Guest Post: Extreme Leverage, Extreme Instability, Extreme Risk

Tyler Durden's picture

Submitted by Charles Hugh Smith from Of Two Minds

Extreme Leverage, Extreme Instability, Extreme Risk   

We tend to speak of leverage in financial terms, but as frequent contributor Harun I. notes, leverage and thus risk is ever-present in everything from oil to technology.

Some call it complexity or hyper-complexity, to me it's all about leverage. The greater the leverage the greater the instability. And developed societies are too heavily leveraged in technology (knowledge), finance (credit) and energy. Remember, your prediction of a 4% failure in housing causing a complete collapse in that sector was dead on. But that 4%, which globally represented much less, collapsed the entire global banking system.

Technologically, there are too few people holding the knowledge to systems that are now considered vital; the same can be said of the monetary systems (the Fed insists on black box operations in conducting monetary matters). Crude oil and all its derivatives from which we get fertilizer to Tupperware to space shuttles: the extend to which we are leveraged via oil is incalculable.

Thank you, Harun. The greater the leverage, the greater the inherent instability and thus the greater the risk.

We tend to think of crude oil as the feedstock for gasoline and jet fuel, but it's also the feedstock for agriculture (fertilizers and transport), plastics (a significant percentage of industrial products) and ultimately everything else via transport.

Conventional economists are constantly cooing that oil accounts for a smaller percentage of the U.S. economy that it did in the 1970s; but does that mean that the economy is any less vulnerable to supply disruptions? The concept of leverage helps us understand how removing $650 billion in crude oil from the U.S. economy (18 million barrels a day X 365 days = 6.5 billion barrels X $100 per barrel = $650 billion) is not just a simple subtraction of 4.5% of total GDP ($14.7 trillion): it would trigger the implosion of the entire U.S. economy.

That's leverage.

How many people truly understand the precise mechanics of last year's "flash crash"? Does anyone really understand what interactions of high-frequency trading computers led to a stick-slip/criticality/crash? How dependent is the system on their expertise?

How many people operate the Federal Reserve's many opaque interventions in the market? What sort of daisy-chain ties the Fed's moves to other central banks? What happens if that web of intervention breaks down or seizes up?

The conventional spectrum of punditry and economists dismissed the idea that U.S. housing was a highly leveraged sandpile waiting for a stick-slip event. But the leverage piled on leverage was self-evident: the consumer borrowing (home equity lines of credit, refinancing, etc.) that fueled much of the "growth" in spending was leveraged off the housing bubble, which also leveraged rising demand for lumber, granite countertops, high-end refrigerators, etc., and a stupendous mountain of derivatives, credit default swaps, mortgage-backed securities and other financial instruments which leveraged up Wall Street's profits and valuations.

The entire sandpile collapsed once its riskiest grains--the designed-to-default subprime option-ARMs and no-document liar loans--succumbed to the inevitable.

Some observers insist there cannot be another recession because there is always 7-10 years between recessions. This is just like saying the U.S. could brush off the removal of 18 million barrels of crude oil a day because the oil only represents 4.5% of the GDP, and surely the economy has declined 4.5% in the past without any permanent damage.

Except that 4.5% is highly leveraged, and the system is totally dependent on it. That leverage creates a fundamentally unstable system, which is highly vulnerable to disruptions which quickly cascade in a series of inter-connected, self-reinforcing feedback loops--just like "flash crashes" and markets which suddenly have no bid.

The recovery is self-sustaining, technology will save us, the U.S. economy is resilient, don't fight the Fed, the stock market is on a permanently high plateau thanks to the Bernanke Put, blah blah blah. Check back in in 15 months and let's see who's right: the "The recovery is self-sustaining, stocks are on a permanently high plateau" crowd or those of us looking at the leverage being piled on leverage.

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10kby2k's picture

Replay of 1999.

YouBetYourLife's picture

Or a replay of 1973.  Only worse.

whatsinaname's picture

Or replay of 1987 - with a 400 point drop on the S&P ? haha

tomster0126's picture

More like 2012!  Hah, what if the Mayans' prediction comes true in the form of the biggest global economic collapse ever?  The Global Depression

tmosley's picture

More like 476 AD.

Happily, our Dark Ages will be shorter, and less dark, as technology exists and knowledge is spread far and wide--almost impossible to wipe out by any means.  Just so long as we don't have a hoard of uneducated barbarians sweep down on us and kill everyone with such knowledge.

But the hegemon will fall.  Make no mistakes regarding that.

Jonas Parker's picture

Deja Moo - or, somewhere I've heard this bull before!

covert's picture

my favorite way to invest. quite right. the only risk is in the unknown.


Pat Hand's picture

Yes.  Oil is the linchpin of the world's tightly-coupled system...  let me re-recommend Bookstaber "The Demon of our own Design"

We are doomed for many reasons...


rocker's picture

We have all heard about the increases on margin for the metals.

CNBC's guest just said Traders can trade a MILLION dollars of Oil for 50 thousand dollars. (1M vs. 50K).

Guess who trades oil everyday. JPM, C, and GS. Hello. Why are banks trading oil with our money jacking up the price?      

Cognitive Dissonance's picture

It's all black magic to the average Joe and it's intentionally projected as such in order to generate overall apathy and a general feeling of helplessness. Everyone just sort of hopes everything keeps cooking along and they don't wake up one morning dead as a door nail. Or worse alive, but without mother's little helpers such as gasoline, electricity, food and transportation.

When everyone gets their food at "stores" and their money from machines, it is inevitable that we will worship that which we are dependent upon. All hail Bernanke/BOA, Exxon, GM and Safeway.

whoopsing's picture

Yes they count on the old shrug of the shoulder's and the 'what can I do?' attitude of the little guy.They know we have to play the game in order to stay in our ' sphere of comfort and safety ' . But this just propel's them to notch it higher and higher. It seem's resistance is coming from somewhere soon . Will the house of card's hold?

TaxEstate's picture

The ONE thing that brought this house of cards down during the Financial Crisis is still firmly in place, and arguably even worse: Leverage. The last crisis was a 'fart in the wind' compared to what's coming...

99er's picture


Three targets:

Wolfe Wave 1325

H&S 1312

AB=CD 1246


FunkyMonkeyBoy's picture

Utter utter junk son, give it up.

topcallingtroll's picture

Let us indeed check back in 15 months.

Global Hunter's picture

These are the same people who think that the crisis in Japan is a local problem and doesn't effect anybody else.  They think its 1 country out of 190, nothing to see here folks.  Tell that to the 25,000 workers in North America affected by Toyota plant closures.  And that's just 1 example.

ziggy59's picture

you are correct..I guess they never heard of cause and effect - heck this more like the butterfly effect, only im calling it the Godzilla Effect.

he's got radioactive hallitosis

tickhound's picture

green shoots, crocus, recovery in earnest... The Federal Reserve - A Global Force for Good.

tek77blu's picture

here's a great interview by peter grandich that talks about these same risks, and a possibly retest of the march 09' lows of the stock market:

YouBetYourLife's picture

I'm ready to pull the trigger and order the solar panels I've been scoping out for the past few months.

Things are becoming more surreal by the day. It's as if we're on the Titanic, racing across the frigid Atlantic at night, with Captain Bernanke at the helm.  Full speed ahead - after all, we're unsinkable, right?

When this supply system breaks, it's really going to break. 

Catherine007's picture

yes. cash on hand, gold, guns and a BIG food supply!

whoopsing's picture

 If trump run's and win's there will be gilt column's on the Whitehouse - he's one tacky bastard

Catherine007's picture

correct. amazing though he admits they are in Libya for oil and that the rebels could be Al Qaeda. Aren't these the same people who blew up the Twin Towers?? The whole show is just becoming ridiculous. 

whoopsing's picture

As fun as it was to hear him speak the truth , the look on merideth's face was even better

flattrader's picture

Birth Cert issue is the best "Rope a Dope" strategy I've seen in a while.

I often wonder if the O Campaign didn't invent it or if it just fell into their lap.

Sudden Debt's picture

The DOW may end at 36000 points while we'll be at the center of the biggest shitstorm in centuries.


nah's picture

Give me a black swan and i care not who makes the laws.



LawsofPhysics's picture

Mark to unicorn baby.  Now where did all those unicorns go?!?!?

Caviar Emptor's picture

Leverage is another way of saying "we'll make it all up with more growth in the future". Otherwise there would be only risk and dubious benefit. 

So a central question is: are the expectations for future growth delusional? 

One look at Paul Ryan's budget proposal answers that question. But that's a problem straight up and down the economy where most institutional investments are predicated on a rosy picture. 

Our mature post-industrial, post-capitalist economy predictably won't generate growth levels we've seen in the past. During the first three years coming out of the Great Depression, Real GDP growth was 10.8, 8.9 and 13%. Coming out of the 1981-82 recession Real GDP growth in 1983 hit 4.5% and 7.2% in 1984. Now we're happy with 2-3% coming out of a deep recession. 

I won't even mention jobs recovery and growth during those periods which was brisk and rapid. All that points to a new paradigm of low growth. Unfortunately it's not because of national debt but in spite of it. It's the result of the consumerist economic model which neutered America's industrial base. Even if we cut the Federal deficit we still have a giant trade deficit because the consumerist economy is fully import dependent. 

tawdzilla's picture

If you consider our deficit is 10% of GDP, real GDP growth right now is really more like -7%.  We are circling the drain indeed with unserviceable debt and a weak tax base.  Paul Ryan says our debt/GDP by 2037 will be 800%, but I'm not sure if we'll even be around that long to see it.    

blindman's picture

risk = probability x consequence.

consequence is subjectively determined and valued.

my 2 cents

mind_imminst's picture

It certainly looks like the another leverage shit storm is coming our way, but as someone mentioned earlier, knowledge is more widespread (as well as mass communication systems). Efficiency is improving. People and companies are still inventing things. Some market participants (entrepreneurs and innovative companies) are creating real value. The only problem is that I don't think the efficiency and value creators can keep up with the destruction being wrought by the central banks.

toros's picture


Smiddywesson's picture

Excellent post Tyler. 

This has occupied my thinking for quite a while.  A highly efficient society is just another way to say you live in a society that will fail if anything at all goes wrong.  Squeezing more zing out of the system comes at the cost of lost robustness.  In a society where millions of people live without sufficent local sources of food, water, and energy, what happens when something goes wrong?  The Japanese earthquake is a good example.  In a world of zero inventory and just-in-time delivery, the shelves were bare in under three days.

Because of leverage, the number of things that can crash that efficient system has multiplied.  Because of leverage, people are at an historic level of ignorance about the possibility that it can happen to them.  A $50k hummvee, yeah they have that, but a few sacks of rice and beans and a water filter, that makes you a kook!  People will spend thousands of dollars on stuff they don't need, including all kinds of insurance, but real insurance, the kind that feeds you and your family just in case, they won't spend a lousy $100 on that.  They are too busy discussing American Idol I guess. 

Geoff-UK's picture

CHS is not value-added on ZH.  Please cancel his posting privileges soonest.

flattrader's picture

No effn' kiddin'.

CHS wrote--

Extreme Leverage, Extreme Instability, Extreme Risk

and the went on to state the

Extremely Obvious

to all the the brain dead.

If he wanted to discuss real leverage, instability and risk a discussion of derivatives, which seems to have fallen off the radar recently, might have been worthwhile (but, probably beyond him.)

SHRAGS's picture

Oil is to modern society what gold is to the financial system - Exeter's Pyramid.

honestann's picture

The predators-that-be don't care how completely they destroy the people, the nations, the economy.  They do what predators do... grab whatever they can.  Unfortunately, unlike other predators, human predators do not just grab what it takes to fill their belly today, they grab what it takes to fill their insatiable desire for wealth and power, which knows no limit.

The predators-that-be, and the entire predator-class need to be dealt with exactly like predators of other species... they need to be exterminated.  Nothing less will do, because nothing else will stop them, and because today the entire predator-class support and protect each other.

On the practical matter of leverage, synthetic leverage must be eliminated.  All forms of fractional reserve practices must be eliminated.  All forms of creating "loans" or "assets" or "money" or "currency" or any other financial instrument out of thin air must be eliminated.

We must return to real, physical gold, silver, and any other real, physical, valuable assets as "value", not pieces of paper called "money" or computer bits.

Time for humanity to "get real"... or go down in flames.  There are no other choices.

Milestones's picture

Right on post!  Hell yes, I'll drink to that. I think the species has come upon the shit-or-get-off-the-pot decade.There is no mere of kick the can.     Milestones

gwar5's picture

I guess I must be a contrarian investor these days... I'm just looking to preserve what I've got and keep it from being confiscated by the Fed through exessive printing.

thedrickster's picture

I'm writing a 20K credit card check and buying FAZ in the morning.

Is that considered leverage or karma? 1:10 reverse splits make me rich in the Bernank's nominal terms, suck it bitchez.

Bartanist's picture

You can add "food & water" as being highly leveraged as well. The entire world food system is now very dependent on the highly leveraged energy sector.

Without cheap energy supplied by a small and decreasing number of players 6 billion people starve to death globally.

tomster0126's picture

The New Dark Ages are here, the collapse is inevitable.  Start stocking seeds and look for splots of arable land to swoop up once disaster hits, it's gonna be rough.