BACK in the days when leadership existed, Franklin Delano Roosevelt got on the radio and announced that the government would stand behind any bank savings deposit up to $10,000. It was a complete surprise to everyone including Congress, but it stopped the run on the banks, and blind-sided legislators got on board the next day to create and pass a bill without delay.
This time around, we have an economic condition set in motion by an unfettered (unregulated) greater fools theory that captured the imagination of our financial system's self-styled masters of the universe. To understand in simple terms what has happened, we can picture the horse racing industry where breeders and owners of horses invest money and hope to get some back if their horse wins or has some value for breeding purposes.
An acquaintance of mine back East sold a winning horse to a Saudi for $125 million which covered a lifetime of horse-breeding losses. Extreme perhaps, but at least this was real money based on a real product.
Beyond the horse owners, however, are millions of people betting on horses all across the country who are part of a zero-sum game. The amount of money they have "invested" in the outcome of a race dwarfs what the horse owners have committed. These people betting on horses are essentially investing in what we could call a "derivative" of the actual horseracing business. If a bettor wins, they don't get a horse; just some loser's money minus the racetrack's or bookmaker's cut.
In the financial world, derivatives of underlying assets have proliferated to the extent that they now amount to $70 trillion world wide according to some estimates. These complex instruments (including bets on betting) are what the financial services industry created and sold to generate more commissions and fees. There is no "horse" of underlying value.
The problem was exacerbated four years ago when the SEC allowed investment banks to bump their leverage from a maximum of 15 to 1 up to 30 to 1. Unbeknownst to most of us small investors, our brokerage firms can actually use our stocks and bonds as collateral and borrow as much as 15 times their value. This is why there is something called SIPC, the Securities investors Protection Corporation that protects our assets and gets our money back (only up to $500,000) if a brokerage firm who has used our stocks to support their loans then goes bankrupt.
Borrowing thirty times their capital meant that for roughly 3 dollars of their own money a brokerage holding company had invested, they could borrow about ninety-seven dollars. If what was then $100 went up by three dollars (a 3 percent increase), they doubled their money. In fact, this leverage allowed them to make staggering amounts of money over the past four years, a great return on what they spent in lobbying fees to get that leverage limit raised. Lehman, now bankrupt, jumped immediately from what was 12 times to 29 times their equity. We know what happened next. When the dollar's worth of investments dropped in value to 97 cents, their three cents of equity was wiped out.
So, when we combine derivatives that no one can effectively value with the fact that 97 cents of every investment may be done with borrowed money, you have the volatile mix we are confronted with today, a mix of loans and investments that Warren Buffet about six years ago described as "weapons of mass destruction."
Sweden had this problem back in the early 90's and they solved it by insisting on gaining (for taxpayers) major shares of the banks they bailed out. Interestingly enough, some banks that saw that handwriting on the wall, and that didn't want to be taken over, found miraculous ways to save themselves without the government bailout. If we belly up to the bar to the tune of $700 billion, I would like the reassurance that we own warrants or options on shares for twice to three times our bailout funds. Why? Because without us taxpayers, the stockholders of those banks will have been left with nothing. They should be happy considering that ten percent of something that will be worth more than a hundred percent of nothing. Us picking up bad debt without a big chunk of ownership just doesn't pass my smell test. Let's see if our legislators agree.