The Two Personal Finance Lessons We Should Learn from the Demise of U.S. Investment Banks

September 15, 2008 by  
Filed under Debt and Credit, Financial Planning

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 

The concept of “good debt vs. bad debt” is a frequent topic of debate on personal finance blogs.  I have contributed to this debate myself with an analysis of using inflated investment returns to justify so-called “good debt.”  What the Lehman failure teaches us is that “good” debt is an ephemeral concept.   

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?


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7 Responses to “The Two Personal Finance Lessons We Should Learn from the Demise of U.S. Investment Banks”
  1. I think it’s a perfect example displaying the dangers of “buying at the top”. These two firms grew their assets assuming those assets would never decline in value. Nothing appreciates at a linear rate, and even the most seemingly bulletproof investments can falter.

  2. It’s funny that you should bring up the concepts of good and bad debt – I was just thinking about this, this morning. It’s very clear now that our mortgages are actually “Bad Debt”. Our houses are liabilities!

  3. Sarah says:

    “securitized packages of real estate loans and related assets, thought to be safe and therefore propped up by “good debt.””

    No, not really. The basic theory behind a lot of these CDOs was that if you bundle together enough bad debt, at least the first x percentage of payments due will be made each month. (If 90% of the payments aren’t made, but you are owed the first 10% that comes in, you suffer no loss at all.) Therefore, if you buy the rights to that first percentage, you are supposed to be fairly safe, even though the underlying assets are not much good at all. This was the fig leaf for the rating agencies (who were being paid to rate the securities by the companies who issued them, by the way) to let them issue investment-grade ratings to these “tranches” of securities.

    To put it briefly, it was always known that this debt was no good. It was originated by people who knew the defaults would be someone else’s problem and repackaged and sold by people who knew the defaults would be someone else’s problem and bought by people who thought (incorrectly) that they could manipulate the bad debt to squeeze some “safety” out of it.

  4. Sarah – Thanks for visiting. Your point is well taken but as you suggest, to the rest of us there was pretense about the validity of the debt between the borrowers and the first tier lenders. No one was telling the homeowner-borrower that there was a high probability that you will be in default. Those lenders weren’t telling their shareholders that either. The rating agencies lacked reliable metrics to quantify the risk and, as you say, they lacked motivation to do so. Then the mark-to-market rule came crashing down on all of them.

  5. Gerard says:

    “No one was telling the homeowner-borrower that there was a high probability that you will be in default”

    I’m not sure if I am misunderstanding your statement. While I agree that some of the products on offer were complex, any reasonable person should have an idea of how high a monthly payment they can service. In fact, I would suggest that most buyers realised this but took the loan out anyway because, “well the banks giving away money”. See page 3 (Clarence Nathan)http://thislife.org/extras/radio/355_transcript.pdf for an example.

    The only exception is the case where the mortgage brokers were selling something they knew was a bad product and I have some sympathy for those people who effectively got “duped”. Still, it’s your money and you make the decisions, regardless of external influences…

  6. Gerard: I agree that most homeowners should have known that the loan terms being offered were not reasonable based on their net worth and cash flow. On the other hand, the lender and/or mortgage broker had actual knowledge that the loan terms were not tenable but convinced the borrower that values were increasing and that refinancing would be possible before the rates re-set. My beef is that the naivete of the borrowers and conniving by the lenders combined to create financial products that have led to a market meltdown.

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