How leverage poked holes in Alan Greenspan’s theory

By Malcolm Berko

Published: November 16, 2008

Dear Mr. Berko: Can you explain how the big Wall Street firms used leverage, why they used it, and why it was believed to be so profitable? Please explain it in simple English so I can understand. And can you explain how these firms like Merrill Lynch, Lehman Bros. and Bear Stearns got beaten up so badly when the mortgage bonds they owned fell in market value? I know why you call Alan Greenspan "The Mumbler,” but why do other pundits call him "Easy Al?” My investment club would really appreciate your thoughts.

D.T.: Durham, N.C.

Dear D.T.: Assume that you decide to increase your income and purchase $10,000 market value of the 11 percent Bagel Bakery Bonds trading at $1,000 per bond. If you write a check to your broker for $10,000, you will get an interest check every 6-months for $550, and in 12 months you will earn $1,100. That’s a nice return.

But you can buy these bonds in a margin account and use "leverage” just like the big boys. You would give your broker a check for 33 percent of that purchase, or $3,333. Because you invested only $3,333 and because the bonds cost $10,000 you will owe your broker $6,777, called a debit balance, on which he might charge you 6 percent interest, or maybe 3 percent if you’re a good customer.

Getting a return

Well, in one year you will have $1,100 in interest from the Bagel bonds and you will pay your broker 6 percent of $6,777 in interest, or $407, on your debit balance. The difference between the interest you earned of $1,100 and the interest you paid to your broker — $1,000 minus $407 — is $693. Because you invested $3,333 and netted $693 in interest, you would have a current return of 20.8 percent.

Get it? Got it? Good! That’s how civilians like you and me can use leverage.

Different rules

However, Merrill Lynch, Bear Stearns, Goldman Sachs, Lehman Brothers, and BankAmerica are permitted by the Federal Reserve Board and the New York Stock Exchange to run their investment business under a vastly different set of rules. If they buy $10,000 face value of the 11 percent Bagel Bonds, they only have to invest $300, 3 percent, to leverage that $10,000 investment and earn $1,100 in interest. And because those firms are very privileged by the FED and NYSE, they only pay 2 percent on their debit balance.

Owning the world

So when Goldman Sachs buys those bonds with $300 of capital, they receive $1,100 in Bagel interest during the next 12 months and pay only 2 percent of $9,700, or $194, in interest. So $1,100 minus $194 interest costs earns Goldman Sachs $903, which is a 301 percent return on their $300 investment. Pretty nifty! That’s called leverage for the privileged!

Archimedes once said to King Hiero of Syracuse: "Give me enough leverage, a place to stand and I can lift the world.” But these brokerages didn’t want to lift the world — they wanted to own it.

Things go wrong

Well nifty it may be, but only if those Bagel bonds maintain their market value or increase in price. If the Bagel business gets stale and people stop buying Bagels, the market value of Bagle stock and Bagel bonds will decline. So if the 11 percent Bagel bond falls in price from $1,000 to $850 per bond, Goldman has a $1,500 loss in market value. Goldman’s $300 investment is wiped out and the remaining loss ($1,500 less $300), $1,200 must be deducted from the capital account of Goldman.

Now, a $1,200 loss in capital is just a grain of sand to Goldman Sachs, but multiply that number by 10 million and the loss to Goldman’s capital becomes $12 billion. And that’s most of the sand on most of the beaches in the state of Florida. And when Lehman Bros., Merrill Lynch, Bear Stearns, BankAmerica, etc. are factored into the equation, there are few sandy beaches left in the nation.

‘Mumbler’ mistakes

This was one of the egregious mistakes that former Federal Reserve Board Chairman Alan "The Mumbler” Greenspan failed to recognize. (He also failed to recognize a housing bubble in mid-2006.) The Fed is the ultimate arbiter of those rates and several of The Mumbler’s colleagues in the Fed cautioned him of this potential danger. But because The Mumbler enjoyed close relationships with most of the big shots on Wall Street, he ignored the warnings of his colleagues.

Greenspan liked the concept of easy money, which is why he was sarcastically called "Easy Al” by his then silent detractors. The Mumbler was an optimist while some other Fed members were pessimists. Which reminds me: "The difference between the optimist and the pessimist is droll. The optimist sees the bagel but the pessimist sees the hole.”

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, FL 33429 or e-mail him at malber@comcast.net.

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