How do you say ‘bubble’ in Mandarin?
The Shanghai exchange has gained 200% in the last 18 months. In Singapore, the stock market nearly doubled last year. And yesterday, the Dow hit a new record too.
And in Bozeman, Montana, it is a dash for trash. On Blixseth!
Mr. Tim Blixseth, whom we mentioned yesterday, is building what is easily the gaudiest cabin in the Montana woods…and perhaps the most expensive house in the whole world.
But, for making headlines, he has plenty of competition. Everything is soaring.
Oil rose to over $58. Gold shot up to $657. And Mr. Jim Wilson of Missouri won a Powerball pot of $254 million.
We were thinking of all this money this morning; it is the Age of Mammon, for sure. Which is why we have our Crash Alert flag still flying. Things don’t go up this sharply without them going down sharply, too – in a crash for example.
But don’t worry, say the experts, all this new sophistication in the financial markets (they have computers now!) makes crashes a thing of the past.
And yet, the Financial Times report from earlier this week troubled our sleep:
“‘There is now such creativity of new and very sophisticated financial instruments…that we don’t know fully where the risks are located,’ said Jean-Claude Trichet, head of the European Central Bank. ‘We are trying to understand what is going on – but it is a big, big challenge.'”
If the head of the second most powerful banking cartel in the world can’t make sense of it, what hope is there for us? We don’t know. But we have an obligation to our dear readers to try. So, for the last three days we have done nothing else…pausing only to pray and burn incense to the credit gods.
Do all these new financial instruments really reduce risk…or do they increase it? First, we have to master the peculiar dialect in which this subject is discussed. Swaps, securitized debt, alphas…you have to understand the language of the high priests before you can enter the temple. Then, when you get inside, you discover that the whole religion is nothing more than hocus-pocus.
After about 20 seconds of reflection, we realized that the answer, for once, lay not in the details, but in the generalities. The particular formula by which a specific derivative contract is constructed only affects the particular participants. But the phenomenon as a whole affects the entire world financial system. $450 trillion is a lot of money. In fact, it’s nearly 15 times world GDP. What it represents is more leverage and higher asset prices. Both make the financial world riskier.
Let’s look again at how it works. The feds make money and credit available. This reduces the cost of borrowing…and boosts up asset prices. Thereby, a man’s suburban castle rises in price, and he is able to ‘take out’ a little cash, by increasing his mortgage. This money gives him the wherewithal to buy a new car, made in Japan. The man himself is now immediately placed in a riskier position; he owes more money than he did before.
And then comes Goldman Sachs (NYSE: GS), which borrows the same money from the Japanese – at very low interest rates – and uses it to, say, finance the leveraged buyout of Equity Office Properties by the Blackstone Group. However much Equity Office Properties owed on its real estate holdings, the new owners are sure to owe more. That’s how leveraged buyouts work; the purchase is made on credit. The effect, once again, is to increase the risk in the system. If you own a commercial building in full, you can sit out a downturn in the business cycle. All that happens is that your income goes down. But if the building is leveraged, you have to pay interest on the debt. And if the interest is high enough…and your income falls low enough…you go broke.
Consider the aforementioned Mr. Blixseth, who is bringing more of the world’s good things to Bozeman, Montana. He is building a luxury ski chalet that he plans to sell for $155 million. What kind of a man would be able to buy it? Maybe someone who just got a wad of cash that didn’t exist before… someone who owned Equity Office Properties and just stuck it to a group of investors for $38 billion! But even buying bricks, mortar, and Italian granite countertops can be a risky proposition. The price of the house could go down. There’s a lot more risk inherent in a $155 million house than there is in one at $155,000.
But that’s not the end of it. The $155 million house can be a financial asset too – it can be used to secure a position in stocks, bonds, or private equity. And the debt used to acquire Equity Office Properties can also be traded, repackaged, sliced, diced and baked in a pie. Then, it too can be counted as an asset and placed in leveraged portfolios, passing around more risk. And as liquidity rises, people not only make more and bigger bets, but riskier ones. It is a classic bubble, where too much money chases too few decent investments. As Martin Fridson points out, the lowest-rated credits – Triple-C or below – which made up just 2% of the junk debt market in 1990, are now closer to 20%.
Still, here are the experts telling us that the financial system is actually less risky – because these fancy new products ‘disperse’ risk. Besides, they say, nothing bad has happened thus far; so, probably nothing ever will.
What do they take us for? The only reason nothing has gone wrong is…that nothing has gone wrong. We are living through the biggest credit expansion in history. When it ends, plenty will go wrong.
But will it ever come to an end? Yes, everything does…
Which is why we keep our Crash Alert fluttering on the mast…