There is a justified apprehension that in credit-based economies, of the type associated with capitalism, the excessive reliance of credit on collateralization perpetuates an unfair advantage for those endowed with more capital. The popular sentiment that money-attracts-money and misery-attracts-misery. However, the rise of capital markets and the spreading of banking philosophies based on the ongoing concern principles, means that market capitalism dilutes such concerns about the misallocation of savings.
Before addressing the potential misallocation of leverage under financial capitalism, let me make a qualification about the differences between savings and investment and credit and borrowing. The two concepts are often confused because ex-post, in an accounting sense, their value is identical and also because in a popular sense saving is seen as a form of abstinence. Likewise, lending is popularly identified with renting an existing asset, e.g. a lawnmower or cash.
To be more exact we should define investment as the carrying of any asset (whether the butter in the fridge or the computer in the office) from one accounting period (whatever period unit one uses, year, month, etc.) into the next period, either because it cannot be entirely used up within a single period or for precautionary or speculative reasons.
Under this definition one would consider consumption as the use of a portion of newly produced or existing assets during the current accounting period. Thus, as Keynes put it, “when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment” . Hence, savings and investment are jointly determined by the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest.
Therefore, one needs a theory of how financial leverage influences these determinants. In the absence of such theory, one can nevertheless intuition (see Mendes 2000) that the rise of finance capitalism has two offsetting effects on investment – contractionary and expansionary – whose net effect has to be ascertained under specific circumstances.
In particular, large scale investments need to be collateralized through a mix of financial assets and guarantees involving a complex engineering between banks and governments. This necessarily degenerates into collusion between these two sectors which occasionally may crowd-out the funding of enterprise in favor of speculation and government spending. In this sense it is a threat to market capitalism.
However, some speculative occurrences in financial assets have as an underlying a non-financial asset like real estate or similar which causes a misallocation of resources into non-financial assets (e.g. the sub-prime real estate bubble and crash in US). On other occasions it is not clear if the speculative frenzy began with non-financial assets and after transmitted to the financial sector or vice versa. However, such cycles are neither the result nor a threat to capitalism.
In conclusion, finance capitalism may cause some misallocation of resources and favor the leveraging of some sectors (e.g. managerial capitalism) but it is not a fatal threat to market capitalism.
Showing posts with label debt. Show all posts
Showing posts with label debt. Show all posts
Tuesday, 8 December 2015
Monday, 25 July 2011
Leverage as Friend and Foe
As far as I am aware there are only four legal ways to become seriously rich in a short period of time: to inherit or marry into money, to hit a lottery or sales jackpot, to become the CEO of a large public company or investment fund in the USA or to leverage one’s way into wealth. Out of the four, only leverage is not fundamentally determined by destiny or luck.
Not surprisingly, this explains why, throughout history, leverage never ceased to fascinate people as a kind of “Aladdin's lamp” for immense wealth. In fact, the history of financial innovation is little more than a continual re-invention of some form of leverage. Leverage or gearing is the percentage of external financing and it is often measured as the ratio of capital to debt or as the ratio of total debt to total assets.
Indeed, credit is an essential element of market capitalism. It allows those with entrepreneurial spirit to invest beyond their own capital and gives those without such spirit the chance to share in the success of entrepreneurship. This means that passive investors must accept a lower return to make it worthwhile for entrepreneurs to take the added risk.
The case to make debt-financed investments applies equally to families and governments. So, in a closed economy this might create an impossible situation where everyone wants to be a net borrower, leaving the central bank as the only net lender by creating the money necessary to fulfill the demand for debt. In such a system those in charge of dispensing credit have an extraordinary power over the fate of the borrowers.
In practice market economies rarely reach this extreme situation for three main reasons. First, many people cannot or do not bother to search for investment opportunities with returns well above the risk free rate of return. In particular, families and governments are often in this situation. Second, many do not have the collateral required by lenders or do not fulfill the requirements to access non-recourse finance. Finally, leverage is a double-edged sword and not all can or know how to cope with the risks of debt-financing.
To understand that there is a thin line between fortune and misery in the use of leverage, imagine that one can invest up to four times the value of his capital to achieve an expected return of 25%. If he succeeds his return will be 100%. But what if instead of an appreciation of 25% there is a loss of 25%? He would be completely wiped out.
The fact that the likelihood of a 25% loss is very small is not enough comfort because it will happen one day. And, if one keeps reinvesting all his proceeds, he will lose all his previous gains. Any roulette player knows this, but people often tend to forget it. Especially when prices have been going always in the same direction, as happened recently in the real estate market (many people had never observed a fall in housing prices).
So is it true that leverage, like death, in the end will always finish by catching us on the wrong side of the bet? Not necessarily, provided that we do not re-leverage all our gains, do not exceed a prudent level of leverage and manage it correctly (for instance by not carrying leveraged positions over-night).
To be prudent one needs to answer the important question of whether there is an optimal level of leverage and what are its determinants. Unfortunately, neither in theory nor in practice can we find an answer to this question.
First, different assets have different levels of volatility (for instance in the last 10 years, intra-day, the Dollar never fell by more than 4.8% in the Euro/Dollar market while in the stock market the shares of Microsoft never fell by more than 12%). Second, in itself, leverage changes the optimal composition of investment portfolios. Thirdly, because the optimal level of leverage may be above what lenders consider safe and lenders are often prone to stampede behavior creating wild fluctuations in what they judge as safe or not.
But, most importantly, at the theoretical level we find ourselves in a difficult position. This is true, even after ignoring the wild fluctuations in banker’s lending limits while considering only the spreads (or mark-ups) they charge to compensate for risk. Theoretically the optimal level can be defined as the level of leverage that maximizes the difference between the returns achieved with debt finance and those obtained without any leverage. The problem lies in the fact that the two curves depicting the marginal efficiency of capital cannot be derived separately.
In the absence of estimates for the optimal level of leverage, prudence dictates that one should err on the down side by keeping a reasonable margin below the level of debt capacity acceptable to lenders. This can be easily defined in relation to margin requirements or the present value of future free cash-flows. With this proviso and knowledge of the nature of debt-financing, investors may be able to turn a potential foe into a friend.
Not surprisingly, this explains why, throughout history, leverage never ceased to fascinate people as a kind of “Aladdin's lamp” for immense wealth. In fact, the history of financial innovation is little more than a continual re-invention of some form of leverage. Leverage or gearing is the percentage of external financing and it is often measured as the ratio of capital to debt or as the ratio of total debt to total assets.
Indeed, credit is an essential element of market capitalism. It allows those with entrepreneurial spirit to invest beyond their own capital and gives those without such spirit the chance to share in the success of entrepreneurship. This means that passive investors must accept a lower return to make it worthwhile for entrepreneurs to take the added risk.
The case to make debt-financed investments applies equally to families and governments. So, in a closed economy this might create an impossible situation where everyone wants to be a net borrower, leaving the central bank as the only net lender by creating the money necessary to fulfill the demand for debt. In such a system those in charge of dispensing credit have an extraordinary power over the fate of the borrowers.
In practice market economies rarely reach this extreme situation for three main reasons. First, many people cannot or do not bother to search for investment opportunities with returns well above the risk free rate of return. In particular, families and governments are often in this situation. Second, many do not have the collateral required by lenders or do not fulfill the requirements to access non-recourse finance. Finally, leverage is a double-edged sword and not all can or know how to cope with the risks of debt-financing.
To understand that there is a thin line between fortune and misery in the use of leverage, imagine that one can invest up to four times the value of his capital to achieve an expected return of 25%. If he succeeds his return will be 100%. But what if instead of an appreciation of 25% there is a loss of 25%? He would be completely wiped out.
The fact that the likelihood of a 25% loss is very small is not enough comfort because it will happen one day. And, if one keeps reinvesting all his proceeds, he will lose all his previous gains. Any roulette player knows this, but people often tend to forget it. Especially when prices have been going always in the same direction, as happened recently in the real estate market (many people had never observed a fall in housing prices).
So is it true that leverage, like death, in the end will always finish by catching us on the wrong side of the bet? Not necessarily, provided that we do not re-leverage all our gains, do not exceed a prudent level of leverage and manage it correctly (for instance by not carrying leveraged positions over-night).
To be prudent one needs to answer the important question of whether there is an optimal level of leverage and what are its determinants. Unfortunately, neither in theory nor in practice can we find an answer to this question.
First, different assets have different levels of volatility (for instance in the last 10 years, intra-day, the Dollar never fell by more than 4.8% in the Euro/Dollar market while in the stock market the shares of Microsoft never fell by more than 12%). Second, in itself, leverage changes the optimal composition of investment portfolios. Thirdly, because the optimal level of leverage may be above what lenders consider safe and lenders are often prone to stampede behavior creating wild fluctuations in what they judge as safe or not.
But, most importantly, at the theoretical level we find ourselves in a difficult position. This is true, even after ignoring the wild fluctuations in banker’s lending limits while considering only the spreads (or mark-ups) they charge to compensate for risk. Theoretically the optimal level can be defined as the level of leverage that maximizes the difference between the returns achieved with debt finance and those obtained without any leverage. The problem lies in the fact that the two curves depicting the marginal efficiency of capital cannot be derived separately.
In the absence of estimates for the optimal level of leverage, prudence dictates that one should err on the down side by keeping a reasonable margin below the level of debt capacity acceptable to lenders. This can be easily defined in relation to margin requirements or the present value of future free cash-flows. With this proviso and knowledge of the nature of debt-financing, investors may be able to turn a potential foe into a friend.
Friday, 7 January 2011
Why the IMF therapy is not working in Greece
The main role of IMF-sponsored adjustment programs is to facilitate a normal access of the borrowing countries to external markets. With the CDSs on Greek debt at 11% (above those of Venezuela) and yields on 10-year debt higher than they were before the IMF program (see chart above) the failure of the program is unquestionable.
One of the reasons why markets do not believe that Greece will be able to avoid defaulting, is probably due to the fact that the IMF approach can only use one of the three tools of their standard treatment - fiscal and budgetary policy. With Greece being a member of the Euro-zone, the other two - monetary and exchange rate policy are not available unless Greece is forced out of the Euro.
Unfortunately, the IMF has no experience of dealing with balance of payment adjustments within monetary unions. Moreover, even in relation to budgetary policy, the IMF does not realize that Greece (like Portugal and Spain) has an economic system based on state capitalism. Thus, unless they starve the Greeks (in a Ceausescu experiment) it will not be possible to achieve an external balance without destroying the state capitalism system, which the Greeks are not willing to do.
Thus the only three alternatives for Greece (and to Portugal, who is trying to mimic an IMF program without the IMF) are: a) to force a significant hair-cut on its bond-holders, b) to receive a major grant from other EU countries, or c) a mix of both. None of these is a pleasant solution but there is no other way out.
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