Friday, September 19, 2008

More capital market stuff

There is a really interesting bit of information in this article.

For the last 30 years, the SEC has required that broker-dealers (i.e. investment banks like Lehman) have a debt-to-net-capital ratio of 12 to 1. That is, they can borrow $12 for every $1 they have in equity. So someone like Lehman, with $100 in equity, would have $1300 in money to invest ($1200 debt + $100 equity). They could use that $1300 to take bets that mortgages would not collapse. If they did lose those bets, then they'd have to come up with the $1200 to pay back their creditors. A bad situation.

However bad this financial mess would have been, it is actually far worse because the SEC gave an exemption to five firms in 2004. They allowed these five firms to have debt to net capital ratios of 30 or 40 to 1. So now they have $4100 in money to make bets with, and when those bets go bad, they owe $4000 to creditors. It's a lot harder to come up with $4000 than $1200. The financial system goes down a lot harder when $4000 suddenly disappears than when $1200 disappears.

The five firms that were granted the exemption? Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley. Bear Stearns? Collapsed and purchsed by Lynch. Lehman? Bankrupt. Merrill Lynch? Getting bought out by Bank of America. Morgan Stanley? Looking desperately for someone to buy them and pay off their debts. We haven't necessarily heard terrible news about Goldman yet, but it is hard to believe they aren't in a similar boat.

In something as complex as the financial system, it would be a mistake to try to identify a single cause of the current crisis. But this certainly has to be a big part of the explanation.

No comments: