Saturday, October 11, 2008

Into the Rabbit Hole?

You may have read about the latest federal actions targeted at making direct capital investments into our nation's banks (Bloomberg - Paulson May Invest). While the focus just one month ago was on getting liquidity back into the system so that we could all continue to go about our business, the delays in doing so and related lack of confidence have led to forced equity selling to raise cash (most notoriously last week in response to Lehman Brothers Credit-Default Swap auction) and shore up the capital base.

A bank's leverage ratio is naturally defined by "Debt/ Equity," and the value of that equation's denominator has taken a plunge. It is easy to see that the most recent bout of selling has caused a vicious cycle whereby stock price devaluation means that our financial institutions could be as levered as ever. In spite of all the talk about "deleveraging," we may well effectively be back where we started or worse, and banks are only permitted to become so levered. This means continued lending restrictions at best, and further contagion on an increasingly massive scale at worst. In this regard, it's no wonder the Treasury decided to lend to companies directly last week.

I almost hate to raise the point, but the same is true for individual brokerage accounts. Regulation-T permits 1:1 leverage to be held overnight, and many brokers are even tightening this due to the recent volatility. Imagine the unintended leverage that some buy-and-hold investors starting out a year ago may be holding had they started borrowing against their accounts without off-setting sales. With the markets down nearly -40% from their highs, it's easy math to imagine.

I have recently written about economic multiplier effects and tipping points (see Why 'We've Got to Stick Together'). We are now somewhere between very near and well into the mouth of that rabbit hole. This market has got to firm up. Sour socialist implications of banking nationalization aside, a capital call or two at the individual level, and that hole becomes mighty hard to crawl out of.


Andrew Abraham said...

Thank you Jeff for your article... we have been chatting on all month regarding the current situation... we are looking for ideas as far a safe place for our money... as well as insight in the markets are bottoming... Any help would be appreciated thanks ...

Jeff Pietsch CFA, Esq said...

Well, I usually don't post comments with embedded links and I obviously can't give individual investment advice over the web, but the question is fair enough.

Many of you are no doubt familiar with the thoughts of Nassim Taleb and his "Black Swan Theory." An example of a Taleb portfolio implementation as I understand it may look something like this:

50% Cash Held in Bank Accounts Sized within Federally Insured Limits

50% Brokerage Account, Allocated as Follows:

10% Precious Metals
10% Real Estate
40% Cash
40% Double-Leveraged Broad Market ETFs

Whereby all non-cash brokerage assets would be dollar cost averged now and on further major downdrafts (or hard asset rotations) in the months ahead.

The markets are down some 40% off their highs and options are insanely expensive due to Vega. Think about how this portfolio would perform in the event stocks go down another 40%, and if they go up 40%. A variety of option income strategies could be employed against the cash position for the especially savvy while mostly mitigating call risk.

Just top of mind. Obviously a hundred variations could be developed. What are your thoughts?

Jeff Pietsch CFA, Esq said...
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