Monthly Archives: September 2008

The Global Financial Margin Call


4. the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s own liability for any loss.

For an investor, margin is a blessing and a curse. When you’re trading on margin, your returns can be very high, but it only takes small losses to wipe you out completely. It’s the problem of leverage. If you invest $1000 but your brokerage is giving you 5-to-1 margin, you effectively invest $5000 instead of $1000. Thus, a 20% return nets you $1000 profit instead of $200. But it’s a problem in the opposite direction too. A 20% loss loses you $1000. You now have a $4000 loan from the brokerage, and the total position of your holdings– if liquidated to pay off your loan in a margin call– will leave your position wiped out.

Margin, for an individual brokerage and an individual investor, can be a very useful tool. Yes, it’s a big risk, but it carries big rewards. It allows the investor to play a large position with a limited exposure, and allows the brokerage to make very liquid loans when they have excess capital.

When margin requirements get very loose, though, and the practice becomes widespread, it becomes scary. Gains happen quickly, as the money moving in the market gain velocity. Losses are worse. If a brokerage has a lot of investors working on margin, a bear market may force them to initiate a margin call on a lot of investors, and their exit of the market can further reduce demand and drive down prices. Thus, each brokerage is in a race to exit the market, and the market crashes — as we saw in 1929.

Leverage is not a bad thing. Without leverage, most people couldn’t afford a house. We don’t save the full price of the house, we save a modest down payment, borrow the rest, and then watch as our 10% down payment reaps the rewards of 100% of the gains of the house price. In a down market, because houses rarely drop more than 10% or 20% in a down market, it’s rare that a price will drop enough in a short period of time to liquidate our down payment…

Enter subprime and alt-A. When lending standards decline, offering houses to people with no money down, the leverage becomes nearly infinite. If I can buy a $400K house with no down payment– only covering closing costs– I now have the ability to make a huge reward with very little risk of my own. It doesn’t take a 10% drop in housing prices for me to be underwater on my investment, but a 10% increase on that house is $40K in profit.

Leverage increases the rate of gain as well as loss. When subprime lending became widespread, everyone was buying on margin and bidding up the prices of homes to obscene levels. The market was crowded not only by homeowners, but by speculators looking to “flip” houses for a quick profit. The rapidly escalating prices was a false signal to homebuilders, who believed that demand had shot up and tried to build houses to meet the demand. The market went up with no signs of stopping — and then it stopped.

As all bubbles do, eventually the perma-bulls have nobody to sell assets to except other perma-bulls. The market can go nowhere but down. At that point, everyone who is leveraged is in big, big trouble. In this case, the market was leveraged top to bottom, and we’re looking at a financial catastrophe unlike few people today living have ever seen.

I said we were leveraged top to bottom, but so far I’ve only spoken about the homebuyers and lenders. It goes far deeper than that. Investors lending out their own money have a responsibility to ensure that they’re lending to creditworthy borrowers. Even if it’s not “their own” money, they usually have to carry those profits and losses on their own balance sheet, and thus it’s their responsibility (often with their job on the line) to ensure the money is handled responsibly. But in this case, the incentive of the lenders was to “churn” loans, because every loan was carried by someone else. The loans were packaged into CDOs– Collateralized Debt Obligations– securities grouping these toxic loans into equities sold to institutional investors who were far more liquid than the banks or the homebuyers.

Even worse, many of those institutional investors were working on their own version of margin, CDSs– Credit Default Swaps. A CDS is an insurance policy against default. If I buy $1B worth of securities, with a worry about losing my entire position in a big default, I can insure my position against default for a much smaller amount. I can then assume that my $1B investment is no longer “exposed”, and go out making another billion dollar investment as if the first billion doesn’t even exist. I’m covered — as long as my counterparty selling me the CDS can remain solvent.

So everyone’s leveraged to the max, top to bottom. How did it get this way? This post isn’t intended to assign blame, but as I’m sure many of you know, I think the government deserves quite a bit of responsibility for its easy-money policies, Fannie and Freddie, and the CRA. Then, of course, there were a lot of investors who got swept up in the “good times” thinking nothing could go wrong, and many of their technical investing brethren who assumed that the new CDO and CDS products would work to improve stability instead of just allowing the bubble to reach historic proportions before bursting. And there’s the old-fashioned greed, by lenders who want to refinance everyone they meet and homebuyers who either bought more than they could afford or treated their homes like ATMs. This one’s big enough that there’s plenty of blame to go around.

So what’s happening now? The global financial margin call. This leverage has to unwind, and the way that happens is going to cause a lot of pain no matter what happens. It would have been easier if everyone just held on through the crisis. But these financial institutions are in a prisoner’s dilemma writ large; if none of them write down the assets and try to de-leverage, they’re all able to weather the storm, but if any of them de-leverage, the firms to do it first get off the lightest. Plus, with mark-to-market rules forcing them to write down the losses, they’re hand is forced. We’re at the point where everyone’s in the process of trying to get out, and the whole system is nearly ready to come crashing down.

And why is the government stepping in? Because the credit markets are frozen. An institutional investor isn’t going to take a big risk right now if they can’t hedge that risk. They’d love to use a CDS to protect themselves, but nobody believes the counterparty selling a CDS is solvent enough to live up to its obligations. AIG is a perfect example. As the largest holder of these CDS contracts, there was no way they could effectively live up to their counterparty obligations, and allowing them to fail would unravel the whole egg in a very fast manner. Thus, the government stepped in and said that nobody has to worry, because if push comes to shove, the US Treasury will be that counterparty. And nothing’s more trustworthy than the US Dollar and the US Treasury, right?

There’s an old adage when it comes to economics: “If you owe the bank $5,000, that’s your problem. If you owe the banks $100,000,000, that’s the bank’s problem.” The problem with being “too big to fail” is that failing hurts the people you owe a lot more than it hurts you. This is where the bailout is coming from, because companies like AIG will cause so much havoc when they fail that we can barely understand the potential implications.

We can debate whether or not this bailout should or shouldn’t occur (for the record, I’m against it), but in an election year, there’s nothing that’s going to derail this monster. What’s important right now is to understand the potential implications. So here’s the possibilities:

Best Case: The whole point of the government intervention isn’t really to fix the situation. This situation can’t be “fixed” in that sense. The system is over-leveraged, and that has to work itself out. The issue is that if it occurs quickly, we’ll have a level of pain that this country is not ready for. If it occurs slowly, we might have a protracted recession and a dull nagging ache, but eventually the economy will grow its way out of the mess. We’re talking a 5-15 year process, but they may stave off double-digit unemployment and bread lines.

Worst Case: Government doesn’t solve the problem, and we still go into a depression. In order to get out of it, and to try to keep the economy moving, they inflate the dollar to try to give the appearance of growth, but America doesn’t buy it. The world abandons the dollar as a reserve currency, and we enter a hyperinflationary depression along the lines of 1920’s Germany.

Even the best case is not good, but the worst case is downright terrifying. But whether or not you support this bailout, I hope this post explains the underlying causes and issues at stake here. We’re in uncharted territory, and the Sword of Damocles is dangling just above. No politician wants to let that sword fall, but there’s a distinct chance that their intervention will destroy us first.

Ron Paul Takes The Last Step Into Irrelevance

Earlier this week, former Presidential candidate Ron Paul finally decided to endorse a candidate for President, and he chose to pick the wackiest man in the room:

The Libertarian Party Candidate admonished me for “remaining neutral” in the presidential race and not stating whom I will vote for in November. It’s true; I have done exactly that due to my respect and friendship and support from both the Constitution and Libertarian Party members. I remain a lifetime member of the Libertarian Party and I’m a ten-term Republican Congressman. It is not against the law to participate in more then one political party. Chuck Baldwin has been a friend and was an active supporter in the presidential campaign.

I continue to wish the Libertarian and Constitution Parties well. The more votes they get, the better. I have attended Libertarian Party conventions frequently over the years.

In some states, one can be on the ballots of two parties, as they can in New York. This is good and attacks the monopoly control of politics by Republicans and Democrats. We need more states to permit this option. This will be a good project for the Campaign for Liberty, along with the alliance we are building to change the process.

I’ve thought about the unsolicited advice from the Libertarian Party candidate, and he has convinced me to reject my neutral stance in the November election. I’m supporting Chuck Baldwin, the Constitution Party candidate.

As you can probably tell from the fact that he doesn’t refer to him by name, Paul is obviously still miffed at the fact that Libertarian Party Presidential candidate Bob Barr declined to attend Paul’s bizarre four-party press conference two weeks ago and then issued his own challenge to Paul to join the Libertarian ticket rather than just endorsing the idea of voting for “any” third-party candidate.

So, there’s obviously something personal going on in the fact that Paul didn’t end up endorsing Barr, but that doesn’t make his endorsement of Chuck Baldwin any less troubling for libertarians who actually hoped his campaign, and the Campaign for Liberty, would amount to something.

As Kip Esquire notes, the Constitution Party is hardly libertarian in any sense of the word, as these excerpts from it’s platform make plain:

This great nation was founded, not by religionists, but by Christians; not on religions but on the Gospel of Jesus Christ. … The goal of the Constitution Party is to restore American jurisprudence to its Biblical foundations and to limit the federal government to its Constitutional boundaries.

So much for the separation of church and state, apparently.

The Constitution Party will uphold the right of states and localities to restrict access to drugs and to enforce such restrictions.

Libertarians for the drug war ? I don’t think so.

The law of our Creator defines marriage as the union between one man and one woman. The marriage covenant is the foundation of the family, and the family is fundamental in the maintenance of a stable, healthy and prosperous social order. No government may legitimately authorize or define marriage or family relations contrary to what God has instituted.

Again, so much for individual rights.

We reject the notion that sexual offenders are deserving of legal favor or special protection, and affirm the rights of states and localities to proscribe offensive sexual behavior. We oppose all efforts to impose a new sexual legal order through the federal court system. We stand against so-called “sexual orientation” and “hate crime” statutes that attempt to legitimize inappropriate sexual behavior and to stifle public resistance to its expression. We oppose government funding of “partner” benefits for unmarried individuals. Finally, we oppose any legal recognition of homosexual unions.

In other words, if Texas wants to put people in jail for engaging in oral sex, Chuck Baldwin and his theocratic friends have no problem with it.

Gambling promotes an increase in crime, destruction of family values, and a decline in the moral fiber of our country.

Nope, nothing libertarian there.

We particularly support all the legislation which would remove from Federal appellate review jurisdiction matters involving acknowledgement of God as the sovereign source of law, liberty, or government.

Cute the theocrats again.

We commend Former Chief Justice Roy Moore of the Alabama Supreme Court for his defense of the display of the Ten Commandments, and condemn those who persecuted him and removed him from office for his morally and legally just stand.

Because nothing says support for the rule of law like supporting a man who violated his oath of office, his duty as a judge, and his ethical standards as an attorney.

Pornography, at best, is a distortion of the true nature of sex created by God for the procreative union between one man and one woman in the holy bonds of matrimony, and at worst, is a destructive element of society resulting in significant and real emotional, physical, spiritual and financial costs to individuals, families and communities. We call on our local, state and federal governments to uphold our cherished First Amendment right to free speech by vigorously enforcing our laws against obscenity to maintain a degree of separation between that which is truly speech and that which only seeks to distort and destroy.

Apparently, Chuck Baldwin knows obscenity when he sees it and doesn’t like it very much.

So, Paulistianians, this is what the vaunted r3volution has come to. Your candidate has endorsed the nominee of a party that opposes the right of gays to marry, thinks the drug war is a great thing, and wants to restrict speech based on what it considers “obscene.”

That, my friends, is not freedom and liberty.

Kip, of course, is among those saying “I told you so”:

I was, along with a few select others, among the first to stand athwart yelling Stop!. We warned against this lunacy, this malignant fever that struck so many intellectually challenged “libertarians” who deluded themselves into thinking that Ron Paul was anything other than a majoritarian, neo-confederate theocrat (who engages in rank homophobia as a hobby).

We were right. You were wrong. We stayed true to our principles. You sold your souls for a bumper sticker and a press conference. Now welcome your new Constitution Party overlords..

As for the future, my advice to Paul supporters is this: By all means join the Constitution Party and vote for [Pastor] Chuck Baldwin. All we who saw through the Paul charade ask is that you do so with your eyes wide open. Know fully who and what you are voting for.

And please, for your sake and ours, stop calling yourselves “libertarians.”

Given what I’ve seen of the man Ron Paul says he’s voting for in November, I can’t say I disagree.

Update: Jack at The Crossed Pond makes this point:

[T]his is a disheartening development. Ron Paul’s endorsement of Baldwin is a disastrous, petulant, ill-considered act that taints his legacy and hinders any positive impact he might provide for the libertarian movement. He has, in either a fit of pique or a conscious revealing of his actual leanings, endorsed a true horror show. Rather than allow the slow healing of the libertarian rift by endorsing the odd and politically bumbling, but at least defensibly libertarian candidate Bob Barr, he has reopened the wounds by endorsing a “loopy ‘America is a Christian nation’ paleo-conservative” Rather than signal his continued opposition to the GOP foreign policy and economic agenda as well as rejection of fringe element mediocre candidates by remaining out of the endorsement business altogether, he has stated his support for a “Theocratic Homophobic Lunatic for President.” Rather than retain some semblance of legitimacy as a libertarian elder statesman and an alternative rallying point for a GOP opposition element in Congress, he has lessoned his cross cultural appeal and potential political leadership by endorsing a candidate with this abortion for a party platform.

And so, the r3volution ends. Not with a bang, not even with a whimper, but in much the same confused, poorly-planned manner in which the entire enterprise was run from the beginning.

Now, while it’s clear that some significant portion of Paul’s supporters will find the Constitution Party quite conducive to their beliefs, where do real libertarians go from here ?

Originally posted at Below The Beltway

Quote Of The Day: Hypocrite In Chief Edition

A two-fer today.

First, from our fearless leader about 4 months ago:

“Our policy in this administration — laws shouldn’t bail out lenders, laws shouldn’t help speculators.”

President Bush, May 19, 2008

And, second, from the Republican Party Platform, passed in convention only three weeks ago:

We do not support government bailouts of private institutions. Government interference in the markets exacerbates problems in the marketplace and causes the free market to take longer to correct itself. We believe in the free market as the best tool to sustained prosperity and opportunity for all.

Yea, sure you do.

Just Say No To The Bailout From Hell

While the rest of the politcal class debates the wisdom of John McCain’s non-supension suspension of his campaign, Libertarian Party Presidential Candidate Bob Barr seems to be one of only a handful of people out there saying we need to look at the bailout itself:

In the name of restoring economic confidence, the Bush administration is demanding unlimited authority to implement a massive financial bailout. The Secretary of the Treasury would become an economic dictator, empowered to re-engineer the economy as he sees fit. These powers fit Kim Jong-il’s North Korea, not the American republic.

The economy is in trouble, but the wrong policy could make things much worse. With the public deeply divided over the proposed bailout, and the future structure of our economy at stake, Congress must stop and take a deep breath before rushing such a far-reaching plan into law.


The federal government cannot eliminate financial losses and should not attempt to do so. It can only shift the burden — in this case from irresponsible borrowers, lenders and investors — to taxpayers. Keeping the walking dead on economic life support will only slow down necessary adjustments. The federal government’s principal responsibility at a time of financial stress should be to maintain liquidity for use by otherwise sound institutions.

Congress certainly should reject an unrestricted, economy-wide purchase of mortgages and mortgage-backed securities, as well as “other financial instruments” at the Treasury’s discretion. Interest groups already are lining up with their hands outstretched, including mortgage lenders and insurance companies, municipalities and foreign banks. The congressional Democrats even want to include home heating assistance and another wasteful “stimulus” package.

If the administration believes there are financial institutions so critical that their failure would put the entire economy at risk, then the president should identify those institutions and make the case for aiding them to Congress and, more important, to the American people.


“My first instinct was to let the market work, until I realized, while being briefed by the experts, how significant this problem became,” lamented President George W. Bush. So, he would turn capitalism into a government-protected enterprise and Uncle Sam into an ATM machine for economic failures. Congress must say, “No.” Why should we, the taxpayer, believe the people who got us into this mess when they say bailing them out is the only solution?

Despite his flaws as a candidate, Barr is, of course, quite correct about all of this.

Here he is talking about the bailout on CNN earlier today:

We all know what will happen here. Compromise will be reached in Congress and another $ 700 billion of taxpayer wealth will be wasted in an effort to keep a system that can barely sustain itself at this point in operation.

It might even work, temporarily.

At some point, though, we’re going to run out of tricks like this and then where will we be ?

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