Leverage Is the Culprit

04/14/2008 12:00 am EST

Focus: MARKETS

Gary Shilling

Columnist, Forbes

A. Gary Shilling, president of Gary Shilling’s Insight, says the current financial crisis was driven by leverage, and its unwinding will have all kinds of consequences.

With the demise of Bear Stearns on March 16th, few can deny that the deleveraging of the global financial structure is underway. Bear was sunk by a tidal wave of overleveraged positions in illiquid securities of questionable value.

Banks and brokers always use borrowed money to enhance the earning power of their capital, but recently leverage has jumped to immense proportions. As measured by the ratio of assets to stockholder equity, Bear Stearns has a ratio of 32.8-to-1; Lehman Brothers, another firm recently under fire, had 30.7-to-1, while Merrill Lynch had 27.8-to-1 and the best of the lot, Goldman Sachs, was a mere 26.2-to-1.

The combined leverage ratio of the top five US brokerage houses leaped from 21 at the end of 2003 to 30 at the end of fiscal 2007.

[During that time,] half the earnings advance of securities firms came from increased leverage. Not surprising, the financial sector's market capitalization made up 22.3% of the Standard & Poor’s 500 at the end of 2006, up from 13% at the end of 1995. From 1996 through 2006, financial stocks rose 16% per year on average while the S&P 500 gained 11.4%.

As massive leverage disappears, the big profits of large banks and securities firms will evaporate as they return to less attractive traditional businesses, to say nothing of the huge losses they will continue to incur. Obviously, this prospect is part of the reason that banks are trading at 1.2x book value and diversified financial firms at 1.4x, the lowest levels since 1991.

The financial sector's explosion, which accounted for much of the stock market's rise from its October 2002 low to its October 2007 peak, will be missing, even reversed, in the years ahead.

The leverage that is disappearing rapidly was, of course, not confined to Wall Street. Consumers leveraged themselves to the hilt with low down-payment mortgages and by sucking out their home equity through home-equity loans and cash-out refinancings. That will leave the average homeowner who has any mortgage at all with no home equity if our 25% peak-to-trough fall in median existing single-family house prices nationwide is valid.

Many American consumers have also maxed out their credit cards and aren’t able to make the minimum monthly payments. Some desperate souls are borrowing from their 401(k)s even though few have saved enough to provide for retirement. Household net worth and homeowner equity, both in relation to after-tax (disposable) income, are on the way down. The next step is a replacement of the 25-year spending orgy by a saving spree, and a reversal of the equally long borrowing binge.

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