What caused the current financial crisis? Clearly, the housing bubble and the resulting drop in home values, which made mortgages loose value. But, was the $700 billion bailout necessary if financial firms would have been managed properly? The answer is no. What happened was that as the Fed made lots of money available, at a very low cost over the last few years. This encouraged firms to borrow too much, and the result was the current mess. Let me explain.
In finance, using other people’s money to make money is what it’s all about. The basic principle is simple: borrow from someone, say at 3%, and re-invest that money at 7% and you just made yourself a 4% profit. Borrow one million dollars this way and invest it as indicated and you have made yourself $40,000. Borrow ten million and you make $400,000 and so on.
The problem is that financial guys like to make lots and lots of money and they tend to be risk takers. In their world, it is not enough to borrow $1,000,000 and lend that same amount to someone to make a cool 4%. They want to make much, much more than that. How do they do it? They use the principle of leverage, which is using other people’s money to magnify one’s rates of return. Let me illustrate this principle by giving you an example of how a hypothetical bank uses leverage. Then I will show you how Bank of America, Goldman Sachs and Merrill Lynch used leverage to make money—and to get in deep trouble.
Let’s start with a new bank, the Ulivi’s Bank. I and a group of partners invest $10 to get it capitalized and we find other people that deposit $100 in our bank. We pay them 2%; we then turn around and lend that same money out in mortgages at 6%. Our profit is a cool 4%, or the difference between what we paid out and what we received in income. Did we really earn 4%? Not really, the owners of the bank make a lot more than the mere 4%. Remember that we only contributed $10 as our capital to get the bank running. This means that we made a rate of return of 40%, which is the $4 profit divided by our initial $10 investment. This is the beauty of using other people’s money to leverage your own capital to increase your returns. You see, leverage allowed us to magnify our rate of return.
What’s the risk of doing this? Just like leverage magnifies rates of return, it also magnifies losses. Let’s assume that instead of making a $4 profit, as we illustrated in the Ulivi Bank case, we actually had a $4 loss (i.e., we made some bad mortgages). This means that bank lost 4% but we, the investors, lost 40% of our capital (that is, we lost $4 of the initial $10 we put of our own money into the bank). Therefore, a 4% loss to the Ulivi Bank turned into a 40% loss to its owners. That’s the risk of leveraging when things turn to against you, like in today’s crisis.
What would you rather make, 4% or 40%? The risk-avoiders will settle for the 4%; the risk seekers would be willing to use other people’s money to magnify returns. Let’s review some risk takers. Banks are allowed to leverage themselves 10 times. So, a bank would transform a 4% profit into a 40% rate of return for its owners. Brokerage firms are allowed to use even more leverage in the pursuit of greater profits. Let me illustrate this point with actual numbers.
Bank of America, as of June 2008, had assets of $1.7 trillion and a net worth of $162 billion. That is, they were leveraging their capital by a ratio of 10.5 times. Goldman Sachs, on the other hand, had assets of $1.088 on the same date, but only $44 billion of equity. They were leveraging themselves by a ratio of 24.7. Merrill Lynch had assets of $966 billion but equity of $21 billion. They were leveraging themselves by a ratio of 46 times.
How would losses affect these firms? Suppose each lost 3% of their assets to bad mortgages. Bank of America would have lost $51 billion or 31% of their net worth. Goldman would have lost $33 billion or 75% of their net worth. Merrill Lynch would have lost $29 billion. This is more than their entire net worth; they would be bankrupt (no wonder Bank of America bought them for nothing down—in an all stock transaction).
Excessive leverage in bad times caused many firms to go bankrupt in 2008. Why did these firms take on excessive risk? What was their incentive to act so recklessly? The answer is simple: executive compensation tied to the short term performance of the company’s stock. Let me explain: most key executives get a reasonable salary; but they also get the right to buy huge amounts of stock in their company’s for nothing down. These are the stock options. Let’s illustrate with an example using Merrill Lynch. Suppose they hired me as their president and they gave me a regular salary plus options to buy 10 million shares at the current market price of, let’s say $80. What does this mean to me? For every dollar I get stock price to increase, I make $10 million dollars.
How can I get the stock price to increase rapidly? Leverage is the answer. Suppose when I was hired Merrill Lynch had a leverage ratio similar to Goldman Sachs of 24.7 Increasing my leverage to a ratio of 46 would allow me to borrow lots of money quickly. I would pay, say 5% to borrow that money, and invest it immediately in mortgages paying 8%. I make a cool 3% but since my leverage ratio is 46, my earning would increase by increase dramatically and so would Merrill’s stock price. I would quickly sell my stock options and cash in perhaps tens or hundreds of million of dollars.
In using this example, am I exaggerating to make a point? No. To back me up, I will quote an article that appeared in Bloomberg.com on 9/26. It reads “Wall Street’s five biggest firms paid more than $3 billion in the last five years to their top executives, while they presided over the packaging and sale of loans that helped bring down the investment banking system.
Merrill Lynch . . . paid its chief executive the most, with Stanley O’Neal taking in $172 million from 2003 to 2007 and John Thain $86 million after a month’s work last year.”
In sum, the current crisis has occurred because of the excessive use of leverage at a time when companies suffered un-anticipated losses. The excessive leverage was used because the incentive system rewarded short term stock price appreciation rather than long term prudent management of the firms.
What’s the lesson here? I recommend you always look for quality of assets in a balance sheet; look for sustainable profits in the income statements, and the use of moderate leverage. By the way, do you know how much leverage Bill Gates’ Microsoft has? None, as in zero.