Thursday, July 23, 2009

John Mauldin on Globalization and Leverage

From John Mauldin (July 17, 2009):

Globalization is a two-edged sword. On balance, it has brought prosperity to those who have embraced it, with rising lifestyles, better health, longer lives, and more. The more we need each other, the less likely it is that we'll shoot each other. Shooting your customers is not a good business strategy. And while the growth has not been even or smooth, only a Luddite would want to return to the early 1800s or 1900s, or even 1975.

The other edge of that sword? We are connected in so very many ways, far more than most of the world suspected. Who thought that insane lending policies at US mortgage banks would bring the world financial system to its knees, increasing unemployment and leading to a global recession?

I love the statement that killing your customers isn't a good business strategy. Mr. Mauldin also comments on leverage--and it's becoming fairly easy to see that leverage is what killed the golden goose:

In the first few years of the G.W. Bush administration, the banking authorities decided it would be OK to allow five banks to increase their leverage from 12:1 up to 30:1. Which five banks, you ask? Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs. How did that work out, just five years later? Three are gone and two survived with large dollops of taxpayer money...Thirty times leverage means that if you lose 3.3%, you wipe out all your capital.

Some stocks fluctuate 3.3% in just one day. Even when I was leveraged just two to one times, I had difficulty sleeping. How did these investment bankers do it? How could they have been so irresponsible, gambling on non-tangible investments? Regular banks are highly leveraged, too, but they usually invest in tangible items like houses.

All this makes me yearn for the good old days--when banks were simple creatures, loaning money at an interest rate higher than their deposit interest rate. Wall Street's unconscionable leverage is exactly why more Americans should look to credit unions for their banking needs.

Note: Barry Ritholtz mentioned the same issue--leverage--in his book, Bailout Nation:

Thus we learn that the tragic financial events of 2008 and 2009 are not an unfortunate accident. Rather, they are the results of a conscious SEC decision to allow these firms to legally violate net capital rules that had existed for decades, limiting broker-dealers' debt-to-net-capital ratio to 12-to-1. You couldn't make this stuff up if you tried. (page 144)

[Update on December 2017: Turns out Ritholtz was wrong. More here:]
If Congress wants to help mitigate the next financial bubble, it needs to pass laws restricting leverage. So far, I haven't seen any proposed bills that attempt to resolve systemic risk in the financial markets. That's a crying shame.

Required blurb: John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:

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