Thursday, January 14, 2010

The Definition of Speculation, Part II (it gets worse)

In my last post I defined speculation as "buying commodities for the capital gain from anticipated increases in their prices rather than for their use," following Kindleberger's Manias, Panics, and Crashes.

According to Hyman Minsky however, speculative is only the middle type of three types of finance: hedge, speculative, and Ponzi.  Minsky, for those unfamiliar, is the late American economist whose genius was unappreciated in his lifetime but has suddenly become quite trendy to quote in relation to the recent economic bubble and crash.

Minsky's three types of finance are defined in reference to debt that the "investor" is assumed to have taken to fund his investments.  In other words, it does not cover self-funding investments.  His model is nonetheless quite useful, as the reality is that most economic activity is funded by debt, be it mortgages, small-business loans, or larger bond floats that are done by major corporations or governments.

Hedge finance, then, is defined as purchasing an investment asset for which the anticipated operating income (rent, dividends, etc.) is sufficient to pay both the interest and principal on the debt incurred to acquire the asset.  Regardless of what happens to the value of the asset, the hedge financier is covered.  He might not make a killing, but he will not go bankrupt; he is "hedged."

Speculative finance is where the anticipated operating income is sufficient only to pay the interest, but not the principal, on the debt incurred to acquire the asset.  The speculative financier can only pay down the principal and avoid bankruptcy by borrowing more money, in the form of new loans or renegotiated terms with the original lender.  He is OK as long as the asset value appreciates and he is able to get new loans, but if the asset value depreciates (as it inevitably does when a bubble bursts), he will have a liquidity crunch and both be forced to sell at a loss and potentially face other consequences of not being able to pay back his loan.

The final type of finance, Ponzi finance, is where the anticipated operating income does not even cover the interest.  The Ponzi financier finds himself falling into ever greater indebtedness as he borrows new money to pay merely the interest on the old, and will find himself in deep trouble as soon as others realize what he is up to, unless he is so lucky that the asset value appreciates fast enough to allow him to sell and pay back all of his creditors.

According to Minsky, when the economy sours, some of the individuals and firms in the hedge category get pushed to the speculative category as their income goes down, while some of the players in the speculative category find themselves in the Ponzi category.  This is precisely what happened in 2008-9 with many of the banks who had liquidity crises as their payments from their CDOs started shrinking as defaults rose.

The original Ponzi, by the way, was not particularly successful at his eponymous scheme, only managing to keep his hustle going for a few months before it crashed.

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