The Financial Industry Mess

Steve Verdon breaks out a good Star Trek reference with "Its dead Jim," but the pointshe makes are solid. Riffing off this essay by Robert Samuelson, Verdon writes:

Then there is leverage–i.e. borrowing money to invest in securities. Really more of a sophisticated form of betting.

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.

Wow indeed. Lehman could have made a huge killing if the market hadn’t turned against them. Of course, that huge killing would likely induce them to gamble again. And again, and again, and again until finally the party went sour.

That is what we are really talking about here, incentives, risk and reward/consequences.

So here is a scenario of the three big financial stories of the past week, Lehman Brothers, Merrill Lynch and AIG, and of Fannie Mae/Freddie Mac, which entity will learn its lesson best?

Put your money on Merrill Lynch, why? Because it doesn't exist as its own entity any more. Sure, Bank of America will probably keep the name around (maybe), but you can be sure that Bank of America will a) keep a tight lease on their leveraging and b) make sure that profits Merrill makes in the future are distributed to Bank of America stockholders, not Merrill stockholders and traders. In short, the market forced the demise of all of htese entities, but only Merrill Lynch has not been sheilded from its failures.

You could argue that Lehman Brothers will learn a lesson, but that is not exactly a sure thing. Bankruptcy, which is not a bad word by the way, can sometimes cause a company to rethink its strategy, but unless more analytical heads prevail at Lehman, the blame will be affixed to the market breakdowns rather than a failing in the business judgment of Lehman's leadership.

Certainly AIG and Fannie Mae/Freddie Mac are going to learn anything in my opinion other than to run to Uncle Sam when the excretment hits the wind producing machine.

Reminds me somewhat of the internet/tech bubble in the 1990’s. People had this wacky notion of the “New Economy”. They had all sorts of goofy ideas such as it higher growth rates were now possible. Negative growth wasn’t really possible. It wasn’t the number of people at work that mattered, but the number of processors. Of course, that all came to an end.

How Wall Street restructures itself is as yet unclear. Companies need more capital. Merrill went to Bank of America because commercial banks have lower leverage (about 10 to 1). It seems likely that many thinly capitalized hedge funds will be forced to reduce leverage. Ditto for “private equity” firms. In time, all this may prove beneficial. Financial firms may take fewer stupid and wasteful risks — at least for a while. Talented and ambitious people may move from finance, where they were attracted by exorbitant pay, into more productive industries.

And there in lies the danger of bailing these firms out. The people who made these mistakes are then insulated from their mistakes. There is no or reduced downside. Being stupid is not longer horrible, just unpleasant and maybe a tad embarassing.

And therein lies the problem. The federal government determined that Fannie/Freddie/AIG were "too big to fail" or occupied too important a position in the economy to be allowed to fail. But I don't really think that is the case. They should be allowed to fail since by preventing their failure, these companies have not been subjected to the brutality and mistake correcting influences of the market place.

The market place is not a neat and tidy place, but it is a wonderful teacher of lessons, and the most important of lessons are usually the most brutal. But if the lesson is not taught, it can't be learned and if the lesson can't be learned, you can bet that it will be repeated and it will surely be worse next time.