Expert Commentary

Investors Are Buying More with IOUs than with Money

When I wrote Conquer the Crash, outstanding dollar-denominated debt was $30 trillion. Just five years later, it is $43 trillion, and most of the increase has gone into housing, financial investments and buying goods from abroad. This is a meticulously constructed Biltmore House of cards, and one wonders whether it can stand the addition of a single deuce. Its size and grandeur are no argument against the ultimate outcome; they are an argument for it.

Figure D-3 depicts just one isolated aspect of the debt bubble as it relates directly to financial prices. In 1999, the public was heavily invested in mutual funds, and mutual funds had 96 percent of their clients’ money invested in stocks. At the time I thought that percentage of investment was a limit. I was wrong. Today, much of the public has switched to so-called hedge funds (a misnomer). Bridgewater estimates that the average hedge fund in January had 250 percent of its deposits invested. This month the WSJ reports funds with ratios as high as 13 times. How can hedge funds invest way more money than they have? They borrow the rest from banks and investment firms, using their investment holdings as collateral. So they are heavily leveraged. And this is only part of the picture.

Hedge Funds' Estimated Assets vs Exposure as of January 2007

Much of the money invested in hedge funds in the first place is borrowed. Some investors take out mortgages to get money to put into hedge funds. Some investment firms borrow heavily from banks and brokers to invest in hedge funds. As for lenders, the WSJ reports today, “the nation’s four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders’ equity, a leverage ratio of 25.5 to 1.” So the financial markets today have been rising in unison because of leverage upon leverage, an inverted pyramid of IOUs, all supported by a comparatively small amount of actual cash. This swelling snowball of borrowing is how the nominal Dow has managed to get to a new high even though it is in a raging bear market in real terms: The expansion in credit inflates the dollar denominator of value, and the credit itself goes to buying more stocks, bonds and commodities. The buying raises prices, and higher prices provide more collateral for more borrowing. And all the while real stock values, as measured by gold, have quietly fallen by more than half! Seemingly it is a perpetual motion machine; but one day the trend will go into reverse, and the value of total credit will begin shrinking as dollar prices collapse.

The investment markets are only part of the debt picture. Most individuals have borrowed to buy real estate, cars and TVs. Most people don’t own such possessions; they owe them. Credit card debt is at a historic high. The Atlanta Braves just announced a new program through which you can finance the purchase of season tickets. Can you imagine telling a fan in 1947 that someday people would take out loans to buy tickets to a baseball game? Instead of buying things for cash these days, many consumers elect to pay not only the total value for each item they buy but also a pile of additional money for interest. And they choose this option because they can’t afford to pay cash for what they want or need. Self-indulgent and distress borrowing for consumption cannot go on indefinitely. But while it does, the “money supply”—actually the credit supply—inflates. But it is all a temporary phenomenon, because debt binges always exhaust themselves.

As far as I can tell, virtually everyone else sees things differently. Countless bulls on stocks, gold and commodities insist that the process is simple: the Fed is inflating the “money supply” by way of its “printing press,” and there is no end in sight. The Fed is indeed the underlying motor of inflation because it monetizes government debt, but the banking system, thanks to the elasticity of fiat money, manufactures by far the bulk of the credit—credit, not cash. If you don’t believe credit can implode and investment prices fall, then why did the housing market just have its biggest monthly price plunge in two decades, and why is the trend toward lower prices now the longest on record? If you don’t think credit and cash are different, then why are the owners of “collateralized” mortgage “securities” beginning to panic over the realization that their “investments” are melting in the sun? Lewis Ranieri, one of the founders of the securitized mortgage market, recently warned that there are now so many interests involved in each mortgage that massive cooperation among lawyers, accountants and tax authorities will be required just to make simple decisions about restructuring a loan or disposing of a house, i.e. the collateral, underlying a mortgage in default. In the old days, the local bank would suss things out and come to a quick decision. But now the structures are too complex for easy resolution, and creditors are hamstrung with structural and legal impediments to accessing their collateral. The modern structures for investment are so intricate and dispersed that a mere recession will trigger a systemic disaster. When insurance companies and pension plan administrators realize that they can’t easily and cheaply access the underlying assets, what will their packaged mortgages be worth then? And what will happen to the empty houses as they try to sort things out? This type of morass relates to debt. Cash is easy; either you have it or you don’t.


This article originally appeared in the April 30, 2007 Elliott Wave Theorist.