I’ve been a longtime enthusiast for Hyman Minky’s analysis. His work plays prominently in my analytical framework. Financial structures evolve over time, and there is an innate propensity for this evolution to regress into a cycle of ever-increasing excess, fragility and instability. Success in finance – by borrowers, lenders, speculators, investment bankers, investors, businesses, central bankers and the like – ensures only more exuberant risk embracement over the course of the cycle. Importantly, debt structures degenerate over time, as the boom is perpetuated by expanding quantities of debt of deteriorating quality.
Minsky’s “financial instability hypothesis” models three categories of debt structures: Sound “hedge finance” – where “cash flows are expected to exceed the cash flow commitments on liabilities for every period.” Less sound “speculative finance” – where cash flows, although inadequate to fully service debt in the short-run, are generally sufficient over the longer-term. And unsound “Ponzi finance” – “cash flows from assets in the near-term fall short of cash payment commitments” and only with some future “bonanza” will cash flows ever be sufficient to service debts and provide any realistic hope of generating profits.
Importantly, “a ‘Ponzi’ finance unit must expand its debt load to meet its financial obligations.” New money and credit in abundance are a necessity for perpetuating the scheme. The greater the ratio of speculative and Ponzi finance, the greater the fragility of the financial sector to rising interest rates and/or other shocks. Ponzi financed assets, in particular, are highly sensitive to both changing perceptions and higher interest rates. Traditionally, higher rates are problematic as debt service costs rise at the same time the present value of future cash flows drops. Quoting Minsky, “The rise in long term interest rates and the decline in expected profits play particular havoc with Ponzi units, for the present value of the hoped for future bonanza falls sharply.”
Minsky: “It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system… Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”
Minsky witnessed a lot, but he surely never imagined an environment of zero rates and endless Trillions of Fed monetization, and how such a backdrop – the perpetual “bonanza” – would extend the “deviation amplifying” Ponzi phase. The Archegos fiasco had me this week sharpening my focus on Minskian analysis. The facts are not altogether clear. But from numerous reports it appears Archegos had fund equity of around $10 billion. Positions have been estimated in the range of $50 billion to $100 billion, meaning a leverage ratio between 5 and 10 to one. (more…)