Photo:bbaltimore, Creative Commons, Flickr
Ever wanted to know more about "Financial Engineering" and "Leverage"? The following story captures the essence of these disciplines:

A father to his son: "I want you to marry a girl of my choice."
Son: "I will choose my own bride!!!"
Father: "But the girl is Bill Gates's daughter."
Son: "Well, in that case…ok."

The father approaches Bill Gates.
Father: "I have a husband for your daughter…"
Bill Gates: "But my daughter is too young to marry!!!"
Father: "But this young man is a vice-president of the World Bank."
Bill Gates: "Ah, in that case…ok."

Finally, the father goes to see the president of the World Bank.
Father: "I have a young man to recommend as a vice president."
President: "But I already have more vice presidents than I need!"
Father: "But this young man is Bill Gates's son-in-law."
President: "Ah, in that case…ok."

"Leverage" is all about turning a small asset base into a large investment. In the above example, the father, whose "asset" in is his son, uses a sequence of transactions, applying leverage, to elevate the social status of his son. Leverage can be very useful when valuation of the underlying asset is fundamentally justified, but leverage can also cause chaos when the value of the underlying asset is based on irrational factors. The leverage sequence above is dangerous since the fundamental value of the son is distorted by the father.

Wall Street loves leverage, but how much of this leverage is based on false assumptions? In 2006 the nation's four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholder equity, a leverage ratio of 25.5 to 1, according to research firm Sanford C. Bernstein & Co. In 2002 those same firms reportedly financed $1.59 trillion of assets with $72.7 billion of equity, a ratio of 21.9 to 1.

The doomsayers believe the leverage used on Wall Street is no different than the father's method to turn his son into the World Bank's Vice President. A great deal of leverage in the current financial environment is based on underlying asset prices that could never be fundamentally justified. Just think of subprime mortgages, negative basis trades, CDOs, ABSs and other instruments that were so complicated that investors never really understood what they were trading.

I'm ending this note with a comment by John R. Ing, one of the cheerleaders for the doom and gloom scenario, who wrote:

The origin of the debt crisis lies with the evolution of America's financial markets using financial engineering and leverage to finance the credit expansion. Financial institutions created a Frankenstein with the change from simply lending money and taking fees to securitizing and selling trillions of loans in every market from Iowa to Germany. Credit risk was replaced by the 'slicing and dicing' of risk, enabling the banks to act as principals, spreading that risk among various financial institutions. Securitization allowed a vast array of long term liabilities once parked away with collateral to be resold along side more traditional forms of short term assets. Wall Street created an illusion that risk was somehow disseminated among the masses. Private equity too used piles of this debt to launch ever bigger buyouts. And, awash in liquidity and very sophisticated algorithms, investment bankers found willing hedge funds around the world seeking higher yielding assets. Risk was piled upon risk. We believe that the subprime crisis is not a 'one off' event but the beginning of a significant sea change in the modern-day financial markets.