Too clever by half

When used by the British, the phrase 'too clever by half' is a serious insult.

It is used to describe a person or scheme that has failed - often after a promising start - because of complexity and overreaching. 'Too sure of one's intelligence in a way that causes displeasure or damage to people' is another definition. The opposite of 'too clever by half' is the person who knows that 'keep it simple stupid' is often the safest and, in the long run, the most profitable course of action.

The current financial crisis came about because the grossly overpaid "geniuses" on Wall Street were too clever by half. While they "only" did three things wrong, those three things were sufficient to land us all in trouble. Excessive leverage, fees layered upon fees, and gross self deception are clearly classifiable as "big wrongs".

Leverage, in ordinary terms, means borrowing - lots of borrowing. A homeowner who makes a 20% down payment is leveraged 4:1. There is some risk for the lender but it is not excessive and the interest rate charged normally provides adequate cover. When the bank packages those mortgages into bonds, there is little addition to the risk.

It is the Wall Street "genius" who buys these bonds using 9:1 leverage (i.e. making only a 10% down payment on the bond and borrowing the rest) who raises the level of risk to what has now proved to be an intolerable level. Combine 4:1 leverage with 9:1 leverage and the total rises to 36:1 with respect to the underlying value. It is not rocket science to see that it doesn't take much in the way of losses, on the underlying mortgages, for the buyer of the bonds to be left with precisely and exactly zero money if he tries to sell them.

Worse yet, in the world of hedge funds, 36:1 leverage is considered modest!

On top of that, when the seller lends the buyer money to buy the bonds, using the bonds themselves as collateral (which has happened all too frequently), the level of risk becomes - at least for any ordinary person - incalculable. If risk managers ever bothered to calculate the potential damage, it seems that they were overruled by overconfident investment bankers and traders.

See also self deception!

Buying long term debt using short term borrowing is known as the "carry trade". It's profitable work if you can keep rolling over the debt, which is not easy in hard times, and if short term interest rates do not spike above that paid on the bonds.

Engaging in the carry trade is a very high risk activity. While it is very similar to the business model used by commercial banks, where demand deposits in checking and savings accounts fund medium and long term loans, they are heavily regulated and statutory capital requirements do not permit leverage much beyond 10:1. Except, to our cost, no small number of them got too clever by half and started finding ways to keep speculative activity, using highly leveraged instruments, off their balance sheets and, until the system blew up in their faces, concealed from their regulators.

Add self deception to the mix. Just a few companies have insured trillions (not a typo - trillions - and the fancy term for this form of speculation is a Credit Default Swap) of dollars of debt, too much of which is now nearly worthless. Those who bought this so-called insurance thought that they were in a nearly risk free position but are now finding themselves badly exposed. There was never a chance that the insurers could ever deliver on their promises if the bet was called, but Wall Street went merrily on its way taking unconscionable risks for a few extra basis points (hundredths of a percentage point) of yield which was further eroded by supercharged fees.

High risk should be accompanied by high reward: that is the position of a well managed Venture Capital Fund but both the managers and the investors recognize and accept that ahead of time. Very high risk, accompanied by only very modestly higher returns, does not constitute good management nor justify supercharged fees. That, not jealousy, is the basis for my description of the Wall Street "geniuses" as grossly overpaid.

Warren Buffet said it well: "You only learn who has been swimming naked when the tide goes out" .

The tide is a long way out now - and a lot of people have been swimming naked.

Let us hope that the impact on the Main Street economy, focused on delivering goods and services rather than speculating with borrowed money, will be limited. Federal Reserve Chairman Ben Bernanke is a expert on the Great Depression. Perhaps he has learned the right lessons.