Dominoes

When I was a kid, I liked to set up large arrays of dominoes so that I could watch them fall.  Early on, I realized the errors in setup were frequent enough that I left gaps such that if I accidentally knocked down a domino, it wouldn’t destroy all of the work.  I usually put in a number of gaps close to the square root of the dominoes.  Once complete, I would fill in the gaps, and after that would come the show.

When the dominoes are set up, there is an unstable equilibrium.  Any jolt to the system will topple most or all of them.  Now, some would say the jolt causes the toppling of the dominoes, but the dominoes were arranged in order to make them all fall at once.  Whether the designer topples the first domino, or a marble from a kid brother rolls into the room, or there is a small earthquake, the array of dominoes was designed to fall.

So it was for the financial crisis.  These thoughts are my own, though others have uttered them as well.   In order for there to be a panic that destroys a large portion of the financial system, there has to be:

  • High levels of leverage.
  • Leverage that is layered, where many parties are lending, and carry trades are common.  Parties borrow to lend more aggressively.
  • Collateralized lending — financial entities lend far more when lending is collateralized.  Most of the time, the existence of collateral prevents defaults.  But when things get really bad there is no protection with most collateral.
  • Problems with highly rated debt.  When debts are highly rated, in order to get high returns out of them, there must be a high degree of leverage applied.
  • There must also be general confidence that it is highly unlikely that there would be significant losses associated with the asset class.
  • Regulators must be similarly blind, and assume that risks are low in that set of assets.

So when the crisis struck it started in real estate lending, moving from Subprime, to Alt-A, to Prime, each one in turn more leveraged, and less likely to be prone to a crisis.  That’s why the crisis was so large.

The system had been optimized across many asset subclasses where many borrowers were trying to achieve equity-like returns through borrowing.  Thus when the overlevered previously safe asset classes began to fail, the failure was large, and had second-order effects that extended to lenders.

No one should say the current financial crisis was an accident; yes, no one aimed for it, but no, it was preventable.  It occurred from human activity that was left unchecked, building up leverage in safe asset classes, and pushing up the trading value of those assets to unsustainable levels.  Regulators had the power to bring it all to a halt, but they were complicit with the bankers.

That’s what you need to have a real crisis, and that ‘s why we still suffer from it.  The crisis will continue until enough of the safe debts have been rationalized, and the total level of debt gets paid down enough for the average borrower to borrow once again on a basis that has significant provision against adverse deviations.  Maybe we’ll get there in another 2-3 years.