Leverage and truth

Context: See Tru'eng anew, focus going forward, mathematics.

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As said before, some of the financial methods lead to fiction, and leveraging is one of these. Let's look at the problem.

According to the Modigliani-Miller theorem, capital structure is immaterial given certain conditions, such as the presence of an efficient market and absence of information asymmetry. There are other factors but notice how the two stated conditions are extremely abstract and wishful. In terms of the first, efficient market, computation is thought to be key. But, too, we need things like Sarbanes-Oxley for the second.

So, what is the point? Well, a lot of the recent problems came from the use of leverage. It used to be that there was caution about margin trading. Using Bill Buckley's concept, 'Stop', that is, don't borrow to speculate. And, the issues have not all been resolved; many are concerned about amount of margin trading that is extant in the current market.

The point is not to argue against modern trading schemes, such as the futures market, much of this goes back to something real; rather, some realism needs to be imposed. The arguments would probably follow closely those related to monetary standard (for example, gold) that is other than the current illusory one (the Fed can print at will).

Taking one recent example, the Fed's low rate allowed cheap short-term borrowing. Many borrowed to create long-term instruments which were inflated via 'magic' from their native junk state.

Well, some fundamental change is required. Supposing someone's hot idea needs funding with cheap money (will that become a rare commodity?). The original source of the funds ought to share in the take, to boot. What about risk? Well, in some cases, the original loaner lost when risk, that was supposedly filtered out, came down the line.

Reinsurance (ah, yes, AIG comes to mind; we had all the risks handled, didn't we guys? 10/26/2008) is supposed to help with some of this. But, how often of late have we seen people puzzled that the model broke down under severe stress such that what was supposedly good showed its junk-ness.

The discussion will continue.

Remarks:

01/05/2015 -- Renewal, see Context line.

11/22/2010 -- Tranching, under the guise of securitization? Silly games.

11/02/2010 -- Two years later, the message is the same, except some changes have occurred. Of real note is that the jobless rate is high; out-housing really set up for that. Also, we need to re-look at that learned from the 'vons' guys, Ludwig and Friedrich. See Near Zero.

10/06/2009 -- Near zero applies to this discussion.

06/17/2009 -- Michael Milken says that structure counts (see WSJ article). Remember, the theme here is that a lot of securitization is bunk, many times. Sheesh, talk about a perpetual motion machine, always moving monies from the pockets of the hapless to that of the fat cats.

03/01/2009 -- Sufficient time has elapsed to allow things to unfold in ways that are of interest to our analysis.

12/18/2008 -- Leveraging, in and of itself, is not bad.

10/26/2008 -- Yes, things fell apart for several reasons: fiction, leverage, and more.

03/31/08 -- This post took little steps in looking at problems related to leveraging, somewhat feeling the way. However, the concepts of leveraging and de-leveraging are found used more often now in books and articles that look at current financial problems.

Modified: 01/05/2015