Into the Rabbit Hole?
By Jeff Pietsch | October 11, 2008 | 2:15 PM | 0 Comments
You may have read about the latest federal actions targeted at making direct capital investments into our nation's banks (Bloomberg - Paulson May Invest). While the focus just one month ago was on getting liquidity back into the system so that we could all continue to go about our business, the delays in doing so and related lack of confidence have led to forced equity selling to raise cash and shore up the capital base.
A bank's leverage ratio is naturally defined by "Debt/ Equity," and the value of that equation's denominator has taken a plunge. It is easy to see that the most recent bout of selling has caused a vicious cycle whereby stock price devaluation means that our financial institutions could be as levered as ever. In spite of all the talk about "deleveraging," we may well effectively be back where we started at or worse, and banks are only permitted to become so levered. This means continued lending restrictions at best, and further contagion on an increasingly massive scale at worst.
I almost hate to bring it up, but the same is true for individual brokerage accounts. Regulation-T permits 1:1 leverage to be held overnight, and many brokers are even tightening this due to the recent volatility. Imagine the unintended leverage that buy-and-hold investors starting out a year ago are now holding. With the markets down some -40% from their highs, it's easy math.
I have recently written about economic multiplier effects and tipping points (see Why 'We've Got to Stick Together'). We are now somewhere between very near and well into the mouth of that rabbit hole. This market has got to firm up. Sour socialist implications of banking nationalization aside, a capital call or two at the individual level, and that hole is mighty hard to crawl out of.
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