Friday, February 26, 2010

Leverage and Investment Banks

Before 2008, Dick Fuld was the ruler of Lehman Brothers. By Andrew Ross Sorkin's account in Too Big to Fail, Fuld and his team were able to plot empire--various mergers and acquisitions-- expanding their sphere of control across the globe. All the while Fuld was earning a huge salary, moving from being very rich to super rich.

And then, it all fell apart for Dick Fuld. By October 2008, this mover and shaker in the world of business and finance had been pushed aside. Again, according to Sorkin, he was left powerless. Depressed and faced with a life of quiet retirement, forced to live a life of mere super affluence.

What happened to poor Dick Fuld? Lehman Brothers made bad investments. Lehman Brothers lost money.

But why isn't Fuld still at the helm? Why aren't he and his team working to turn Lehman Brothers around?

The problem is that Lehman Brothers was "over" leveraged. They had financed too much of their business activity by debt rather than equity.

"Too much" by what standard? The standard is obvious. The equity finance was not enough so that it was the stockholders that suffered all of the losses. Those holding the debt of Lehman Brothers had to take some loss as well. That meant default, and bankruptcy.

And so, Fuld lost control.

From the point of view of Fuld, the problem with Lehman Brothers was that they made poor investments and had too little equity to cover all of the losses. Given the poor investments, the problem with Lehman Brothers was that it was "over-leveraged."

To me, this sounds like Fuld had a personal problem. To what degree are the personal problems of politically powerful men like Fuld being turned into imagined problems with "over-leverage" for the economy as a whole?

It is something to keep in mind.

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