Leverage Please

The past few weeks have not been kind to the leveraged companies and financial institutions in America. Their meteoric decline has yielded calls from those who were alive in the 50's and 60's when consumer credit was not widely available, to stop the over consumption. True, some people may have over consumed; however, this should not be confused with leverage.

Companies too apply leverage through borrowing, and often end up with debt levels which are many times their capital. The reason companies apply leverage in the first place is in attempt to raise their return on their own equity. The reason this leverage is productive and beneficial to the greater society is that these companies are really using leverage to capitalize on their competitive advantage. With leverage, a company can find what it does better than anyone else and exponentially multiply their returns. This is good, because this causes capital to be allocated in a more efficient manner, forcing companies to focus on their core competencies.

Politicians who are calling for the deleveraging of America should take a step back and think about what they are really saying. To me they are telling us that they want companies that have become experts in their industries to only produce at 20% capacity (reduction from 25 times leveraged to 5 times). If American companies are to compete globally, they better be able to bet the farm when the deck is stacked in their favor.

Why the Bail Out Won't Work

The final Bail Out bill passed by congress last week includes a key provision that should prevent any significant participation from the Banks who needed it. Section 113 of the plan requires that the Treasury receive non-voting warrants from participating financial institutions. A warrant is a contract to receive a company's shares at a set price some time in the future. If significant warrants are outstanding on an institution, investors will avoid allocating capital to these organizations for fear their ownership will be diluted once the warrants are exercised. Why would we want the government to own these banks anyway, haven't we spent the last 30 years trying to denationalize our economy?

Told you so

No one likes an "I told you so", and for the past two weeks we've got to hear it from the European bankers. We had to hear about how their superior regulation and central control led to their advantageous position going into the credit crisis. Today, it was revealed that they have leverage ratio's similar to the Wall Street investment banks, and in excess of the American commercial banks. If their central banks don't act with prompt and pervasive action, they'll be joining the ranks of Lehman and WaMu. You really have to hate it, but now is the time to grab the finger pointing "I told you so'ers" and turn their hand back around and jab them in the eye. Good luck to the heavy handed regulators and socialized governments in finding resilience in their institutions, they're going to need it.

Fourth Ghost of Christmas Past

In last night’s debate, Sarah Palin was demonizing Wall Street for their corruption and greed. Wall Street investment banks have no doubt had some involvement in the current financial situation we are in today, but probably stop short of corruption and what does greed have to do with anything anyway?

I’m not really sure what greed is, although many people give it the negative connotation associated with A Christmas Carol and Ebenezer Scrooge. In the play, Scrooge hordes all of his profits and resources, seemingly to the detriment of his workers and acquaintances. Unfortunately the fourth ghost of Christmas past never visited Scrooge to tell him what a good deed he was doing these people. By accumulating these resources and allocating them in a very efficient manner, he was likely able to provide opportunities to more people in his town that may not have been available otherwise.

What did Wall Street do that was so greedy? They came up with innovative ways to carve mortgage securities into different tranches with similar risk profiles and apply leverage so investors could efficiently and effectively allocate capital to this market. The result of their so called greed was that the mortgage backed securities market grew from nearly nothing in the late 1970’s to a $10 trillion dollar market today. As a result home ownership reached record levels.

Who was greedy? Politicians were greedy in that they continually applied pressure to Fannie & Freddie to continually expand this market which resulted in lending to unqualified buyers. These politicians were simply telling Scrooge to give away the farm in hopes it would be returned in pristine condition 30 years later. It’s not the markets failing that caused this; it’s the government’s intervention in the markets that has led us to where we are today.