Managing Your Money for the Future – The New Financial Era Has Begun

After years of excessive borrowing by companies and individuals, the leverage monster has finally come home to haunt us.

What is different about the 2008 crash?

The 2008 market crash was an accident many years in the making, just waiting to happen! In this regard, we should be neither shocked, nor surprised.

With the advent of the ever increasing power of computers throughout the 1990’s until now, financial engineers have evolved and developed an increasing array of sophisticated derivative products that have leveraged, or geared, our financial system to breaking point.

For each dollar that you deposited with your bank, that bank in turn could lend many multiples of that dollar to someone else, largely via derivative products. When those leveraged and borrowed assets turned sour with the onset of the housing market bubble, someone had to be liable.

Understanding how the 2008 crash happened.

Simply put, a derivative security or product is an extension of the underlying asset for investment or speculative purposes. A simple example is the option to buy stock. This is known as a call option. A call option gives the holder the right, but not the obligation, to purchase stock at an agreed price (the strike price), on or before a pre-determined date (the expiry date). For this right, the holder (or buyer of the call option) pays the seller a price (the premium). The buyer’s risk is limited to the price paid for the option, as this loss cannot be more than the premium paid. For the seller of the option however, the risk profile is very different, in fact, it can result in unlimited losses!

Consider the following example;

You have bought a call option in XYZ stock for $1.00 with a strike price on XYZ of $10.00. If the stock falls below $9.00, you would not exercise your right, and you would lose your $1.00 premium when the option expires. The seller would make $1.00 profit, his maximum profit. Now, what would happen if stock XYZ starts moving higher before the expiration date?

The smarter seller of the option would have made sure that he owned XYZ as covered stock, at the time he sold you the option, thereby ensuring his $1.00 profit. Unfortunately, in the context of the 2008 crash, this did not happen. If XYZ suddenly moved to say $20.00 before expiration, you would exercise your option and make a $9.00 profit (the difference between the current price of $20.00, less the strike price of $10.00, less the premium of $1.00). If the seller did not cover his position as the stock moved higher (against him), he would have to suffer the $9.00 loss as he is obliged to deliver the stock to you at $10.00. Or worse, he would have to borrow money to purchase the stock, to deliver to you. Starting to sound familiar?! And if XYZ moved even higher, the problem for the seller only gets worse.

Take this very simple example, multiply it literally by billions of dollars (if not trillions), and you can get a sense of how huge this problem has become. On top of this, many of these derivative products have become so complex, with such massive leverage and gearing, that it is impossible to quantify the extent of this crisis. By their very nature, derivatives allow you to leverage and gear your capital to many multiples, some as much as 40 times!

When the chickens come home to roost, someone has to pay!

Wall Street can thank the taxpayer for this assistance.

Previous seismic events in the financial markets did not have this excessive derivative equation. Throughout this leverage period over the last two decades, it can be argued that the bulk of what is now known as “toxic debt” was both unregulated, and had no standard measurement of valuation, only serving to exacerbate the problem. Hence, the rating of this “toxic debt” by the credit agencies was meaningless. So, when the holder calls up his derivative “investment”, the other party has to pay-up. If the party cannot pay-up, either they have to declare bankruptcy, or if you are big enough, ask the taxpayer to bail them out. Failure to do the latter would be more catastrophic for all of us. The now familiar story!

How can you avoid falling into the same trap?

The answer is surprisingly simple - do not leverage your personal assets!

Your credit card can be the most devious form of personal leverage without you even realizing it. Many credit card companies love it when you over-borrow on your credit card, because they know that they can charge you exorbitant interest rates, leveraging to their own benefit at your expense. The now infamous adjustable-rate mortgage (ARM) is another example, as they usually reset to a higher interest rate.

The bottom line is that you have to ensure that you and your family do not fall into this debt trap! You have heard the call time and time again, DO NOT BORROW MORE THAN YOU CAN AFFORD. One of the most important things you can do, as your career progresses, is to ensure that you have net personal assets (you own more than you owe). Do not break this rule, not ever! In the “good times”, when interest rates are low, and access to borrowed money is easy you often hear then that you should borrow more to invest. On the contrary, it is during these times that you should be building your net asset base first and foremost. You can be certain of the financial direction after the “good times” are over. The trajectory is always down!

The new financial era has just started, causing great uncertainty and stress. The rules of banking, and in particular lending, are going to have to be dramatically reassessed. This will have a direct impact on our personal lives, and the way we do business. In short, if you can work to eliminate your debt completely, you will have taken a significant weight off your shoulders, and ensure that you are on the right path towards your financial security.