Monday, March 13, 2017

Glycerin Truck of Leverage

"A toast to Mama Dollar and Papa Dollar. If you want to keep this building and loan in business, you'd better have a family real quick!"
--George Bailey (It's a Wonderful Life)

Bill Gross recounts a discussion he had recently with his own kids about the complexities and risks associated with investing. In particular he focused on explaining the concept of financial leverage as created by the banking system. "It still mystifies me," he told them, "how a banking system can create money out of thin air, but it does."

His subsequent example of how your one dollar deposited at the Bank of USA becomes two dollars is well worth reading a few times...and sharing with your family members in pay-it-forward style. It helps explain how the US financial system has multiplied, as Gross estimates, $3 trillion in 'base credit' into $65 trillion in 'unreserved credit.'

The obvious risk, as recognized by his son, is the situation where depositors collectively become risk averse and simultaneously demand the dollars back that they think are theirs. This is, of course, the essence of a bank run. We were on the verge of a massive run in 2008 and other countries including Greece and Cyprus have provided previews since then.

The bad news is that the US has created more debt relative to GDP than at the beginning of the credit market meltdown nearly 10 years ago. China and other countries are in the same boat.

Gross concludes that, "our highly levered financial system is like a truckload of nitro glycerin on a bumpy road." One mistake could set off a credit implosion and bank runs of epic proportions.

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