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Investing and Economics Blog

Leverage, Complex Deals and Mania

Anyone involved in finance should understand mania in the markets. It is not a shock that financial markets do irrational things. They do so very frequently. Anyone who has not read, Manias, Panics, and Crashes: A History of Financial Crises, should do so. Leverage often is a catalyst that turns bad investments into panics that damage the economy. A previous post on this topic: Misuse of Statistics – Mania in Financial Markets.

Enron was the pit canary, but its death went unheeded

Just as Enron packaged bad investments into a private equity fund run by its chief financial officer, Wall Street packaged mortgages given to people who couldn’t afford the payments into sleek new instruments called RMBS and CDOs. But Enron’s machinations couldn’t make the losses go away, and Wall Street’s shiny acronyms can’t turn a defaulted mortgage into good money.

As for the lessons we’ve forgotten, how about this one: financial statements aren’t supposed to be fairytales.
…
when all was booming, Wall Streeters said they deserved their pay because the market said they were worth it. But now things are falling apart, they say the market doesn’t work, and we need to stop short-selling, and taxpayers need to pony up. If there is a tiny bit of good in all this, it’s that Wall Street, although it was complicit in the Enron mess, managed to walk away relatively unscathed. This time, Wall Street has brought itself down.

I think the odds that Wall Street has brought itself down is very low. Even that the ludicrous excesses of Wall Street are at risk is very unlikely. Perhaps for a few years their might be some restraints put on excesses. But most likely politicians will respond to huge payments by arranging favors for those that want to bring excesses back. If this can be prevented that would be great, but I doubt it will.

Related: Investing books – Tilting at Ludicrous CEO Pay – Losses Covered Up to Protect Bonuses

October 4th, 2008 John Hunter | 4 Comments | Tags: Economics, Financial Literacy, Investing

Comments

4 Comments so far

  1. Redesigning the Global Finance System at Curious Cat Economics Blog on November 20, 2008 8:37 am

    There are not easy answers though their are some pretty basic principles people should agree on (excessive leverage is dangerous, massive positions that endanger entire economies are dangerous…). But how to deal with those issues is not easy…

  2. Too Much Leverage Killed Mervyns at Curious Cat Investing and Economics Blog on January 22, 2009 8:30 am

    I also object to those that unjustly take from the other stakeholders involved in an enterprise… I detest that financial gimmicks by “private capital” that ruin companies…

  3. CuriousCat: What the Bailout and Stimulus Are and Are Not on February 23, 2009 9:45 am

    The huge banking bailouts and stimulus bill are meant to counter-balance the huge problems the economy is suffering through….

  4. Curious Cat Management Blog: Why Congress Won’t Investigate Wall Street on May 1, 2009 5:33 pm

    The incredibly dire current economic results should encourage some thought about choices we have made. The failures of the political leaders (putting their donors interests above the public interest) is something that should be investigated seriously…

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