All out panic has not yet set in for markets, but financial markets can only remained over leveraged so long. Since the Fed has stopped buying treasury securities to prop up markets and fill banks with US dollars the market has jerked downward toward its natural price. It is still trying to find its equilibrium price level and will most certainly overshoot the bottom again as it convulses its way off of the Fed line life support which has sustained it the last 12 months.
Deleveraging Equals Deflation
Here’s a simple equation for you. If you give a bunch of testosterone juiced 20 somethings a bunch of money and only a certain number of assets to buy with that money… what happens to the price of those assets? Obviously prices rise and fall with the demand for any given asset, right? What happens then if you tell those same 20 somethings they can spend “50 times as much as the cash in their accounts”? Prices (overal) rise about 50 times, right?
What happens then, if suddenly 1% of those testosterone junkies get “shut off” from the leverage juice and kicked out of the tranding club? The entire girth of the market has dropped 50 times the amount of the initial capital stake, right? Consider a simple example (100 traders, $1000 initial capital, 50 times max leverage):
Initial capital state (no leverage): 100 traders x 1000 dollars = $100,000 initial entire market value.
50x leverage state: 100 traders x 1000 dollars x 50 = $5,000,000 entire market value.
Kick out 1 trader: 99 traders x $1000 capital x 50 leverage = $4,950,000 entire market value.
This represents a drop of $50,000 of market value – which in our intitial state would have represented HALF OF THE ENTIRE CAPITAL MARKET!
Now an astute observer would say $50000 of initial capital hasn’t been lost, and even the $1000 initial capital has been absorbed by the market into one of the accounts of the other traders – with the leverage on that absorbed capital remaining intact. While the latter is true, the former is not. Each time a leveraged trader drops out of the market – the ENTIRE market capitalization of the system is deflated by the amount of capital x some portion of the leverage of that trader. At some point, the remaining traders (wary of the fate of the first hapless loser) fail to fully apply their newly accumulated leverageable equity. As a result, the total market shrinks a little – the first round of asset deflation.
In our little example, eventually there would remain only 1 trader (after all the others went bankrupt), with no leverage (no longer needing it after accumulating all the assets) and the market size would be some much smaller fraction of the initially leveraged $5,000,000.
Here’s the rub: Everyone in our little experimental trading world also had/has needs in the consumer world: food, energy, cars, trips to the spa, etc. The problem is that as financial asset prices skyrocketed, so to did prices of everything else. So traders and average joes had to buy food and cars at prices set by how much the traders could borrow.
How Deleveraging and Deflation Are Happening in the Real World
Today we live in the world with fewer and fewer traders “levering up” to play what they’re finding to be a losing game. Capital markets (on the whole) must shrink as traders reduce or eliminate their financial asset leverage.
The problem is, everyone else in the world has had to live in the “other” part of the world where asset prices for things we buy have skyrocketed to the point where massive borrowing (leverage) is required to buy houses (30-40 year mortgages), cars (6-7+ year loans common now), and education ($150K+ 10 year bachelor degree graduate debt not uncommon). People in the real world can’t afford assets at these prices and have suddenly become unwilling to borrow to buy (or equally like lenders unwilling/unable to lend).
The result is MORE traders leave the game, more normal people lose their jobs and stop consuming, and the 2nd… 3rd… 4th… round of deflation occurs until those who still HAVE capital and chose NOT to engage in leverage buy up the worthwhile assets for pennies on the dollar.
If this sounds like a repeat of history, you’re right – you win a gold star. We re-doing the great depression all over again – regardless of what Fed Chairman Bernanke insists he will prevent. We are a hyper leveraged global economy – and people’s appetite for leverage is gone. The Jig is UP.