Leveraging anew

With a new year looming and with a coming change to the political and economic landscapes, the tone of the blog will need to adapt. All things are not by nature fraudulent (made-off shows the need for due diligence, but some people are trustworthy - yes, Boy Scouts, for one). Too, some know how to handle the map/territory problem.

So, let's start with leveraging (and its associated fiction). Earlier posts seem like diatribes in some cases, as they were not complete. As an aside, that is one drawback of the blogging paradigm; as, even with extensive linking, coherence is not as readily attained as it can be in sequential text.

Leveraging is not bad, in itself. After all, we have used the lever since Archimedes explained the principle and use. But, financial types went overboard with leveraging many times, including in the great market drop of 1929. Laws were put into place to limit using debt for things that were highly risky. These laws seem to have been forgotten, of late, as fairy dusting allowed magical returns to become realistically expected. Then, we had a mess; made-offing was the most recent example.

Friedman, in a recent article, noted that we need an ethical as well as a financial bailout. He used "I'll be gone" to describe a syndrome related to leveraging. In short, we had people thinking that someone else would have to clean up their mess. Why care about it when the perpetrator was long gone? (Yes, CEOs as diaper messers (we've said it before)). Friedman said that Madoff was the "cherry" on this cake of ours.

By the way, the article notes that we were not walking our talk. We were trying to shovel the 'casino' of capitalism under the rug while telling everyone else that we're the best.

One could probably argue that leveraging went awry due to misunderstandings. A common theme here is that computational and mathematical ideas have been interloped and used to screw things up. Take what we learned from the Modigliani-Miller theorem in which a type of equivalence is shown between debt and equity (to put it loosely). Gosh, folks, just look at the list of assumptions. A whole bunch of economists have built careers just looking at implications of this list.

One that we'll quibble about is the efficient market bit of fairy dust. Too, MM deals with a firm, yet who is usually a large holder of equity. The public, consumers all!! Yet, we counsel them to not indebted themselves in order to play the market (or used to, as a lesson from the Great Depression).

In short, there are intrinsic differences twixt equity and debt that MM does not eliminate. The discussion here would ask how anything wrong for those behind the firm could not hold in the collective. You see, look at the tranche mess (where crap was gathered, sliced/diced, then rated to not smell).

Okay, now, to look at an example of leveraging financially, consider the mortgage. Some of the older folks like to pay cash, for whatever reason, for their houses. Or, we saw movement of monies this way from sales in high-valued (using the term advisedly) area to a buy in a low-valued area (think CA to AZ, if you would). But, let's consider a normal situation.

If you want to buy a house with some form of down payment and then make periodic payments, that loan is a type of leverage. You will have some equity, with a lien, of course, and enjoy current benefits based upon future payment. One assumes that the future payment requirements will be met. Also, various risks are handled with things like home-owners insurance. All in all, this model has worked well for millions over the years. One could think of several examples like this. Perhaps, an enumeration of these would be a good thing to do here.

But, there are many things that went wrong. Such as, allowing leverages to be built (almost ad nauseum) upon leverages which is very suspect, just by definition. As well, some were put into mortgages without having the means to pay. We'll look at all of these at some point.

Remarks:

04/03/2011 -- Tis tranche and trash.

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.

03/03/2010 -- Applies to the debate about MM and equity/debt.

10/14/2009 -- Knowledge can, and ought to, be leveraged.

08/18/2009 -- As promised, FEDaerated is here.

07/23/2009 -- After the bust and the rebound, toxic assets are still a problem due to tranche realities.

Modified: 04/03/2011