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Market turbulence

The harbingers of doom are back in the news: the infamous credit-default swaps. Several nations of southern Europe — most prominently Greece — have seen prices on swaps on their sovereign debt skyrocket, meaning that it is growing increasingly costly to purchase protection against a sovereign default. The credit-default swap market is a very liquid one; whatever may be said against these derivative instruments, they at least have the virtue of sending clear market signals about the debt instruments, which are usually far less liquid, to which they are attached.

These debt fears have roiled markets all week. There are even whispers that the European currency union is threatened. Germany, buoyed by a structurally mercantilist economy and sounder public finances than most Western nations, is playing hardball, wanting no part of a bailout of debtor nations on the EU periphery. Certainly if Italy were dragged into the debt crisis, the euro would be deep, dark trouble.

Now a default on Greek sovereign debt would surely be painful for Greeks and not a few investors, but the real worry is that this is all, as a German strategist puts it, “a dress rehearsal” for what could be in store for the US and UK down the road.

Last week the bond expert Bill Gross released a commentary on sovereign deficits entitled “The Ring of Fire,” in which he examined the rapidly accelerating deficit position of a number of major economies. His language was stark. UK Treasury bonds “are resting on a bed of nitroglycerine.” The coming decade is “likely to be fed by the melting snows of debt deleveraging.”

On Capitol Hill, the AIG debacle continues to dismay and outrage. Treasury Secretary Geithner and former Treasury Secretary Paulson endured some stern questioning from Congress. At issue: why Goldman Sachs and other investment firms should have been made whole, with public capital, on their swap contracts with the ruined insurance company. Could these financiers not been made to absorb a 10% haircut? That Paulson was a former CEO of Goldman does not reinforce his claims of probity. Geithner was formerly the President of the New York Federal Reserve bank, a quasi-private entity whose major shareholders are . . . New York finance firms. There is no want of cause for suspicion in all this.

Meanwhile, it is worth keeping in mind the fact that just this week a number of the Federal Reserve’s extraordinary liquidity support programs — a mass of peculiar acronyms — have officially concluded. There were the emergency measures undertaken in late 2008 to facilitate trading in markets that had frozen solid. Of course, anyone with any sense knows these programs will spring back to life the moment they become necessary again. But the devil is in the details: what exactly would constitute “necessary”? The markets may have been testing this all week.

The uncertainty in the world of finance is palpable. The only certainty is that the interesting times will persist.

Comments (2)

The coming decade is “likely to be fed by the melting snows of debt deleveraging.”

Would this sentence make more sense if I drank some alcohol? Could someone, please, write a dictionary of econ-speak for the economically-challenged (I smell profit!)? Perhaps if we simpletons understood where our money were really going, we might rise up and slay the deleveraging oppressors or at least make them leverage again, whatever that means :)

The Economically Simple-Minded Chicken

The argot of finance is indeed frustrating, Chicken.

Leverage is simply a term for borrowing. If I buy a stock at $10 and it moves to $20, I double my investment an earn a cool $10. But what if I go to a bank and borrow $100 so that I can buy ten shares of the same stock? I still double my investment, but the profit is now $100 (minus borrowing costs). So $10 of my own capital, levered 10X, produces bigger profits.

At the height of the recent boom, investment banks on Wall Street were leveraged 25 to 1 or more. Smart people have told me that the GSEs (Fannie and Freddie) were levered 85 to 1(!).

So leverage juices profits in good times, but it works the other way in bad. What happens if I borrow $100 to buy ten shares of that same stock, and it drops to $5 a share? Now I've lost virtually all my own capital, and I still owe the bank for the borrowed cash, plus interest.

Deleveraging is simply the process by which banks, investors, funds, etc. "unwind" all that borrowing, to get out from under the risks it implies, and to establish their capital position on firmer ground. The "melting snows" imagery suggests, perhaps, why Bill Gross is in the investment, rather than the writing business. But in fairness, it is not easy to convert the technical language of finance into that metaphorical language which aids in illustration and understanding.

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