptions of customers regarding the health and vitality of an institution. To further add to this brew I can also share that the way the Fed advertises when it injects cash in the system allows sophisticated traders to create the vast portion of the stock price move for the day in very small windows of activity. So often this marginal dollar impact is not a matter of the daily shares but a few minutes of the day’s volume and shares making this marginal dollar effect that much more powerful. As a final point let’s add one last twist. What if instead of just buying stocks and commodities our new speculative dollars go into futures contracts, each of which represent hundreds of shares of the underlying assets being traded?

Well you get the point.  Our government has once again figured out a clever way of using financial markets to try to repair fundamental problems. You might argue that no one seems to get hurt and maybe it will help us get out of this mess. If we are lucky that may be the case, but a lot of us were taught that you usually don’t get something for nothing, and this is where the laws of unintended consequences sometimes raise their head, otherwise known as Black Swans. In this case, one could argue that is exactly what we are beginning to see, because along with QE2 we have seen the enormous spike in commodities prices across the board from agriculture to energy. And it is these very spikes in costs which have pressured the costs of living around the world that may have been a catalyst to the activities we are now seeing spread across the Middle East. So my caution remains, beware when you have one idea, especially one which has such a dubious record of success. 

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.