Today we’re watching stage two of the market meltdown take place. Those of you who read my column on a reasonably regular basis know my basic tenets for why this is happening: markets need to find true prices, something they haven’t been able to do since the Fed started buying “distressed” (read: toxic) securities in the aftermath of the Lehman meltdown and 2009 and 2010 market collapses.
Newsflash: We Ain’t There Yet
In order to restore normally functioning financial markets, REAL investors have to decide what the true value of assets are in order to establish a true floor under markets. Any substitute for this process only wastes tax-payer money and delays the inevitable. Markets have been inflating repeatedly since the turn of the new millenia, first by margin traders (2000 dot-com bubble), then by off-balance sheet institutional investors (banks 2007-08 Bear Sterns rescue, Lehman failure), and now by the “full faith and credit of the United States and China” (2008-July 2011).
The Problem Remains: Too Much Leverage
Leverage in finance is a means by which someone with a small amount of money buys control of a very large amount of assets. So long as asset prices go up (a.k.a. more people join the fray and borrow/lever up to by the same limited number of assets), the game continues and those early entrants exiting make a tremendous windfall. At some point however, financial markets run out of credible borrowers (a.k.a. Suckers), and the last person in sells at a loss, followed by everyone else in the chain until 75-80% of the leverage / borrowing capacity of the market has been pushed out of the market. We appear to be in an ongoing massive contraction of that borrowing capacity right now.
A Graphical Depiction of What Maximum Market Capacity Leverage Might Look Like
I don’t think anyone has ever tried to construct what a picture of the entire global debt structure looks like, but I can assure you it is not good. What I can show you (courtesy of a GREAT chart site) is what the margin debt levels look like historically. As you might imagine given the market implosion the last couple of weeks, we appear to have hit the maximum borrowing capacity of individual participants in the margin trading of financial markets.