Lessons from an old bull market
Banks borrowed heavily to make lucrative investments during good times. Since then, losses from the subprime mortgage meltdown have eroded their cash cushions. Amy Scott reports banks are being taught a lesson learned from last century.
Money in bunches (TENGKU BAHAR/AFP/Getty Images)
More on Wall Street
TEXT OF STORY
Renita Jablonski: Citigroup raised $4.5 billion on the stock market yesterday. Analysts say it'll have to raise several billion more. Like many investment banks, Citi borrowed heavily to make lucrative investments during the good times. But losses from the subprime mortgage meltdown eroded Citi's cash cushion. As Marketplace's Amy Scott reports, the banks are being taught a lesson many investors learned early in the last century.
Amy Scott: In the great bull market of the 1920s, investors got giddy on leverage. You could buy $1,000 worth of stock with just a hundred of your own money. You borrowed the rest using the stock as collateral.
Richard Sylla: If it went to $1,100, you actually doubled your own money, because your own equity increased from $100 to $200.
That's financial historian Richard Sylla. He says the downside is a small drop in the share price could wipe investors out. And the crash of 1929 brought the party abruptly to a halt.
Sylla: When the market crashed, they had basically lost all of their money. And the government said people should not borrow so much money to buy stock because they might lose it all. And that came in with the New Deal financial reforms.
Today, if I wanted to buy $1,000 in stock, I'd need $500 of my own. But financial institutions are allowed to gamble with a lot more borrowed money than you or I. During the latest boom, they ratcheted up the leverage. By early this year, big brokerage firms like Bear Stearns were borrowing more than $30 for every $1 of their own money. That was fine while the assets in Bear's portfolio traded up. But when prices started falling, Bear's investors and creditors demanded their cash back and the firm couldn't pay. Bill Gross is managing director of the investment company Pimco.
Bill Gross: It's like having a few beers. On the way up, the intoxication feels real good. On the way down in terms of a hangover, not so good.
Now banks and brokerage firms are trying to dry out. They're taking steps to bring their leverage back down to earth. Anil Kashyap teaches finance at the University of Chicago business school. He says one way to reduce leverage is to raise capital.
Citigroup, Lehman Brothers, Merrill Lynch, and Morgan Stanley have all raised some cash in recent months. Kashyap says the alternative is for banks to shrink their businesses by selling assets like loans and mortgage-backed securities. And taking on less risk.
Anil Kashyap: You could have a really big reduction in loan availability. And that's gonna mean that some people that, you know, essentially are innocent bystanders are gonna find that they're not gonna able to get credit for a while.
And that, Kashyap says, could tip the economy into recession.
In New York, I'm Amy Scott for Marketplace.
