The article discusses how the financial system's leverage has become increasingly complex and risky following an era of cheap money. It's not just the amount of debt that's concerning, but how that debt is structured. Modern leverage is complicated by five main factors, making traditional risk assessment methods less effective.
One complication is the increasing reliance of borrowings on the value of underlying assets when cash flow is insufficient to service the debt. This can create complicated linkages; for instance, a leveraged equity bet secured by long-dated Treasury bonds is exposed to both stock price and interest rate changes, which can quickly exacerbate risks and increase cash calls.
Another factor is the broader range of investments being leveraged. Debt is now financing assets like infrastructure, start-up ventures, intellectual property, collectibles, and catastrophe bonds, instead of just traditional real estate or liquid securities. These assets are harder to assess, making loan-to-value determinations challenging.
The article also points to the growth of "embedded leverage," where financial engineering techniques, such as digital or binary options, increase the loss intensity for a given event, allowing sellers to nominate large losses for remote events to earn higher premiums.
Regulatory measures like disclosure and increased capital, while helpful, are often insufficient because information lags, and capital modeling for complex leverage types is difficult. A significant portion of exposure also lies outside the banking system, where oversight is inconsistent. Ultimately, the economy's reliance on speculation, often backstopped by governments, makes limiting leverage challenging.
