Saturday, May 08, 2010

Financial Leverage

I love this description of the 1929 Wall Street trust as described in John Kenneth Galbraith's The Great Crash 1929 (1988 revision published by Houghton Mifflin Company, page 57-58):
The principle of leverage is the same for an investment trust as in the game of crack-the-whip. By the application of well-known physical laws, a modest movement near the point of origin is translated into a major jolt on the extreme periphery. In an investment trust leverage was achieved by issuing bonds, preferred stock, as well as common stock to purchase, more or less exclusively, a portfolio of common stocks. When the common stock so purchased rose in value, a tendency which was always assumed, the value of the bonds and preferred stock of the trust was largely unaffected. These securities had a fixed value derived from a specified return. Most or all of the gain from rising portfolio values was concentrated on the common stock of the investment trust which, as a result, rose marvelously.

Consider, by way of illustration, the case of an investment trust organized in early 1929 with a capital of $150 million — a plausible size by them. Let it be assumed, further, that a third of the capital was realized from the sale of bonds, a third from preferred stock, and the rest from the sale of the common stock. If this $150 million were invested, and if the securities so purchased showed a normal appreciate, the portfolio value would have increased by midsummer by about 50 per cent. The assets would be worth $225 million. The bonds and preferred stock woulds till be worth only $100 million; their earnings would not have increased, and they could claim no greater share of the assets in the hypothetical event of a liquidation of the company. The remaining $125 million, therefore, would underlie the value of the common stock of the trust. The latter, in other words, would have increased in asset value from $50 million to $125 million, or by 50 per cent in the value of the assets of the trust as a whole.

This was the magic of leverage, but this was not all of it. Were the common stock of the trust, which had so miraculously increased in value, held by still another trust with similar leverage, the common stock of that trust would get an increase of between 700 and 800 per cent from the original 50 per cent advance. And so forth. In 1929 the discovery of the wonders of the geometric series struck Wall Street with a force comparable to the invention of the wheel. There was a rush to sponsor investment trusts which would sponsor investment trusts, which would, in turn, sponsor investment trusts. The miracle of leverage, moreover, made this a relatively costless operation to the ultimate man behind all of the trusts. Having launched one trust and retained a share of the common stock, the capital gains from leverage made it relatively easy to swing a second and larger one which enhanced the gains and made possible and third and still bigger trust.

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