David Warsh's latest economics column delves into the renewed interest being given to economist John Geanakoplos' paper explaining how the real issue that brought down the economy was a misunderstanding of "the leverage cycle." Basically, the argument is that everyone (mainly, the Fed) gets so focused on the interest rates, that they stop focusing on the leverage/collateral involved. It's sort of the central banker equivalent of when the mortgage broker tries to get you to ignore all the real terms in your mortgage and just gets you to focus on how much you'll be paying each month. The argument, then, is that the government could have done much more to prevent the crisis if it had simply paid more attention to the leverage situation, which had obviously grown totally out-of-hand. Basically, the argument says that in a competitive market for credit, leverage will always rise, as some parties take bigger and bigger risks, forcing others to do the same. But then everyone's way overleveraged, and when the music stops, basically everyone's left without a seat. It's an interesting theory -- one that sounds good, though on a first read I'm not entirely convinced. While the issue of how much leverage was out there is obviously a part of the problem, I'm not entirely sure that the government would realistically be able to totally control the issue. While it could put in place certain regulations, it seems like there would always be loopholes that allowed leverage to occur elsewhere. Either way, I'm going to do some more reading on the subject, but wanted to pass it along here to see what others thought of it in the meantime.

One issue that's constantly popping up these days is friction between distributors and content or service providers. Companies on either side of the equation often overvalue their contribution, whether it's movie studios thinking they have the leverage over Netflix, or ISPs thinking they've got the upper hand over the likes of Google when it comes to net neutrality because they "control" the pipe. The content or services are worthless without the distribution; without the content, the distribution is worthless. It's not the case where one side always has the power, and often over time, the balance of power shifts. Such is the case with the news that Vodafone UK has enabled Twitter SMS services for its customers. Twitter irritated some of its international users last year when it stopped sending them SMS updates because of the costs. It's a pretty typical story in mobile: if you have a service you want to offer to users via SMS, you've got to be prepared to pony up the cash to mobile operators to reach "their" customers. When Twitter was a nascent service used by web dorks and media types, somebody like Vodafone wouldn't care about it. But as the service has gone mainstream, suddenly it behooves Vodafone to strike a deal with Twitter, make the costs workable, and be able to offer the service to its customers. The mobile industry has long engaged in these stupid battles over who "owns" the customer. Typically, the operator's take has been that they own the pipe, so they own the customer. But maybe they're finally figuring out that without any compelling services to travel through it, the pipe's not such a big deal.

You know how movies studios keep making the same movie over and over and over again with just slight changes? It seems that the entertainment industry simply has a problem recognizing that doing the same thing repeatedly won't lead to different outcomes. In particular, the entertainment companies continue to think that because they own the content, that they somehow have leverage against the new generation of distributors -- missing out on the fact that it was always the distribution side of things that gave them the leverage, rather than the content itself. That is, they're overvaluing the content and undervaluing the services that make that content useful. That's why the record labels were unable to realize that they handed Apple tremendous power over digital music sales. It's why the record labels still don't seem to realize that they need YouTube more than YouTube needs them.

Now it's the movie studios' turn.

Jeff Nolan points out that the movie studios are apparently pissed off at Netflix, saying that they're trying to renegotiate deals on tougher terms. As Nolan points out, those studios may discover they have a lot less leverage than they think. If a studio pulls its movies from Netflix, those studios may find that it hurts them a lot more than it hurts Netflix, which has increasingly built a dominant position in the movie distribution space. Yet, of course, because these firms overvalue the content, they don't seem to be able to see this coming, despite all the foreshadowing...

Over the weekend, the story made the rounds about Warner Music's dispute with Google over getting money from YouTube videos. As we discussed in our post on the topic, it seemed like Warner had very little leverage here: Google has no legal responsibility to pay anything, and removing the videos from YouTube seemed a lot more likely to harm Warner Music and its artists than Google. As noted by some folks, for many kids these days, YouTube is how they find and listen to music these days. Forcing your songs off YouTube would be like demanding their removal from the radio twenty years ago.

Yet, more details are coming out on this story, and it appears that both Warner Music and Google may recognize Warner Music's precarious position here. In fact, it appears that it wasn't Warner Music that demanded its music be taken down. Instead, reports are coming out saying that Warner instead went to Google with higher monetary demands, and it was Google's response to start pulling the music down, to demonstrate to Warner Music that YouTube is a lot more valuable to Warner Music than Warner Music is to YouTube (a lesson that Warner Music execs desperately need to learn).

Warner Music's response, apparently, has been to try to pretend it has some leverage, supposedly leaking a somewhat questionable story that it, and other major record labels, are preparing to launch a "Hulu for music." However, as Greg Sandoval notes in the News.com link in the paragraph above, this seems like little more than idle speculation by the labels. They had talked about this months ago, and have done nothing since. Instead, it was a bluff by the record labels in a weak attempt to convince Google that it needs to play ball or face competition. Google is likely to call the bluff -- because Google still recognizes what the record labels seem to have trouble recognizing. The power of YouTube isn't in having a site that plays videos, it's in the audience -- and you don't recreate that overnight.

Following my post on the makings of the financial crisis, some folks noted that I didn't really discuss the issues of leverage and derivatives, and how they ended up screwing up Wall Street something fierce -- as, instead, I focused much more simply on the issue of "risk" and sort of swept those details under the rug. I'd been intending to tackle the subject this week, but it looks like Andy Kessler has already done the job for me, with an excellent description of how Wall Street went from helping people trade stocks into a bunch of cowboy hedge fund traders who didn't even realize what they were trading, but knew they were making tons of money -- so they kept borrowing to do more of it. They got suckered by their own dog food and ate until they became seriously overstuffed.

Still, those profits weren't enough. Their customers were making great money buying Wall Street's derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

It was the easy trade. Borrow at 3 percent and make 6 percent or 8 percent or 10 percent. They liked it so much, they levered up. Meaning instead of just borrowing a dollar for every two dollars of assets they owned (which by the way, thanks to the 50-percent margin requirement, is the amount of leverage that you and I are allowed to buy stocks from these same firms), they borrowed 20 to 1, 30 to 1, and even 50 to 1, if they could get away with it. And man, it was a lucrative trade. So why not?

I'll tell you why not. Because all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it's a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company. Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time.

It's a good read. Kessler and I agree that a new sort of Wall Street will come out of this -- and that's for the best. Money will flow again, but there will be new opportunities for banks to get back to basics.

The evolving credit crunch has forced some tech companies to to suspend plans to buyback their stock due to an inability to raise the necessary cash. Either way, you'd think that in light of current conditions, companies would be hesitant to leverage up by expanding their debt levels and removing some shares from the market. But current conditions don't seem to be much of a deterrent to some firms. VeriSign has announced the successful sale of $1.1 billion worth of convertible bonds with the proceeds earmarked for share repurchases. Although the move carries risk, Wall Street analysts tend to love this kind of move. One analyst lauded the announcement, claiming that VeriSign will now have a more "mature capital structure". The thinking is that VeriSign is a large company with slowing growth and so the quickest way to maximize returns is to take on debt and bet on itself. If the company executes well, then the move will look brilliant. But it leaves the company little to no margin for error should things not go exactly as planned.