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After years of excessive
borrowing by companies and individuals, the
leverage monster has finally come home to haunt
us.
What is different
about the 2008 crash?
The 2008 market crash was
an accident many years in the making, just
waiting to happen! In this regard, we should be
neither shocked, nor surprised.
With the advent of the ever increasing power of
computers throughout the 1990’s until now,
financial engineers have evolved and developed
an increasing array of sophisticated derivative
products that have leveraged, or geared, our
financial system to breaking point.
For each dollar that you deposited with your
bank, that bank in turn could lend many
multiples of that dollar to someone else,
largely via derivative products. When those
leveraged and borrowed assets turned sour with
the onset of the housing market bubble, someone
had to be liable.
Understanding how
the 2008 crash
happened.
Simply put, a derivative
security or product is an extension of the
underlying asset for investment or speculative
purposes. A simple example is the option to buy
stock. This is known as a call option. A call
option gives the holder the right, but not the
obligation, to purchase stock at an agreed
price (the strike price), on or before a
pre-determined date (the expiry date). For this
right, the holder (or buyer of the call option)
pays the seller a price (the premium). The
buyer’s risk is limited to the price paid for
the option, as this loss cannot be more than
the premium paid. For the seller of the option
however, the risk profile is very different, in
fact, it can result in unlimited losses!
Consider the following example;
You have bought a call option in XYZ stock for
$1.00 with a strike price on XYZ of $10.00. If
the stock falls below $9.00, you would not
exercise your right, and you would lose your
$1.00 premium when the option expires. The
seller would make $1.00 profit, his maximum
profit. Now, what would happen if stock XYZ
starts moving higher before the expiration
date?
The smarter seller of the option would have
made sure that he owned XYZ as covered stock,
at the time he sold you the option, thereby
ensuring his $1.00 profit. Unfortunately, in
the context of the 2008 crash, this did not
happen. If XYZ suddenly moved to say $20.00
before expiration, you would exercise your
option and make a $9.00 profit (the difference
between the current price of $20.00, less the
strike price of $10.00, less the premium of
$1.00). If the seller did not cover his
position as the stock moved higher (against
him), he would have to suffer the $9.00 loss as
he is obliged to deliver the stock to you at
$10.00. Or worse, he would have to borrow money
to purchase the stock, to deliver to you.
Starting
to sound familiar?! And if XYZ moved even
higher, the problem for the seller only gets
worse.
Take this very simple example, multiply it
literally by billions of dollars (if not
trillions), and you can get a sense of how huge
this problem has become. On top of this, many
of these derivative products have become so
complex, with such massive leverage and
gearing, that it is impossible to quantify the
extent of this crisis. By their very nature,
derivatives allow you to leverage and gear your
capital to many multiples, some as much as 40
times!
When the chickens
come home to roost, someone has to
pay!
Wall Street can thank the
taxpayer for this assistance.
Previous seismic events in the financial
markets did not have this excessive derivative
equation. Throughout this leverage period over
the last two decades, it can be argued that the
bulk of what is now known as “toxic debt” was
both unregulated, and had no standard
measurement of valuation, only serving to
exacerbate the problem. Hence, the rating of
this “toxic debt” by the credit agencies was
meaningless. So, when the holder calls up his
derivative “investment”, the other party has to
pay-up. If the party cannot pay-up, either they
have to declare bankruptcy, or if they are big
enough, ask the taxpayer to bail them out.
Failure to do the latter would be more
catastrophic for all of us. The now familiar
story!
How can you avoid
falling into the same
trap?
The answer is
surprisingly simple - do not leverage your
personal assets!
Your credit card can be the most devious form
of personal leverage without you even realizing
it. Many credit card companies love it when you
over-borrow on your credit card, because they
know that they can charge you exorbitant
interest rates, leveraging to their own benefit
at your expense. The now infamous
adjustable-rate mortgage (ARM) is another
example, as they usually reset to a higher
interest rate.
The bottom line is that you have to ensure that
you and your family do not fall into this debt
trap! You have heard the call time and time
again, DO NOT BORROW MORE THAN YOU CAN AFFORD.
One of the most important things you can do to
manage your money for the future, as your
career progresses, is to ensure that you have
net personal assets (you own more than you
owe). Do not break this rule, not ever! In the
“good times”, when interest rates are low, and
access to borrowed money is easy you often hear
then that you should borrow more to invest. On
the contrary, it is during these times that you
should be building your net asset base first
and foremost. You can be certain of the
financial direction after the “good times” are
over. The trajectory is always down!
The new financial era has just started, causing
great uncertainty and stress. The rules of
banking, and in particular lending, are going
to have to be dramatically reassessed. This
will have a direct impact on our personal
lives, and the way we do business. In short, if
you can work to eliminate your debt completely,
you will have taken a significant weight off
your shoulders, and ensure that you are on the
right path towards your financial security.
December 2008.
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