Financial crises and excessive leverage – How 2 best understand it

Financial crises and excessive leverage – Contrary to popular opinion, stock markets generally continue to reflect companies’ intrinsic value during financial crises. For instance, after the 2007 crisis had started in the credit markets, equity markets too came in for criticism.

In October 2008, a New York Times editorial thundered, “What’s been going on in the stock market hardly fits canonical notions of rationality. In the last month or so, shares in Bank of America plunged to $26, bounced to $37, slid to $30, rebounded to $38, plummeted to $20, sprung above $26 and skidded back to almost $24. Evidently, people don’t have a clue what Bank of America is worth.”1

Far from showing that the equity market was broken, however, this example points up the fundamental difference between the equity markets and the credit markets. The critical difference is that investors could easily trade shares of Bank of America on the equity markets, whereas credit markets (with the possible exception of the government bond market) are not nearly as liquid. This is why economic crises typically stem from excesses in credit rather than equity markets. Financial crises and excessive leverage

Financial crises and excessive leverage

The two types of markets operate very differently. Equities are highly liquid because they trade on organized exchanges with many buyers and sellers for a relatively small number of securities. In contrast, there are many more debt securities than equities because there are often multiple debt instruments for each company and even more derivatives, many of which are not standardized. Financial crises and excessive leverage

The result is a proliferation of small, illiquid credit markets. Furthermore, much debt doesn’t trade at all. For example, short-term loans between banks and from banks to hedge funds are one-to-one transactions that are difficult to buy or sell. Illiquidity leads to frozen markets where no one will trade or where prices fall to levels far below a level that reflects a reasonable economic value. Simply put, illiquid markets cease to function as markets at all. Financial crises and excessive leverage

During the credit crisis beginning in 2007, prices on the equity markets became volatile, but they operated normally for the most part. The volatility reflected the uncertainty hanging over the real economy. The S&P 500 index traded between 1,200 and 1,400 from January to September 2008. In October, upon the collapse of U.S. investment bank Lehman Brothers and the U.S. government takeover of the insurance company American International Group (AIG), the index began its slide to a trading range of 800 to 900. Financial crises and excessive leverage

But that drop of about 30 percent was not surprising given the uncertainty about the financial system, the availability of credit, and their impact on the real economy. Moreover, the 30 percent drop in the index was equivalent to an increase in the cost of equity of only about 1 percent2, reflecting investors’ sense of the scale of increase in the risk of investing in equities generally. Financial crises and excessive leverage

There was a brief period of extreme equity market activity in March 2009, when the S&P 500 index dropped from 800 to 700 and rose back to 800 in less than one month. Many investors were apparently sitting on the market sidelines, waiting until the market hit bottom. The moment the index dropped below 700 seemed to trigger their return. From there, the market began a steady increase to about 1,100 in December 2009. Our research suggests that a long term trend value for the S&P 500 index would have been in the 1,100 to 1,300 range at that time, a reasonable reflection of the real value of equities. Financial crises and excessive leverage

In hindsight, the behavior of the equity market has not been unreasonable. It actually functioned quite well in the sense that trading continued and price changes were not out of line with what was going on in the economy. True, the equity markets did not predict the economic crisis. However, a look at previous recessions shows that the equity markets rarely predict inflection points in the economy3. Financial crises and excessive leverage

Financial crises and excessive leverage

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