It's all about leverage. I've been waiting for this public quote for 2 1/2 years. It's very simple math. And it's also the key to understanding the crisis and why all of the banks are insolvent. You've heard it several times here before. Henry Paulson, when he was still CEO of Goldman in 2004, successfully lobbied the SEC to change the rules on capital ratios. Leverage exploded from a previous limit of 12:1 to beyond 40:1 for all 5 firms, and when you consider that a substantial portion of the assets were synthetics then the real leverage numbers were much higher.
By the way, reinstating the pre-2004 rules of 12:1 would go a long way toward a financial fix and yet it was left undone by Dodd-Frank, which only required that the Federal Reserve undertake a study of capital ratios and report findings to Congress. That will certainly solve the problem.
Back to the math. In a world of 40:1, assets don't have much downside. Consider what this means in a simple example.
- If your collective assets drop in value from 100 to 97, you're done. Toast. Game over. At least that's how it's supposed to work.
Here's a further illustration.
Goldman Sachs could have $1 trillion in assets anchored by just $25 billion in capital. Assume Goldman's asset base loses 30% in value as happened in 2008, creating a paper loss of $300 billion, which if they were forced to mark honestly, would leave them insolvent to the tune of approximately $275 billion. This is what I mean when I've written before that the banks aren't just a little bit insolvent, instead their insolvency depth is a multiple (in this case 6x) of their original capital.
Read more: "Less than a 3 percent drop in asset values could wipe out Wall Street" - Crisis Panel Says In Final Report - Home - The Daily Bail
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