SIGNS OF THE TIMES - MAY 14, 2007
Signs Of The Times
May 15, 2007
"It's the best of all
worlds, global growth is strong and the dollar is weak."
-Wall Street Journal
Chief Market Strategist at Bank of America
However, there are some observers
who are becoming concerned. A piece in WSJ.com on April 30 provided
an outstanding review of over-employed leverage, or as it is
euphemistically called - liquidity.
Hedge-fund manager John Paulson
made $1 billion using a complex financial instrument to pump
up a bet that the subprime mortgage market would crater. The
parent company of retail giant Sears made $74 million using a
similar device to boost its wager that a basket of stocks would
rise in value.
Both were playing with leverage
- the magical power that allows investors to make big investments
without putting big money on the table. These days, they have
lots of company. Thanks to advances in financial engineering,
investors have never had so many different ways to make commitments
that exceed their bankrolls. And never before has leverage wormed
its way into so many nooks of the financial world.
We're living on planet leverage,
and regulators and market gurus are growing nervous.
How did this happen? For starters,
hedge funds and leveraged-buyout funds have proliferated. They're
pioneers in boosting returns using borrowed money, the most traditional
form of leverage. Also, investment banks are pumping out newfangled
leveraging tools such as derivatives, complex securities that
allow hedge funds and other investors to add leverage without
The kicker, of course takes
us one step beyond the liquidity euphemism into the surreal with
the convenience of being able to "add leverage without
Recently, Warren Buffett has
warned that widespread use of derivatives is endangering the
financial system and observed "It's easy to put on leverage,
but not as easy to take it off."
On April 4 the Financial Post
had an article that included "the rapid evolution of
products" and that "The new strategies include
collateralized loan obligations, currencies and credit-default
In returning to the WSJ.com
article which also noted that dealers offer "derivatives
in dizzying variety. The values of some are tied to single stocks,
others to baskets of stocks or market indexes, still others to
bonds, oil, or even the weather."
And exemplifying another piece
of financial jargon, Buffett is quoted again, "total-return
swaps make a mockery of margin requirements."
The important thing to be noted
is that this is not the first time that financial innovation
has inspired new instruments, and when it arrives - chagrin.
The earliest huge mania that
was complete with all the miracles of financial innovation was
the South Sea Bubble of 1720. Bitter disappointment followed
and was nicely recorded for posterity:
"the English Nation
run a madding after new inventions, whims, and projects [promotions], that impoverish, fiddle them out
of their money, by the strange, un-heard-of engines of discount,
transfers, tallies, debentures, shares, projects, and the devil
and all figures and hard names."
That bubble peaked in May to
June of that fateful year. The market drifted with weak rallies
during the summer and crashed in the fall. The South Sea Company,
which was the big-cap wonder, crashed from a high of 1000 to
only 120 in only six months.
SIGNS OF THE TIMES - MAY 14,
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