(This is Part 2 of a series. Go back to Part 1.)
An ocean of liquidity has been sloshing over the globe as the world's central banks increased their money supplies at faster and faster rates. And those monetary increases have percolated through the world’s economies, multiplying many times through the capacity of various types of financial entities to create new credit. Equally important has been the voracious appetite of consumers, corporations and governments to take on new debt.
This exponential mountain of money and credit is the defining characteristic, in the financial area, of our global situation right now. As important as other considerations might be, this is the overriding one in the financial world since it is setting the stage for radical changes in global financial and economic well-being.
Sceptical that money has been increasing at a fast rate? Here are several examples of the actual rates of money increase for various countries over the last year: China, 16.7%; India, 19.7%; Australia, 14.1%; Mexico, 12.2%; Brazil, 11.9%; the United Kingdom, 13.8%; the Eurozone, 10.9%; the U.S. (reconstructed M3), 13.7%. Interesting, hmm? This inflation of the money supply has been happening all over the world.
By the way, the U.S. Federal Reserve has stopped publishing the M3 figure (the broadest measure of the money supply), so this M3 figure is the number arrived at by John Williams of Shadow Government Statistics. Now, why would the Fed want to hide the M3 number? Gee, could it possibly be because it wants to increase the money supply beyond all previous bounds without the public catching on? Yes!
What's interesting about this financial phenomenon is that so much of it takes place beneath the surface. For instance, the Fed likes to portray itself as "fighting inflation"—while, as noted, it has been allowing the money supply to quietly rise at an unprecedented rate. But the story doesn't end there. This "core" increase in the supply of money is then leveraged—"geared up," as the British say—by a veritable army of banks, investment banks, GSEs, mortgage securitizers and other financial entities, all with the power to create new credit and thus more money.
Why have central banks all over the world been increasing their money supplies at an increasing rate?
It goes back to the mountain of debt mentioned above. This huge amount of debt has created an historic degree of leverage throughout the system, and this vast leverage has made the global financial system much more fragile, that is, vulnerable to a crash. To prevent such a crash, central banks have been injecting more and more fiat money into the financial system to stimulate it, and the system has responded by creating mountains of new credit. It's a lot like giving a heroin addict yet another injection to prevent him/her from "crashing."
As an example of leverage, the financial analyst Ed McCarthy points out that Goldman Sachs, "the smartest investment bank in the world," has a "gearing" on its capital of approximately 32 times. Thirty-two times. That is eye-popping leverage, but Goldman is hardly alone in that—high leverage has now become commonplace in the financial industry. An industry which is now responsible for 40% of the earnings of the S&P 500 companies, up from 15% not long ago. Brave new world.
Why is leverage so dangerous? Let's say that we're a hedge fund and we're using 10 to 1 leverage, that is, we're borrowing $9 for every $1 of equity that we have, so we're investing $10 instead of $1. Now that's great if our investment, say into a bunch of sub-prime mortgage CDOs, goes up. For example, if our investment goes up 10% we've doubled our money. On the other hand, if our investment declines 10% our investment is wiped out.
Can't happen? It just did. Two big hedge funds at Bear Stearns just went out of business, their combined equity of some $1.6 billion totally wiped out, because some of the subprime mortgage market bonds that they held went down more than 10 percent. This same phenomenon has affected funds in California and Florida and also now a hedge fund in Australia and a bank in Germany. Stay tuned.
This situation will almost certainly spread further, and given the degree of financial leverage in the system, it could easily cascade into a financial crisis.
This gigantic credit/debt bubble (two sides of the same coin) has been expanding in all sectors of the economy from corporations to governments to consumers.
Corporations have taken on a massive amount of new debt in recent years. For example, there have been trillions of dollars in takeover activity as hedge funds and private equity funds buy various public companies and take them private. In order to do this, these funds borrow the money from various institutional investors and then use it to finance the buy-out deal. This borrowed money, once the deal is completed, is then added to the debt of the acquired company, so the take-over more or less finances itself. How cool is that?
Of course, now the acquired company has a ton of new debt on its balance sheet, making it much more fragile financially than it was before, since it is operating now with much greater leverage. This has been happening all over, a frenzy of take-over activity, and in its wake, a growing colossus of financial overleverage.
And the vast amounts of debt taken on by acquired corporations is the least of it. Any public company that doesn't want to be taken over is also buying back its own stock (to make it more expensive) and paying for it with lots of debt (to make its balance sheet unattractive)—thus hoping to present itself as an undesirable target for a takeover.
Note that the common denominator, for both for acquired and unacquired companies, is lots of new debt. Of course, all this buying of stock has driven world stock markets—until quite recently—higher and higher in a levitating feat that is quite oblivious to the exponentially rising risk in the financial system.
(This is the end of Part 2. Go to Part 3.)
—jim sloman, 3.1.07
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