I’m trying to figure out just who said it was okay for the huge banks on Wall Street to leverage their investments at a ratio of 30-to-1.
What does that mean?
When you purchase a mutual fund in your IRA account with $1000 in cash, you can buy $1000 worth of securities. That’s a 1:1 leverage. If you buy stocks on margin in a brokerage account (typically you can buy $2000 in securities on margin if you have $1000 invested in your account), although you must pay the going rate in interest on what you borrow, typically 10% or so.
That’s a 2:1 leverage, or 1.5:1 if you take interest costs into account.
Big banks (and hedge funds) on Wall Street can buy thirty times what they have in cash to invest. If a money manager has $1 billion in cash, he can purchase $30 billion in stocks or bonds. If the investments go up 1% in value his actual return on his $1 billion is 30%.
Where does that money come from? It comes from your investment account, your stocks and the companies you invest in.
People wonder why the $4 trillion the Federal Reserve has loaned to the big banks hasn’t actually greased the wheels of the banking machine. Doh! The banks borrow this money from the Fed at 0% then use it to buy U.S. Treasury bills, for a guaranteed return of 4%. If you’re operating on 30:1 leverage (typical on The Street), you get a 120% return on your investment, with zero risk.
Using historical returns, it takes twenty years of savvy investing to get a 140% return on an investment (the net return has been 0% since 2000). These big banks can do that in a year or less, guaranteed.
So, the taxpayers (1) pay 40 cents on the dollar to borrow the money from China (at 4%) that the Federal Reserve loans to big banks at 0% interest (which is below the 3% inflation rate, so the banks make 3% right off the bat), (2) then we pay the banks the 4% return on the T-bills they buy, all of which (3) equals almost 10%, which (4) times the 30:1 leverage equals 300% return, all paid by the taxpayers.
It gets worse. The Too Big To Fail (TBTF) banks have leveraged an amount equal to ten times the GDP of the whole United States. Five banks on Wall Street are worth ten times the whole annual output of the United States.
It gets worse. You can recognize that there is also a downside risk to 30:1 leverage. The Wall Street Reform Act reduced this risk to the TBTF banks by spreading their risk beyond the five banks, to the entire banking community – i.e. the regional banks, all the way down to the mom and pop banks in Smallville.
When the banking system went belly up four years ago the TBTF banks took a hit (but have since made a 3000% return on their investments as the stock markets have since increased by 100%) and only one TBTF bank failed. Next time that happens, the whole rest of the banking system will fail so they can remain solvent.
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