I watched The Big Short (2015), again, last weekend. It is compulsory viewing for players in the financial markets, and a wonderful exposé of the consequences of greed, ignorance and “the madness of crowds”.
China Evergrande Group, one of the biggest real estate developers of the world, is in trouble. Is it simply a consequence of too much leverage, too much debt, in markets where borrowing has been made easy, if not emptying, by the practically universal quantitative easing policies of central banks? Or has it all been precipitated by yet another (actual or anticipated) clampdown initiative against tall poppies by the Chinese government?
Whatever the ultimate economic cause, the role of government(s), and their effect, both positive and negative, on issues that affect systemic risk, can no longer be ruled out or ignored. Regardless, though, $300bn is a lot of debt, no matter the asset profile and its ability to service and repay liabilities.
Or is it just human behaviour and, more particularly, crowd behaviour — led so often, as we are, by popular trends, fashion and fomo (fear of missing out)? The traders who make money out of these human phenomena do so, in the main, based on the principle of fifo (first in, first out) — they sip the froth, we down the full glass and languish with the hangover.
Occasionally, though, thorough analysis and understanding of the facts is what decides the big winners, as was the case in the collapse of the sub-prime mortgage market and the instruments it spawned (including those delicious credit default swaps, remember?) to best take advantage of the foolish followers. We don’t learn our lessons, and we never will. In China, Evergrande was the biggest issuer of dollar-denominated high yield bonds — ring a bell?
What is it that persuades us to suck every drop of yield out of safe asset classes (like mortgage bonds), until at last they succumb to the weight of leverage, or the mismatch of the term structures cause their final collapse? We can’t resist the urge.
Ignorance, and the reluctance to admit it, plays a big part in the feeding frenzy of the misinformed wannabes. Populism is the world of followers, not leaders. Don’t be a fool.
In a world of low, even negative, interest rates we need to be all the more cautious over the excessive use of debt — the wisdom of tried and tested survival ratios and relationships within income statements and balance sheets cannot be set aside. Leverage can be the friend of growth, or even survival, but only within the right mix — strained from that balance, debt destroys its host.
There are so many get-rich-quick (properly), asset-value growth stories, fuelled by immediate feedback loops, that beggar belief, let alone bear understanding or rigorous analysis. Some succeed, so there is a place for these things — a small place — in the portfolios of professionals, but not in widows and orphans funds, and not in the savings profile of us ordinary people. We can’t deal with volatility, we won’t see it coming, and we don’t know how to hedge.
Never invest in anything you don’t understand, ever. Never be fooled by the jargon-laden sales pitches and explanations given by those peddling this stuff — they don’t understand it either; the fancier the words, the less the knowledge, I’ve found — but they live off risk-free commissions that pay well during assets acquisition frenzies regardless of the outcome.
Financial analysis seldom requires more than a good grasp of arithmetic to fully explain it. If you can’t work it out on a simple financial calculator, and if you can’t explain it to a nonfinancial friend in just a few sentences (using small, everyday words), then don’t do it.
Small planes crash when pilots ignore what the instruments are telling them. Big markets crash for the same reason. The truth can be so inconvenient when you’re having fun.
• Barnes, a former SA Post Office CEO, has had more than 30 years of experience in various capacities in the financial sector.
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