Free Market Capitalism Cuts Both Ways

It hasn't been pretty in the financial markets lately. Collapsing subprime and structured debt prices, contracting credit markets, busted deals, and a sharp correction in stocks all have investors on edge. And it should be so. For investors had become far too complacent for far too long.

For years now, investors have priced financial assets without adequate risk premiums. Motivated by former Federal Reserve chief Alan Greenspan's bailout policy and 1% fed funds deflation scam, investors climbed perilously far out on the risk limb.

With money markets paying essentially nothing, investors sought out higher returns in all classes of riskier assets: residential and commercial real estate, stocks, commodities, collectibles, art, etc.

The bull markets in everything, ex cash, created investor hubris on a global scale rarely seen. But overly enthusiastic buyers were only part of the issue. If pricing were the only problem, the readjustment would certainly sting. However, this mess goes way beyond imprudent pricing. The most egregious aspect of the financial market trouble is the amount of leverage in the system.

In order to exploit modest nominal returns or small security inefficiencies, banks, brokers and investors fund highly leveraged and dubious investment programs. I have termed this phenomenon, bubbles in debt and dumb, the "twin BIDs." Emboldened with "other people's money," buyers paid whatever it took to generate the management fees and carry on the investment scheme. Low investment returns simply required more leverage to make results acceptable.

The results of this excess credit include idiotic mortgage underwriting and real estate valuations, stupidly priced and overextended leveraged buyout transactions, a massive equity and fixed-income bull market, and ridiculously levered stock and bond hedge funds.

Today, the bigger problem is not the quality of the underlying assets, but rather the debt being supported by those assets. A modest price reduction in the value of collateral causes big problems in highly margined financial markets. The scariest part of all is no one truly knows the extent of the leverage in the system!

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