The Two Personal Finance Lessons We Should Learn from the Demise of U.S. Investment Banks
Lehman Brothers Faces the Hard Truth
Lehman Brothers has been forced to face the hard truth. It has filed bankruptcy and will be sold off for a small fraction of its book value of just six months ago. Bear Stearns collapsed earlier this year. Merrill Lynch has sold itself to Bank of America. Other investment banks are on the brink but may survive. Fannie Mae and Freddie Mac, although not investment banks per se, have been taken over for similar reasons.
There are two personal finance lessons that Mr. ToughMoneyLove believes that we can and should learn from these developments. Before I state these, let’s look at the common factor in these recent failures: extreme use of debt leverage.
Balance Sheet Ballistics
Let’s examine key components of the Lehman Brothers balance sheet at the ends of 2003 and 2007:
2003: $13 billion in shareholder equity (a measure of net worth)
$312 billion in assets
2007 $22.5 billion in shareholder equity
$691 billion in “assets”
This tells us that in 2003, Lehman owned $24 in assets for every dollar of equity on its balance sheet. In 2007, “assets” had increased at a much faster rate compared to equity, to $31 in assets for every dollar of net worth.
Merrill Lynch experienced the same balance sheet blow-up, with assets doubling from $480 billion in 2003 to $1.02 trillion in 2007. At the same time, shareholder equity moved only slightly from $29 billion from $32 billion.
Lesson No. 1: “Good Debt” Can Turn into “Bad Debt” in a Hurry
Lehman and the other investment banks thrived on securitized packages of real estate loans and related assets, thought to be safe and therefore propped up by “good debt.” The homeowner/borrowers leveraged up their first mortgages, second mortgages, and HELOCs, often in the name of “good debt.” Lehman and others facilitated this and leveraged it again on their own balance sheets. The ratio of debt-to-equity grew way too fast and too high. Then kaboom! The good debt turns to bad debt in six months, billions of dollars are lost, sending Lehman into a death spiral. Many of the worst losses at the personal level are yet to come. Imagine being a Lehman employee or shareholder right now.
The people running Lehman were not stupid – they were highly educated and sophisticated in the world of finance. They just became infatuated with the apparent successes of their use of “good debt.” Their judgment became clouded. So please remember its demise next time you are tempted to fall into a “good debt” trap.
Lesson No. 2: In Times of Trouble, Net Worth Wins Over Credit Score
If you have been a steady reader, you know that Mr. ToughMoneyLove is on a campaign against credit score obsession. The investment bank failures support my views. When the securitized debt that Lehman thrived on became worthless, it was forced to write it down. Its balance sheet became ugly. It resorted to seeking new capital from outside sources, but no one was sufficiently interested. Twelve months earlier, Lehman probably could have borrowed funds at favorable rates because its “corporate” credit score was excellent. But when its net worth plummeted, that changed.
The lesson for consumers is that even with a good credit score, credit will not always be available to get you out of financial trouble. If you lose your job or suffer some other money calamity, only a strong net worth will carry you through. That 750 FICO score will be nice to look at but it won’t put food on the table. In fact, miss one payment and that score plummets. With a positive net worth, you won’t be missing payments. Net worth beats credit score every time.
Mr. ToughMoneyLove encourages you to learn from these very public mistakes of the investment banks. Are there other lessons to be learned here?