Then, any drop in asset values will set off the debt trap.
By one measure, for about every $40 in assets, the nation's five largest investment banks had only $1 in capital to cover losses, meaning that a 3 percent drop in asset values could have wiped out the firm.
The debt accumulated prior to the recession became a burden on households because the recession was associated with a large drop in asset values and a decline in expected income.
If the drop in asset values really reflects the collapse of a moral-hazard-driven bubble, the reallocation of control is putting assets into the "right" hands; if it reflects an essentially arbitrary run on domestic intermediaries, it puts assets into the "wrong" hands.
In a pure moral-hazard version of the crisis, then, the drop in asset values is basically appropriate, and the transfer of ownership is an efficient move from the world's point of view: assets are being placed under the control of those who can use them best.
Because most private sector investors like myself cannot countenance an unhedgeable risk of a 50% overnight drop in asset values private sector capital flees, even as asset prices and labor costs collapse.This leads to Mr Gave's suggestion:Let's imagine that I am thinking of investing €10mn in distressed Spanish real estate, but am worried about Spain leaving the euro and a new peseta devaluation.
The decline in incomes at the top is likely driven by the decline in capital gains income and the general drop in asset values.
Making matters worse, these financial conglomerates were allowed to dramatically increase their leverage, making them highly vulnerable to the slightest drop in asset values.
It was wildly overleveraged, with only $1 in equity for every $38 in debt, meaning a drop in asset values of less than 3% would wipe out the firm.
A small drop in the asset value of a leveraged bank leads to distress and possible insolvency, and this can be contagious in such a system.
Variables employed in the tests include further drops in property prices of up to 20%, interest rate increases under worse-case scenarios; slow GDP growth and losses in asset values.
