Leverage

This article in the Economist illustrates how leverage is complicating adjustment. Financial institutions are highly leveraged. As their equity falls liquidity falls much faster.

Even if markets can be stabilised this week, the pain is far from over—and could yet spread. Worldwide credit-related losses by financial institutions now top $500 billion, of which only $350 billion of equity has been replenished. This $150 billion gap, leveraged 14.5 times (the average gearing for the industry), translates to a $2 trillion reduction in liquidity. Hence the severe shortage of credit and predictions of worse to come.

Leverage bolsters profits on the way up. It is dangerous to forget that what goes up can come down. Galbraith's book "The Great Crash" has a great discussion of what happens when leverage applies in reverse.