INVESTING: Excessive use of leverage now walloping Wall Street

Here’s a well-worn saying about businesses that engage in risky behavior: “You only find out who has been swimming naked when the tide goes out.” If so, we are nearing low tide and the biggest nude beach on the planet is on display in lower Manhattan.

These recent events are historic. Lehman Brothers, a 158-year-old firm that survived the Depression and world wars, was forced into bankruptcy due to leveraged bets on subprime securities and risky loans made over the past few years.

AIG, the world’s largest insurer with 116,000 employees and $110 billion in revenue, is being bailed out by you and me, after losses on complex derivative contracts. While most of the company’s insurance businesses are sound, the firm was brought down by providing insurance against losses on subprime securities held by banks and other investors. When those securities lost substantial value, AIG was on the hook to cover those losses, which depleted its capital base.

Merrill Lynch, seeing the writing on the “Wall,” was forced into the arms of Bank of America at a price that was one-third of its value a year ago. And all this came one week after the government’s seizure of the mortgage giants Fannie Mae and Freddie Mac.

That the government stepped in to rescue AIG after letting Lehman fail is causing some consternation. However, with things moving so fast, the Treasury’s Hank Paulsen and the Fed’s Ben Bernanke have to make quick decisions. The main thing about AIG that worried regulators was the interconnected nature of the derivatives.

Allowing AIG to fail would have rippled through to European banks and investors around the world-a risk to the global financial system. Lehman, on the other hand, was recklessly leveraged, with more than $30 in borrowed money for each dollar of equity. Thus, regulators left it to the shareholders to take the hit.

We can now see why Warren Buffett has called derivatives “financial weapons of mass destruction.” I was looking over the transcript of the Berkshire Hathaway annual meeting held last May and you really begin to appreciate the genius of the man.

Buffett notes, “If you are dependent on borrowed money, every day you hope the world thinks well of you.” He offers that Berkshire could run its business with considerably more leverage than it has, “but we wouldn’t have slept as well at night. So why do it?”

Berkshire’s stock actually has risen in value the past couple of weeks of this crisis. In contrast, consider the fate of AIG’s former chairman, Maurice “Hank” Greenburg, who spent a lifetime building the company, and owned 11 percent of the stock. He personally has lost $16 billion since the beginning of the year. A look at the leverage ratios of a few of these companies tells it all: Lehman: $640 billion in assets, $26 billion in equity (a 24-to-1 ratio); AIG: $1 trillion in assets, $78 billion in equity (12.8-to-1); Berkshire Hathaway: $278 billion in assets, $118 billion in equity (2.4-to-1). The first two are insolvent, while Berkshire’s stock market value is $194 billion. The deleveraging of America has arrived, and it’s not pretty. But soon these words of Ben Graham will become significant: “Be fearful when everyone else is greedy, and be greedy when everyone else is fearful.”