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3rd December 2022 > > Leverage and correlation.

tl;dr

Leverage can hurt. Correlation can hurt. Combine the two and you have the ingredients for a series of high-profile disasters.


Market Wrap








Market Wrap

To be strictly accurate BTC has broken the 17-handle to the downside, though only by $6 at the time of writing.


There are a lot of economic problems in the world today, mostly because of political decisions made by Western leaders. The inability of politicians and especially finance ministers to help rectify problems of their own making is demonstrated by the fanfare accompanying the utterly pointless announcement of a cap of $60 per barrel of Russian oil by the G-7 (*).


Curious Cryptos’ Commentary — Background to leverage and correlation

The CCC has often referred to the toxic combination of leverage and correlation to explain some of the current market travails. I have had questions that show that I have been making assumptions about what those two words mean to those who are not from a banking background. I will try to rectify this oversight today.


This may seem like an arcane subject for a slow-starting Saturday morning, but it helps us to understand the root causes for many of the problems we have seen in the crypto world during 2022.


That rapid and monumental ramp-up in crypto prices during 2021 may have made holders of coins smile at their prescience, but it appears to have led to hubris amongst others. Business leaders who failed to pay attention to leverage and correlation are making us all pay the price today.


Of course, if you are a crypto naysayer, this is always going to be how it pans out eventually. But even if you fall into that category, these are still important lessons that crop up in every market on a regular basis.


The easiest place to start to understand leverage and correlation is with a subject that most of us are familiar with, either as a concept or in practice. And that subject is the process of buying a house using a small or sometimes zero amount of cash collateral (aka the deposit) and paying the rest with a mortgage (aka a loan collateralised by the market value of the house).


Mortgages have been around since the 12th century in England but access to them was very limited until the 1960s or so. Until that time banks rarely extended this facility to those whose wealth and income was derived solely or mainly from their occupation. My grandparents moved from Seaham Harbour to Garston not long after the war. The house was bought with cash for maybe just hundreds of pounds. It is worth rather more today.


As mortgages became much more widely available, that created more demand for housing, whose supply will always be limited with the UK’s over restrictive and inefficient planning permission process. The high multiple of house prices to average income can be traced back to the democratisation of the mortgage market.


When you have a mortgage, you are leveraged.


You make monthly repayments of interest and usually of part of the capital too. Keep up all the payments on a typical 25-year mortgage, and at the end of the term you own your house outright.


Which is all well and good except that it is impossible to know how interest rates will move even over the course of the next twenty-fours. Any predictions for rates a quarter of century out are as reliable as the predictions for the one-year trajectory for UK government debt made by the OBR (Office for Budget Responsibility) on behalf of Treasury mandarins. But that’s a discussion for another day.


It is also impossible to know how your future financial situation will pan out.


Leverage is a tool, and a very useful one at that. But over-leverage – manifesting itself in this example by being unable to afford the monthly payments because of interest rate rises, or a change in your financial situation, or both – can lead to disaster. In this case, loss of your home due to repossession.


To understand correlation, we need to look at the collateral for your mortgage, in this case your house. Or to be more precise, the expected price in cash to be realised following a sale.


If just one borrower gets into financial difficulties, say due to losing their job, and there are no wider economic issues, the bank takes possession of the house, sells it on the open market, repays the loan, and any excess is returned to the borrower.


This is not a good situation for either the lender or the borrower, but it is relatively manageable, though please understand I do not underestimate the personal and emotional turmoil that someone must go through in that scenario.


The issue of correlation arises when the cohort of borrowers finding themselves in financial difficulties is due to some common reasons.


An obvious one would be a sudden and significant ramp-up in interest rates. That probably sounds familiar to all of us. Now that market manipulation of interest rates on a grand scale by all CBs (Central Banks) is hopefully now over – except for the ECB – interest rates will now be permanently higher than we have seen for the last decade or more.


Those who took out 10-year fixed rate mortgages before Spring of 2022 are sitting pretty for a long time. It is unclear how well positioned are the rest of the mortgage borrowers.


Another one would be a recession, which is always accompanied by job losses. Few people are insured against that scenario, and even fewer can service their mortgage payments without an income.


Either or both scenarios will impact house prices to the downside. Monthly data already shows house prices declining month-on-month in some parts of the country, due to rising interest rates, which reduces demand from buyers.


The US yield curve is the most inverted it has been for decades. This is a strong signal that we are six to eighteen months away from a recession in the US. The rest of the Western world will follow suit.


Raising interest rates into the teeth of a recession is not going end well.


And this demonstrates the toxic combination of leverage and correlation.


As more borrowers get into trouble, there is more supply of houses whilst demand is reducing. House prices can only tumble in that situation.


Banks meanwhile start to see the stock of their collateral reduce versus the value of the loans they have made. Banks spend much of their time worrying about their balance sheet, and rightly so. Reductions in house prices only incentivise banks to foreclose earlier than they might otherwise do so, increasing supply yet further, and increasing the downward pressure on house prices.


Correlation makes this theoretical vicious circle a reality.


That is enough for today.


Tomorrow we will unpick how these two risks led to the failure of FTX, and BlockFi, and the potential implications for the BTC miners.


(*) Utterly pointless because as of now the price of Russian oil is $50 per barrel. Even if it goes higher than $60 the G-7 simply sources oil from elsewhere, and the Russian supplies will take up the gap.

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