Journal morgan_greywolf's Journal: The investment banking crisis for geeks 1
Those of you with little business knowledge and reading lots of confusingly-written news articles might be confused by what caused the whole investment banking collapse, with financial legends such Lehman Brothers and Merryll Lynch tanking. So here it is in a nutshell, explained in geek language by a geek for geeks.
Newsweek finance columnist Robert Samuelson, in his latest article, (RTFA. Really. You'll enjoy it.
Finally, investment banks rely heavily on borrowed money, called "leverage" in financial lingo. Lehman was typical. In late 2007, it held almost $700 billion in stocks, bonds and other securities. Meanwhile, its shareholders' investment (equity) was about $23 billion. All the rest was supported by borrowings. The "leverage ratio" was 30 to 1.
Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you've made 10 percent on your $10 investment. (Technically, the price has to exceed $101 slightly to cover interest payments.) If it goes to $110, you've doubled your money. Wow.
Note, however, the part that he leaves to the imagination of the reader: what happens if that stock tanks and drops to $90? Heh. Well, they still have to pay back the $90 they borrowed, plus they lost the $10. And if it really tanks bad and drops to $80, they lost $20 for a 200% loss. The risk cuts both ways.
Well, that doesn't seem so bad, though, right? It can't be that all these stocks, bonds and other securities can all go down at the same time, right? Right. Except that the same investment banks made a string of bad purchases. Again, Samuelson puts it this way:
Dubious mortgages were packaged into bonds, sold and traded. Investment houses had huge incentives to increase leverage. While the boom continued, government remained aloof. Congress resisted tougher regulation for Fannie and Freddie and permitted them to run leverage ratios that, by plausible calculations, exceeded 60 to 1.
Now wait a minute. What allowed all of this to happen?
Samuelson hints at it:
Merrill and other retail brokers, which once served individual clients, have ventured into investment banking. So have some commercial banks that were barred from doing so until the repeal in 1999 of the Glass-Steagall Act of 1933.
So, wait a minute. You mean all of this was caused by deregulation of the financial markets? You betcha! As David Lightman put it yesterday in that article I just linked:
In 1999, President Clinton signed the Financial Services Modernization Act, which tore down Glass-Steagall's reforms by removing the walls separating banks, securities firms and insurers.(emphasis added)
Isn't this kind of financial deregulation exactly what caused the Great Depression? Yeah. You should really ask Slashdot reader mcgrew about that, because he seems to know all about it.
Do the math. We're headed for a financial collapse of epic proportions. Pay no attention to the musings of McCain and Palin or Obama and Biden. They're just trying to get elected. Keep reading the articles by guys like Samuelson and mcgrew. These guys know what they're talking about.
Nice (Score:1)