Monday, October 05, 2009

Speculation v. Leveraging

Yesterday, I sat through a Book TV program in which a half witted progressive projected all of the wrongs of the world onto his partisan enemies. The tenured professor of progressive propaganda had an acute hatred of speculators.

I really dislike the progressive game where the elite identify a group that the brownshirts are to hate and struggle against.

I prefer a more balanced approach that observes what people are doing coupled with an analysis of those things that lead to positive results and those things that lead to naught.

I believe that speculators can do a great deal of good. For example, people speculating on corn futures might buy a crop at the beginning of the season. This allows the farmer to concentrate on the farming.

Speculators in the stock market provide valuable pricing information. This pricing information helps people decide how to invest resources. Back to the farming expample. If speculators are expecting a shortage of soy beans and an excess of corn, the future price for corn would be low, and the price of soy beans high. A wise farmer might switch crops for a year based on this pricing information.

The pricing information helps people make better decisions. The futures not only helped the farmer avoid risk of a crop failure, selling the crop on the soy market made the farmer more money and help keep the tofu shakes flowing.

There is a good side of speculation.

In 2008, we saw the speculative markets were out of whack with reality. So, clearly there was something in the waters that disrupted the speculative markets and caused a horrific imbalance.

I contend that this force is leveraging. Leveraging happens when an investor borrows against one equity to invest in another.

Leveraging can dramatically increase profits from an investment. If I had 1000 shares of stock and leveraged that equity to buy another 1000 shares, I would have 2000 shares. If the stock doubled in price, I would have all sorts of money. Of course, if the stock fell, I would be in deep hurt as I would have to find a way to pay back the money I borrowed.

Since every purchase and every sale of an equity affects the equity, one finds that leveraged speculative buys and sells have a leveraged effect. The leveraged effect effectively creates false information. Highly leveraged positions create systemic faults. For example, during the market crash of 2008, speculators were forced to liquidate their leveraged positions. This accelerated and deepened the crash.

While speculation provides valuable information, speculation appears to provide false information.

Unfortunately, one of the primary tools of speculation is a thing called a short sale. To sell short, a speculator borrows and equity then sells it.

The very first step of the process is the borrowing of the equity. This borrowing of the equity makes short selling an inherently leveraged position. Taking a $10,000 short position in a company involves borrowing $10,000 in shares from other investors then selling those shares. This borrowing of shares is a leveraged position.

Many of the put and get options on the market are backed by short sales in the stock. If I borrowed money to buy a get option, I would actually have created a double leveraged scenario with the broker shorting the stock to create the derivative and my borrowing to buy the derivative.

The hedgefund industry will bundle highly leveraged positions and sell the leveraged positions as equity. This equity in turn is shorted and borrowed against.

This process of ever greater leveraging creates a greater and greater separation between speculative plays and the real value of the underlying equities. The end result is a situation like 2008 where the underlying equity in the market appeared sound, but our hedgefunds, insurance companies and banks had internally created an instable house of cards.

Speculation is not inherently evil. When combined with leveraging, speculation creates systemic risk.

We could reduce systemic risks by reducing the extent to which speculators leverage their holdings.

This appears, at first, to be a call for greater regulation. However, I would point out that most of leveraging tools on the market are creation of regulators.

For example, widespread short selling exists because the sales are not recognized as loans. Would you lend your shares to a speculator if you shared the risk of the speculation? The short selling industry depends on selling shares without the full knowledge of the share owners. Much of the institutionalized short selling happens because of artificial gaps in transactions created by clearinghouses.

The question of regulation v. deregulation is a moot point as pretty much all of the leveraging tools are tools created by regulations.

Tools that closed the gaps on leveraging would have the same effect as greater direct control by regulators.

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