*wall street-- part 2*

Hi all - so I didn't mean to cause any panic by that last post. There is certainly a lot of panic in the market now. I do not think it is a time to panic as it relates to the cash sitting in your bank account; remember deposits at your local bank are insured up $100k by the FDIC (if you have more than that then put it in multiple accounts at different banks). The carnage certainly did continuing today. Monday it was Lehman, Yesterday was AIG, where the government has stepped in and essentially took control (provided $85 billion in liquidity to the firm but took control and will likely be selling it off piece by piece in a more "orderly" process). Probably a good thing...if AIG went down like Lehman it would have been several orders of magnitude worse. After Lehman and AIG the panic continues to banks like WaMu, which is essentially done, they'll be sold by week's end. HBOS in the UK just sold today in a firesale to Lloyds. The biggest surprises of the day however were Morgan Stanley and Goldman. These are the two true juggernauts of Wall Street that everybody thought were untouchable. Morgan Stanley particularly is now under extreme pressure. Morgan Stanley going down would be as bad or worse than AIG given its size and breadth. Their stock dropped almost 30% today alone. The firm has started into a death spiral. Lots of folks are pointing at speculators that are driving the bank down to make a profit by short selling the bank's stock. This could be part of it. But this is also more simply a classic "run on the bank", just like it as been with the other firms. Morgan Stanley is trying to a few last ditch efforts to stem the tide otherwise it could be sold by week's end also. Some people think the most venerable of all Wall Street firms, Goldman Sachs, is now not immune from collapse.

Given all this it might make sense to set forth a simple example of the power of leverage. Simplest example that everybody can understand is a home mortgage. If you don't have $1 million to buy a house then you have to borrow, right? lets say you manage to put together a $100k down payment, so you have 10% equity to put down and you borrow 90% of the value of the home from the bank in the form of a mortgage. The beauty of leverage is that if the house appreciates to $1.1 million and you sell then you can pay off the mortage and you pocket $200k, you've made 2x your return. For the asset only appreciating 10% (from $1m to $1.1m) you made a 100% gain. Beautiful. But if the home value goes down just 10% to $900k then the reverse is true, your equity is wiped out. You had 9:1 leverage ($900k debt to $100k equity) and it didn't take much to lose 100%. Now consider that millions of home owners in the country purchased homes with much more than 9:1 leverage. Many put essentially no money down and bought with 100% leverage. As long as home prices keep increasing that's great for you...the return to your equity is turbo-charged. But when hoem prices move the other direction you're in a world of hurt. The same is happing at these large banks. Banks are essentially a large pool of financial assets that are financed with both debt and equity. Equity is the stock price you see in the market. Problem is that these investment banks are much more than 9:1 levered like in my example above. Bear Stearns and Lehman were about 33:1 levered. Morgan Stanley and Goldman are about 25:1 levered. Using the same numbers above, if the bank had $1 million of asset that means its equity investors (you who own the stock) only have $38,460 of equity in the game and all the rest is debt. In such a highly levered set-up it doesn't take much of a reduction in the value of the assets to suddenly wipe out that small equity cushion and the bank becomes insolvent. The banks all hold billions in mortgages and other loans to corporations, many of which were provided to homeowners/companies that couldn't afford them. As these home owners and companies default there is a ripple effect and the value of the mortgages the banks hold decreases. They are so highly levered that they move quickly toward insolvency. Right now were living through the downside of debt. This is exacerbated by a panic...and I'm sure most know, banks accept money and make loans and keep reserves in case customers demand cash from their accounts. If all customers were to demand cash simultaneously, however, the bank could not return the money because they lent out a portion of it to somebody else (likely through a mortgage). So with asset values falling and even consumers demanding cash, the banks are pushed to a standstill and insolvency.

Anyway, hopefully that was helpful to somebody...simple stuff but important basics to know/understand.

Jared