From foreign policy to theology, I have been bouncing around in my blog. Now I want to get back to my own skills, Finance:

An inverted debt pyramid is a modern concept in finance, not fully realized in most circumstances beyond the text theories with examples only becoming common in the last few years.

Let me start off with some basic ideas:

A person has $50,000 that he wants to invest in an asset that is worth $200,000, so he borrows $150,000 to make up the difference from 1st bank. Simple enough right, so the person has a leverage to equity ratio of 4:1, which is pretty good.

The 1st bank eying the objective of investing in an asset worth $800,000, borrows $600,000 from another bank, which is again a 4:1 ratio. The individual original stake is still 4:1, but the bank has freed up its capital by borrowing against the client's loan to increase its ability to make more money through investing.

Then,the "other bank" wanting to invest in an asset worth $3.2 million, they borrow $2.4 million from yet another bank. Again to this bank, it is only a 4:1 ratio again.

From an original cash equity $50,000, you have helped to create a series of building blocks that build a pyramid of debt and financing for a chain of investments.

So what if the value of the $3.2 million asset decreases to $2 million. In most circumstances, it means nothing as values change day to day, so it might rebound later. However, creditors for the bank may get a little scared on the value of the banks asset, so they make a margin call, demanding equity to reflect 4:1. This means "other bank" must put up another $500,000. The bank cannot come up with the money, so sells the asset at $2 million dollars, pushing prices down by 37.5%.

Anxious to recuperate cash, "other bank" demands the 1st bank add more cash to adjust against its own equity to 4:1 after the value has fallen to $500,000. The adjustment is an additional $300,000. 1st Bank has no choice, except to sell.

A new bank raises interest on the investment loan of the investor to 15% as the market conditions has changed and the investment values has fallen. The Investor is forced to sell his asset at 125,000 to cover the staggering bills. The investor has lost his $50,000 equity and an additional $(25,000).

This vicious cycle has cascaded down a long chain of institutions and groups with total losses equal:

$1.575 million

Not only is equity annihilated, but everyone is carrying a large amount of unsustainable debt as well.

Ironically, this concept proves that "trickle down" does exist in economics, however the realistic application of them is far different in this case than the virtuous cycle of Friedman. Instead I would point that debt applied in such a manner would be vicious and destructive cycle as equity is destroyed on the individual level and more debt is added, people will hire less, economic activity stall, and cash is frozen.

Just some food for thought.....