Leverage, confidence and the credit crunch

My proposition is about the economic circumstances that now prevail. I think lack of confidence created a fall in prices, which by the process of leverage operating more quickly in reverse in turn created a lack of liquidity (or money) the so called credit crunch, which is really a confidence crunch.

When most people buy homes they pay a deposit – traditionally 10% of the price for buyers who have never bought before, and borrow the rest, paying interest on the loan over a long period until they own the house outright, free from the loan. If the house rises in value, then the rise in value applies to the 100% that has been paid for the house. The buyers has in effect “leveraged” the 10% actual money that he or she have put down in cash, so that if the house price rises the rise is attributable to an amount that is ten times in value.

The house owner pays interest on the loan but is able to live in the home and would have paid rent anyway, because he or she needs a place to live. If the house owner rents the home, a benefit accrues in income, with the possibility of leverage still if house prices rise.

This concept of leverage has almost always been used in modern economies. The events that led to the great stock market boom of 1928 (immediately before the crash of 1929) arose because everyone, literally everyone, could borrow money to buy stocks and shares, so that they could leverage their purchases and get their money to work as though it was ten times larger, just as a house buyer does.

Now house buyers would still buy houses if house prices never rose, because they have the advantage of being able to use the asset to live in or rent out. Instead of paying rent, they would end up owning the home, as a retirement nest egg or as a way of helping their children.

If stock and shares never increased in price there would be far fewer buyers. They are trading because people expect them to rise or fall in value, not because of any income stream they offer. When people buy homes they buy them to live in with any benefit from leverage being incidental, the prime purpose is to have somewhere to live and live with the freedom that home ownership brings.

If home prices fall it should not matter, provided that you can still afford your mortgage costs each month. All a fall in home prices means, in the long term is that you might have bought cheaper later, but that applies to almost every purchase that you will ever make. The fact that you are leveraged does not send the house values into a deep spiral of decline; the average house value in the United Kingdom have fallen only 16% in the past twelve months, and that average includes plenty of homes that were sold under real distress by owners or developers in great financial difficulty.

However the leverage in the financial markets – stocks, shares, commodities and similar assets – has driven down prices for these by more than 50%. A lever works very well to jack something, using the energy of the lever, but a lever in free fall works even more efficiently to drag prices down.

Now, as the great crash of 1929 showed, leverage works to drive prices high very quickly, but when people lose confidence leverage works in the opposite direction even more quickly, driving prices down very low.

The fall in prices means that those who have bought assets with leverage at high values are wiped out when the price declines, with a knock on effect. The banks in this have operated both as lenders against assets that were leveraged, and as traders in assets using leverage so that they have been terribly exposed and have almost collapsed. They have been leveraged down by two levers.

The most important question is why do prices collapse, why does the demand for assets quickly decline to cause a collapse in prices? I have always thought that if there was a psychology of herd mentality it would explain the answer to this question. I know that it has to do with confidence, but the underlying cause of increases in confidence and sudden shifts to lack of confidence is not clear to me.

Confidence is about belief, and often about greed; the same motivations that drive an intelligent person to be conned by a trickster motivate people trading in markets. If they lose belief, they lose.

Whatever the cause, I think that the world economies are experiencing as confidence crisis, not a credit crunch. The credit crunch – the lack of capital for investment is simply a consequence of loss of confidence. The investor loses confidence in assets, which drives prices down, which in turn reduces bank liquidity, which in turn drives prices down which leads to bank failures as leverage works just at least as well in lowering prices as it does in raising them, but if anything more effectively.

In uncertain times people turn to fundamentals for investment – things that they know are real and will always be needed. These comprise of land, food and energy. I am not clever enough to advise you what to do with your money, which might be at risk in banks or stocks and shares and so forth, but land, food and energy will always have a value.



2 Responses

  1. I think a good explanation is “The South Sea Bubble” and the point where the Bubble reached its peak,

    “…The price finally reached £1,000 in early August and the level of selling was such that the price started to fall, dropping back to one hundred pounds per share before the year was out, triggering bankruptcies amongst those who had bought on credit, and increasing selling, even short selling – selling borrowed shares in the hope of buying them back at a profit if the price falls…”

    ref: http://en.wikipedia.org/wiki/South_Sea_Bubble

    You have to think that people were borrowing increasingly larger amounts of money and that the income to amount borrowed was becoming greater, so that the affordability of a house was in question, a simple thing to think before the credt crunch , would be how could the children of today afford to buy their first house in another 10 years time if the house prices continue to increase at the current rate?

    Robert I was thinking that well before the credit crunch and there is nothing amazing about thinking in a logical and straightforward way the question is why were so many people convinced of continuous house price increases?

    The one walking in the opposite direction of a herd is often the stupid one until the herd falls off a cliff ! ?

    A house really should be a depreciating asset not an appreciating asset because of maintainence, need for modernisation etc ? Its pretty much the same we expect a car to depreciate in value for these reasons?
    One of your Genersys Solar Thermal Panels is a depreciating asset which is dificult to calculate given that the price of a replacement may be higher year by year, however the calculation that you make is that of it paying for itself by the logic of saving the purchase of fuel, not that next year the panel fitted to your roof will be worth 50% more!! so if you take apart a house component by component then you can see the madness of house price increases, what is the is the electrical installation going to be worth in 20 years time? £0 because it will need replacing, it is easy to carry this forward to kitchen, bathroom, probably the only original thing left will be the bricks, some of the woodwork and the land after 50 years?
    The important principle is that income needs to be linked to the price of a home.

  2. A good explanation of the situation is Irrational euphoria and
    Irrational melancholy

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