Daimnation!: Dance, dance, dance or, "irrational exuberance"

March 19, 2008

Dance, dance, dance or, "irrational exuberance"

The Economist tries to make sense of financial madness (greed a factor):

[...]
Yet, like Wile E. Coyote running over the edge of a cliff, financial services kept on going. A service industry that, in effect, exists to help people write, trade and manage financial claims on future cashflows raced ahead of the real economy, even as the ground beneath it fell away.

[...]

This process has turned investment banks into debt machines that trade heavily on their own accounts. Goldman Sachs is using about $40 billion of equity as the foundation for $1.1 trillion of assets. At Merrill Lynch, the most leveraged, $1 trillion of assets is teetering on around $30 billion of equity. In rising markets, gearing like that creates stellar returns on equity. When markets are in peril, a small fall in asset values can wipe shareholders out.

[...]

Sooner or later, though, the music stops. And when it does, the very mechanisms that create abundant credit will also destroy it. Most things attract buyers when the price falls. But not necessarily securities. Because financial intermediaries need to limit their leverage in a falling market, they sell assets (again, the system is pro-cyclical). That lowers the prices of securities, which puts further strain on balance sheets leading to further sales. And so the screw turns until those without leverage will buy...