Wall Street’s Unraveling

Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you've made 10 percent on your $10 investment. (Technically, the price has to exceed $101 slightly to cover interest payments.) If it goes to $110, you've doubled your money. Wow.

Once assembled, these components created a manic machine for gambling. Traders and money managers had huge incentives to do whatever would increase short-term profits. Dubious mortgages were packaged into bonds, sold and traded. Investment houses had huge incentives to increase leverage. While the boom continued, government remained aloof. Congress resisted tougher regulation for Fannie and Freddie and permitted them to run leverage ratios that, by plausible calculations, exceeded 60 to 1.

It wasn't that Wall Street's leaders deceived customers or lenders into taking risks that were known to be hazardous. Instead, they concluded that risks were low or nonexistent. They fooled themselves, because the short-term rewards blinded them to the long-term dangers. Inevitably, these surfaced. Mortgages went bad. The powerful logic of high leverage went into reverse. Losses eroded firms' tiny capital bases, raising doubts about their survival. This year, Lehman lost nearly $8 billion in "principal transactions." Otherwise, it was profitable.

How Wall Street restructures itself is as yet unclear. Companies need more capital. Merrill went to Bank of America because commercial banks have lower leverage (about 10 to 1). It seems likely that many thinly capitalized hedge funds will be forced to reduce leverage. Ditto for "private equity" firms. In time, all this may prove beneficial. Financial firms may take fewer stupid and wasteful risks—at least for a while. Talented and ambitious people may move from finance, where they were attracted by exorbitant pay, into more productive industries.

But the immediate effect may be to damage the rest of the economy. People have already lost their jobs. States and localities, particularly New York City and New Jersey, that depend on Wall Street's profits and payrolls will face further spending cuts. Banks and investment banks may tighten lending standards again and impede any economic recovery. The stock market's swoon may deepen consumers' pessimism, fear and reluctance to spend. There may be more failures of financial firms. It's hard to know, because financial crises resemble wars in one crucial respect: They result from miscalculation.

© 2008