Sunday, October 5, 2008

They were mine before

I gave her one, they gave him two,
You gave us three or more;
They all returned from him to you,
Though they were mine before.
--Lewis Carroll, Alice in Wonderland

That's how I felt when I read today's top news. JP Morgan held $17 billion in cash for Lehman, billions that might have kept the company afloat had JP Morgan not "frozen" the funds. But Lehman owed JP Morgan $23 billion, while JP Morgan held $188 billion in liquid assets for Lehman, until Lehman's filed for bankruptcy with a debt of $618 billion. And that's why taxpayers have to pay $700 billion just to clear away the debris (no one thinks the investment will rebuild the castle). It's enough to make your head spin off.

The amazing thing about all this is the leveraging. These companies were leveraged 30 to 1--meaning for every dollar they invested they borrowed 30. When values rose, they made out like bandits. When values dropped, like underwater homeowners, they had to scramble and hope the banks didn't call in the loans. For a pretty good description of leveraging, check out Andy's post over at Shine on Yahoo. And for a detailed description of the effect of leveraging on the current Wall Street crisis, this from Martin Hutchinson's September 15th column on The Bear's Lair:

Investment banks traditionally had a leverage limit (total assets to shareholders’ equity) of about 20 to 1. That limit was fudged to a certain extent with subordinated debt, but fudging was limited by investors’ unwillingness to buy subordinated debt of such intrinsically unstable institutions. However, while investment bank assets traditionally consisted of commercial paper, bonds and shares that trade every day and can be valued properly, they have now come to include investment real estate, private equity stakes, hedge fund positions, credit default swaps and other derivatives positions that do not even appear on the balance sheet. Thus even 20 to 1 in modern market conditions is excessive.

Adding in subordinated debt, and claiming that say Lehman has an “11% capital ratio” works fine in bull markets, but not when things get tough. Scaling that 20 to 1 up to 30 to 1, as Lehman had at its November 2007 year-end, is asking for trouble. Even if the off-balance sheet credit default swaps and other derivatives don’t lead to problems, and there are no assets parked in “vehicles” that have to be suddenly taken back on balance sheet, an institution that is 30 to 1 levered needs to see a decline of only 3.3% in the value of its assets before its capital is wiped out. Such a decline can happen frighteningly quickly – it represents only a 10% decline in the value of a third of the assets. ...

The commercial banks are not as leveraged. At the latest quarter-end, Citigroup was the most leveraged at 15.4 times, JP Morgan Chase 13.3 times, Wells Fargo 12.4 times, Wachovia 10.8 times and Bank of America 10.5 times. That more modest leverage is the advantage of proper regulation. Even Fannie Mae and Freddie Mac, who benefited from a quasi-state guarantee and were dubiously regulated since they held a stick over their regulator in the form of the Congressional Democrat power structure, had leverage ratios of only 21.5 times and 29.4 times respectively.

There's plenty of people smarter than me talking about exactly what those assets were that companies bought with all that leverage. Mat Miller over at has posted a sad and hilarious chart showing how $600 billion in subprime mortgages metastasized into trillions in failed assets--packaging, repackaging, sale, resale, and adding debt every step of the way.

The rationale for such complexities is credit-risk transfer. The realities: securities and leverage so much bigger, more complicated and detached from actual assets that value itself became an abstraction. Writes Mizen: "Investors are far removed from the underlying assets both physically (due to the global market for these assets) and financially (since they often have little idea about the true quality and structure of the underlying assets several links back in the chain)."

Where do we go from here? Well, reduced leveraging sounds good to me, accompanied by requirements that keep loans and their risks closer to home, and an end to the "off balance sheet" assets that hide both the extent of the leveraging and the value of the assets purchased with all that borrowed cash. There are some lessons we once learned when we first purchased a home that Wall Street would do well to re-learn.

  • If I have to make a higher up front investment in the asset (less leverage) then I am going to be motivated to make a more careful evaluation of its value.
  • If the value of my asset is updated annually and publicly posted (in my town, appraisal data is readily available online) then I can keep track of the value of not only my own investment but also all similar investments (the houses around me).
  • If I dispute the appraised value of my asset (say because it will cause my taxes to go up), then I can bring evidence to a government arbitor to establish the value that I think my asset has.
  • And when values are falling, I can decide early that I want to bail, or more likely I can decide to simply hold onto my asset until times are better. I can do that because I am not highly leveraged (or "under water"), so the bank isn't going to be coming for my house.

This was not the first real estate bust, and it won't be the last. Rather than again following the same Wall Street geniuses who increased leveraging to unsustainable levels and brought us off-balance-sheet derivatives like the credit default swap, we need to return to some first principles--transparency, responsibility, and reasonable limits on the amount of debt anyone should assume. And we've now realized, far too late, that companies won't take responsibility for their actions or choose the path of long term stability over short term gain on their own. We're going to need regulation for that.

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