Thursday, April 07, 2011

Extreme Leverage, Extreme Instability, Extreme Risk

Leverage isn't just financial--it's in crude oil and technology, too.

We tend to speak of leverage in financial terms, but as frequent contributor Harun I. notes, leverage and thus risk is ever-present in everything from oil to technology.

Some call it complexity or hyper-complexity, to me it's all about leverage. The greater the leverage the greater the instability. And developed societies are too heavily leveraged in technology (knowledge), finance (credit) and energy. Remember, your prediction of a 4% failure in housing causing a complete collapse in that sector was dead on. But that 4%, which globally represented much less, collapsed the entire global banking system.

Technologically, there are too few people holding the knowledge to systems that are now considered vital; the same can be said of the monetary systems (the Fed insists on black box operations in conducting monetary matters). Crude oil and all its derivatives from which we get fertilizer to Tupperware to space shuttles: the extend to which we are leveraged via oil is incalculable.

Thank you, Harun. The greater the leverage, the greater the inherent instability and thus the greater the risk.

We tend to think of crude oil as the feedstock for gasoline and jet fuel, but it's also the feedstock for agriculture (fertilizers and transport), plastics (a significant percentage of industrial products) and ultimately everything else via transport.

Conventional economists are constantly cooing that oil accounts for a smaller percentage of the U.S. economy that it did in the 1970s; but does that mean that the economy is any less vulnerable to supply disruptions? The concept of leverage helps us understand how removing $650 billion in crude oil from the U.S. economy (18 million barrels a day X 365 days = 6.5 billion barrels X $100 per barrel = $650 billion) is not just a simple subtraction of 4.5% of total GDP ($14.7 trillion): it would trigger the implosion of the entire U.S. economy.

That's leverage.

How many people truly understand the precise mechanics of last year's "flash crash"? Does anyone really understand what interactions of high-frequency trading computers led to a stick-slip/criticality/crash? How dependent is the system on their expertise?

How many people operate the Federal Reserve's many opaque interventions in the market? What sort of daisy-chain ties the Fed's moves to other central banks? What happens if that web of intervention breaks down or seizes up?

The conventional spectrum of punditry and economists dismissed the idea that U.S. housing was a highly leveraged sandpile waiting for a stick-slip event. But the leverage piled on leverage was self-evident: the consumer borrowing (home equity lines of credit, refinancing, etc.) that fueled much of the "growth" in spending was leveraged off the housing bubble, which also leveraged rising demand for lumber, granite countertops, high-end refrigerators, etc., and a stupendous mountain of derivatives, credit default swaps, mortgage-backed securities and other financial instruments which leveraged up Wall Street's profits and valuations.

The entire sandpile collapsed once its riskiest grains--the designed-to-default subprime option-ARMs and no-document liar loans--succumbed to the inevitable.

Some observers insist there cannot be another recession because there is always 7-10 years between recessions. This is just like saying the U.S. could brush off the removal of 18 million barrels of crude oil a day because the oil only represents 4.5% of the GDP, and surely the economy has declined 4.5% in the past without any permanent damage.

Except that 4.5% is highly leveraged, and the system is totally dependent on it.That leverage creates a fundamentally unstable system, which is highly vulnerable to disruptions which quickly cascade in a series of inter-connected, self-reinforcing feedback loops--just like "flash crashes" and markets which suddenly have no bid.

The recovery is self-sustaining, technology will save us, the U.S. economy is resilient, don't fight the Fed, the stock market is on a permanently high plateau thanks to the Bernanke Put, blah blah blah. Check back in in 15 months and let's see who's right: the "The recovery is self-sustaining, stocks are on a permanently high plateau" crowd or those of us looking at the leverage being piled on leverage.

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