24 September 2008

How to build a Financial House of Cards

Stephen Foley of The Independent suggests this is what happened:
In the NZ herald it was titled Banking Collapse: A Dummies' Guide

You've got £1. Invest it wisely, you might end up with £2. If you had £1 and borrowed another £1, then invested them both, you would end up with £4. Even when you've paid back the £1, you have made double the profit. That's leverage.

Now, say for the sake of argument you've got $30bn of cash and other assets. You use those to persuade others to lend you $1 trillion. You make multibillion-dollar profits for years, pay huge bonuses and recycle all the money into new loans to businesses, to home buyers and to small investors. That's leverage, Wall Street-style.

But imagine you invested your money unwisely. What if your £2 investment ended up halving in value? You have just £1 left, and that has to be paid back to your lender. You would be wiped out.

Multiply that to Wall Street proportions, and you've got the credit crisis. If that sounds too simple, it is maths that was derided for years by the bankers who faced their day of reckoning yesterday. They had complex models to prove that all their investments, all used as collateral for each other, could not halve. Their models didn't predict the US housing crash.

Why were they allowed to borrow 30 times the value of their assets? Because they borrowed from each other. Because they believed they had invented clever ways of reducing the risk of leverage. Because they were greedy. And because nobody stopped them.

Independent Tuesday, 16 September 2008

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