Thursday, March 27, 2008

Understanding The Credit Crunch - Part 2

An earlier post Understanding The Credit Crunch remains one of the most widely read entries on this blog. The fact that many are still grappling with how we got into this predicament, explains how exasperating the problem is. The Federal Reserve has been aggressively lowing interest rates, opening the loan window to more firms, and accepting more collateral in an effort to stem the damage. The problem has spread well beyond the sub prime sector with the auction rate preferred market freezing up and municipal securities falling in value being examples of just how far the credit crunch has spread.

To briefly elaborate on my previous post, the problem stems as much from leverage as it does from credit quality. Margin requirements, which are determined by the Federal Reserve, allowed hedge funds and other institutional investors to borrow against their bond holdings and leverage their investment to many times their invested capital. Just like in the 20's, as long as prices rose the leverage allowed for much more profit. However, when prices began to fall it was like someone shouting 'fire!' in a crowded theater, everyone rushed for the exits at the same time and many were trampled in the stampede.

You probably can understand leverage best by thinking of your own home. Most people have seen the price of their home go up substantially over the last decade. Yet the long term compound increase in the median home price has averaged a little over 6% a year. How can so many people make so much money in real estate if prices only rise about 6% annually? The answer is leverage. If you had bought a home 10 years ago for $100,000 and it appreciated at 6% then today it would be worth about $179,000, a profit of $79,000. But you were unlikely to pay cash for your home. Instead you put down 10% or $10,000 and borrowed the rest. So that means your cash investment grow from $10,000 to $79,000 for an annual return on invested capital of about 23% a year! Nice work if you can get it.

As long as prices rise your leverage works hard for you. But woe to those who buy at market peaks. If your home falls by 10% you have lost all of your equity. Any further decrease leaves you underwater on your 'safe' investment. This is what has happened to many homeowners, and it is the same problem in the credit markets. The leverage has wiped out the equity of many aggressive investors, forcing liquidations which suppresses the prices of those securities and causes the liquidation of even more types of investments, in a vicious circle that has threatened to cause a collapse of the banking system.

That is why the Federal Reserve stepped in to work out a deal for Bear Stearns, if BS had gone into bankruptcy is could have caused a collapse of confidence in an already shaky system and led to a total collapse of our banking system. That the Fed has taken such extraordinary steps is a testament to just how serious this problem has become.

Fortunately, at least some in our government and in governments around the world understand how dire our circumstances are and have begun to take the concerted steps necessary to bring balance back to the global banking system.

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