Leverage ahoy : Systemic Risk is back

Leverage ahoy : Systemic Risk is back
Systemic Risk is back 0 Comments | By

John Maynard Keynes wrote that the wheels of capitalism are dependent, to a large extent, on “animal spirits” or the basic human trust that allows individual investors and lenders to assume and properly manage the risks associated with lending and investing. Systemic risk builds when this sense of trust evolves into complacency and dulls market skepticism, leading to a lack of proper risk awareness among aggregate market participants.

Several years ago I saw analysis, I believe from work done by Ned Davis Research, that over the prior 100 years there had been two periods when the ratio of Credit to GDP spiked above a historical range of 140% to 160%. In 1929, the ratio was 265% prior to the Great Depression ….. and in 2007 it rose to 300% prior to the market downturn. In that last credit market meltdown, over-aggressive gearing and complacent financing practices directly led to a disproportionate level of debt relative to equity and income generation. All hell eventually broke loose. History was written.

Financial system risk is arguably directly caused by, and proportional to, leverage. Indeed, it is my contention that leverage can be viewed as “the source of risk”. Systemic leverage is all encompassing and unlike other more sophisticated models which can sometimes leave out key risk elements that may prove critical, leverage trickles down to create risk across almost all primary “risk buckets” including Credit, Liquidity, Market, Operational, Strategic and Macroeconomic. And of course, as the system has learnt painfully, models can be wrong or applied wrongly or not be all-scenarios-anticipating.

A leverage based risk indicator for measuring and indicating the potential build-up ofsystemic market risk could be simple, transparent, and intuitive. It can be used effectively as a leading indicator of total risk in the system. The examination is of Nominal Household Debt relative to Nominal GDP. While there have been, and are, several studies in the market regarding leverage, we could analyze the numerator in several possible ways to gain additional insight into the primary ratio/index.

But I digress. Where I started on this stream of consciousness was based on reading this morning (USA Today) about Household Debt having become notable once again, with the headline saying Americans’ outstanding credit card debt hit a new record. The Federal Reserve said Monday that Revolving credit (mostly credit cards), increased by $11.2 billion to $1.023 trillion. That nudged the figure past the $1.021 trillion highwater mark reached in April 2008, just before the housing and credit bubbles burst. Over the past year, revolving credit has surged by $55.1 billion, or 5.7%, according to the Fed. Non-revolving credit, such as auto and student loans, rose by $16.8 billion to $2.8 trillion in November. The paper does go on to quote analysts that the new all-time-high for credit card debt does not today pose the same risks to the economy that existed in 2008 … because incomes are higher. The ratio of credit card debt to U.S. GDP is about 5% now compared with 6.5% in 2008. But there is no question that to bated-breath voyeurs of Risk, It’s a potential early warning sign that has not yet, but could, become clear sign of a financial stability issue for the broader economy. Given also that credit card delinquencies have increased to about 7.5% from 7% a year ago, underscoring growing stresses. While that’s still below the 15% delinquency rate reached during the financial crisis and the 9% historical average, the increase over the past year should raise concern. Again, with jobs and income growing, the rise isn’t creating significant problems now but it could if the economy and labor market take a downward turn.

Something bad could happen. I await with excited nervousness. There is Risk ! Remember, I told you so when the smell of trouble in paradise first wafted.

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