Solution to Our Economic Mess? Limit Leverage!

My friend Eric emailed me regarding my post "Skin in the Game," noting that I made some good points, but asked me what my solution would be. He suggested limiting leverage, which I agree with completely, and I realized that the Bernanke quote I liked so much from yesterday's post is illustrative of exactly this concept.

October 15th, 2007 – Bernanke: It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions.

See, the problem isn't that investors buy MBS and lose their money. The problem is that investors can put up $100MM in capital and buy $3B of MBS with someone else's money - that's called leverage, and that 30-1 ratio was not at all uncommon. The Fed's role should be to prevent systematic risk - in other words, it doesn't matter if you lose all your money, but there should be regulations to make it so that you cannot put the financial system at risk. Examples of things that put the financial system at risk, in case you're unaware, are described by the Top Gun quote: "Your mouth's writing checks your body can't cash," aka, the AIG problem - selling insurance (credit default swaps) you can't make good on.

Allowable leverage ratios can and should be different for assets with different risk profiles: if you have 30-1 leverage, a decline of roughly 3% would wipe out all your capital, so you'd better be buying very safe assets. But herein lies the rub: you may have heard of Long Term Capital Management (LTCM) - a hedge fund that blew up about 10 years ago. The problem was that LTCM, and the banks they dealt with, thought that the trades LTCM was making were very safe - and allowed LTCM to amass massive positions with minimal capital - they had leverage of up to 100 times. This meant that if LTCM put up $10Billion in capital, they could control $1Trillion in assets. At this ratio, all it takes is a 1% decline in the value of LTCM's positions for them to get wiped out.

Well, the recent crisis was similar - investors were massively levered in AAA rated, "safe" mortgage backed securities, which turned out to be not safe at all. Interestingly, this time there was no big hedge fund like LTCM that threatened the health of the financial system by levering up and risking the capital of a number of banks - the problem we saw was that banks did this themselves - they figured instead of earning small returns, they could lever up and earn bigger, still "safe" returns by buying these new products like CDO's and MBS.

So as we can see there are two problems - the leverage allowed, and the misjudging of the safety of the assets. Since we've proven again and again that we ("we" being everyone) cannot accurately assess the risk of severe downturns in asset prices, the solution should be to limit leverage across the board.

I want to address two similar comments that I've had from two different people regarding my analogy in the "Skin in the Game" post where I asked, rhetorically, why underwriters aren't being asked to hold 5% of equity offerings or corporate bond offerings.

"The problem with IPOs as an analogy is that an IPO represents one security, which the buyer has a reasonable chance to analyze thoroughly. With an MBS package, the buyer has no chance to analyze the quality of the multitude of underlying mortgages. "

"If I'm buying a share of a mortgage-backed security, I can't get info about the people whose mortgages I own pieces of. I *have* to trust the middleman, because that's who (hopefully) met these people, that's who read their tax forms, that's who got their credit reports. If I can't check on that info myself, then there is a higher burden, both on the original lender, and on the rating agency. "

This attitude is perfectly illustrative of why we're in this mess. The answer is simple: if you cannot value the security, you should not buy it. You don't "trust the middleman," - you buy something else.

Comments

[Moon Kil Woong:]

I agree leverage must be managed better. I think everyone who knows anything about financial systems agree and know that leverage over 30x is dangerous. Strangely, it makes you wonder why no one is hollering as our central bank decides it can take an unlimited amount of leverage. That doesn't include the $8 trillion in guarantees it's also backstopping. In total, if you can include their backstops similar to AIG's CDS insurance, their leverage would put both AIG and Citibank to shame.

Jun 19 03:08 AM

[Economic Lens:]

As long as the government steps in to protect those who lose money from over leverage, this practice will continue. We have created a system where the risk takers transfer their risk to the government and public at large. Our current path is unsustainable with YOY trillion dollar deficits. America is not too large to fail as we are going to find out in the next few years if things continue on their current course.

Jun 19 05:12 AM

[Leftfield:]

The suggestion that "underwriters hold 5% of equity offerings or corporate bond offerings" is a piece of a solution, but management compensation and the lapdog corporate board "oversight" is central, not a diversion.
You mention that the Wall St. products that have hit the fan involve trusting middlemen that due diligence was done in, say, mortgage packages. No, the system and people still in place make all the money and do none of the heavy lifting. The "reform" just proposed by Obama is another employment bill for empty suits who extract wealth by any means necessary, Wall St. and DC, and go round and round with self-important charades adding layers to their games followed by impotent, expensive "fixes." As the example of LTCM illustrates, there have been no shortages of warnings and the payscales on Wall St. and Washington actually encourages more of the same.
Yes, the fix is on. Wall St. is a middleman to a long term shakedown of America along with enabler DC. When you have a Steve Jobs with an inspired product and business that is actually, really his creation, you can trust far more. We've handed so much to empty suits who are middlemen and what have we got to show for it?

Jun 19 07:24 AM

[john s. gordon:]

give the author a gold medal for this one.
> jack

Jun 19 08:29 AM

[LilBob:]

I agree with everyone saying that there shouldn't be so much use of leveraged capital, but I think government limits on such practices are not the way to go. What I do believe in is greater requirements regarding the sharing of information with investors. Personally, I'm very much a "Freedom of Information," type, as in: Investment firms should be able to do whatever the hell they want, so long as there are government requirements in place that require them to tell investors exactly how they are managing funds. I strongly disagree with all the lingo about "proprietary strategies," and "unique thinking," if this latest crisis has shown us anything it's that pretty much all the firms do pretty much the same thing, and when things are going well, they brag about their prowess, reward executives with huge salaries and bad-mouth those firms that stick to more conservative investment strategies. When things go in the crapper, they cry about half-million dollar salary caps, beg the Fed for money and those firms that were being bad-mouthed for "not having the vision," or "having outdated laptop strategies," are lauded for their responsibility and insight.

It's all about the information. The solution is not more regulation regarding what investment firms may do, but stricter accounting and reporting standards so that investors know where their money is going, and they will be better able to make informed decisions. (Even though most investors are idiots and are prone to the same behaviors described above).

Jun 19 08:39 AM

[Paul in Texas:]

It's interesting to note that 4 of the 5 comments so far have complained about the government. If you want to start fixing the problems, change the people in government. Actually look at the way your Congressmen have voted. If they voted contrary to your wishes/values, vote for someone else in the next election.

Jun 19 08:45 AM

[Henry Buttal:]

Paul,
I think you took a great article by Kid Dynamite and made it better with your comment.
When the "crisis" occurred in the Fall, one of my observations was that (despite comments by Government Sachs) most companies didn't pay their payroll by issuing commercial paper. Rather, the commercial paper market had become one of the tools the prime brokerages were using to supply leverage to the hedge funds.
Moral hazard was suspended for those who had access to the correct set of ears. And H. Paulson and spouse got to maintain their social lives without disgrace.

Jun 19 09:22 AM

[Kid Dynamite:]

@LilBob - this is an important point - i would certainly agree with you, but for one thing: investors are, largely, "stupid" - for lack of a better word for it. We've proved it over and over again.

I'm in favor, like you say, of allowing firms and investors to do "whatever they want." However, since I don't want firms making huge bets and then running to the government (TAXPAYER!) for a bailout, the key is to make sure no one is too big to fail. If we limit leverage, such that no firm is systematically significant, then we could let everyone do what they want - everyone has the right to lose their own money!

i don't think freedom of information is enough of a solution, unfortunately


On Jun 19 08:39 AM LilBob wrote:

> I agree with everyone saying that there shouldn't be so much use
> of leveraged capital, but I think government limits on such practices
> are not the way to go. What I do believe in is greater requirements
> regarding the sharing of information with investors. Personally,
> I'm very much a "Freedom of Information," type, as in: Investment
> firms should be able to do whatever the hell they want, so long as
> there are government requirements in place that require them to tell
> investors exactly how they are managing funds. I strongly disagree
> with all the lingo about "proprietary strategies," and "unique thinking,"
> if this latest crisis has shown us anything it's that pretty much
> all the firms do pretty much the same thing, and when things are
> going well, they brag about their prowess, reward executives with
> huge salaries and bad-mouth those firms that stick to more conservative
> investment strategies. When things go in the crapper, they cry about
> half-million dollar salary caps, beg the Fed for money and those
> firms that were being bad-mouthed for "not having the vision," or
> "having outdated laptop strategies," are lauded for their responsibility
> and insight.
>
> It's all about the information. The solution is not more regulation
> regarding what investment firms may do, but stricter accounting and
> reporting standards so that investors know where their money is going,
> and they will be better able to make informed decisions. (Even though
> most investors are idiots and are prone to the same behaviors described
> above).

Jun 19 09:42 AM

[crawlars:]

"The Money Game" video, google it.

Jun 19 10:13 AM

[Clive Corcoran:]

Re LilBob
You touch on a key point which is public accessibility to complete information about all of the holdings of financial intermediaries so that early warning systems could alert to excessive leverage and systemic risk.
But transparency is the most overused and hypocritical bits of terminology used by policymakers and Wall Street. In fact the "game" is to obscure the real facts rather than to make them transparent.

Jun 19 10:49 AM

[Kid Dynamite:]

more importantly, i don't think it would matter as much as you guys expect. remember - the information about the crap that the big boys owned was public - that's why Einhorn was warning people about Lehman. the problem wasn't that we didn't know what they held, the problem was that we underestimated the risk of the positions.

you can look at how much crap Citi owns right now - the real question is what their future charge off rate will be. if you believe the party line that everything is getting better, then Citi will be fine. If you are a realist/bear like me, then you think Citi has a lot more losses to come.

i don't think the problem is transparency - it's how to use the information


On Jun 19 10:49 AM Clive Corcoran wrote:

> Re LilBob
> You touch on a key point which is public accessibility to complete
> information about all of the holdings of financial intermediaries
> so that early warning systems could alert to excessive leverage and
> systemic risk.
> But transparency is the most overused and hypocritical bits of terminology
> used by policymakers and Wall Street. In fact the "game" is to obscure
> the real facts rather than to make them transparent.

Jun 19 11:11 AM

[foxburrow:]

I very much appreciate the caveat emptor argument for securities/loan offerings. However we've clearly learned that institutional purchasers believe they have real government backstops/guarantees in the name of "systemic risk" prevention. They effectively have the taxpayer as a silent partner.

As an effective systemic risk/taxpayer protection tool, how much of a security would the issuer be required to retain? 5%? 10%? 20%? I never thought I'd agree with Barney Frank or George Soros, but I think mandated "skin in the game" is the exact prevention needed to minimize future crises.

Jun 19 11:45 AM

[Kid Dynamite:]

good comment, Foxburrow - this is why the blogosphere has been screaming about making sure that in the future no institution is TBTF (too big to fail) - which is one thing that the reform plan really fails to do!

again, it comes back to leverage - if we limit leverage, then the government/taxpayer won't need to come in and bail them out - because they won't be systematically essential.

along those lines, i wrote before about how any firm that pays back TARP money should absolutely NOT get a second chance if things go bad in the future - they should be crossed off the "to be bailed out" list...


On Jun 19 11:45 AM foxburrow wrote:

> I very much appreciate the caveat emptor argument for securities/loan
> offerings. However we've clearly learned that institutional purchasers
> believe they have real government backstops/guarantees in the name
> of "systemic risk" prevention. They effectively have the taxpayer
> as a silent partner.
>
> As an effective systemic risk/taxpayer protection tool, how much
> of a security would the issuer be required to retain? 5%? 10%? 20%?
> I never thought I'd agree with Barney Frank or George Soros, but
> I think mandated "skin in the game" is the exact prevention needed
> to minimize future crises.

Jun 19 11:52 AM

[Maxe Paul:]

Hers an idea banks/bankers, make a limit leverage ETF ( leveraged x3 of course!) that tracks the amount of leverage on Wall Street!

Jun 19 11:54 AM

[Heaven, Hel...:]

This is a good article and dialogue. If I may, I would like to add to the following statement:

"the information about the crap that the big boys owned was public - that's why Einhorn was warning people about Lehman. the problem wasn't that we didn't know what they held, the problem was that we underestimated the risk of the positions."

While this is true, what we did not know was the extent to which Lehman was interconnected with the broader financial community via credit default swaps and the resultant contagion it could spread, something which by the way will be largely solved via mandated clearing of CDS.

Jun 19 01:24 PM

[Jeff Nielson:]

Unless I missed it, one point has been missed in an otherwise good discussion: that U.S. financial institutions (mostly the big-banks) have demonstrated that they are INCAPABLE of de-leveraging.

Many of these banks are even AFRAID simply to put already-foreclosed property onto the market - because they are incapable of absorbing the LEVERAGED write-downs.

The derivatives time-bomb (roughly $1 QUADRILLION in notional value) has finally BEGUN to de-leverage - and has managed to shave a few percent off of a mountain of gambling debts still 20 TIMES LARGER than the global economy.

This is why those U.S. big-banks who don't go bankrupt in the immediate future are guaranteed of "zombie status" for decades to come.

Jun 19 01:50 PM

[Graham and ...:]

Reduce leverage. Those are first principles.

Of the two, pverl leverage is more dangerous than misjudging asset value. The latter can cost you no more than 100% of your investment; the former can cost a multiple of your investment.

Jun 19 02:07 PM

[Gregman2:]

Unfortunately poor business decisions too ften have a public consequence (which is one reason to be very wary of privatizations).
Limited leverage...does this tie in with the notion of increased reserve requirements?

Jun 19 02:29 PM

[jimmy46:]

You're looking at a symptom, not the cause.

WHY DO FIRMS USE SO MUCH LEVERAGE?

IT'S BECAUSE THEIR STOCK OPTIONS AND BONUSES ARE MAXIMIZED WITH RISKY BEHAVIOR.

CUT OUT OPTIONS AND TAX BONUSES MORE AND >>>EMPLOYEES&... WON'T BEHAVE THE WAY THEY HAVE.

Jun 19 02:35 PM

[joebhed:]

The Chicago Plan for Monetary Reform.
Friedman's "Financial and Monetary Framework for Economic Stability."
Fisher and Soddy's Full-reserve banking.
Leverage? What leverage?
Commercial banks on full-reserve lend real money into the economy.
Savings/Investment banks lend at 2 to 1, but put no risk on the other banking sector.
Forget uber-regulation.
This is the definition of self-imposed regulation.
The depositor is in charge of the financial economy.
Let the banks get back to banking.

Jun 19 05:39 PM

[mkreisel:]

When hyperinflation arrives, shouldn't you buy rather than sell?

Jun 19 08:47 PM

[jhartz:]

Paul,

The problem with that solution is the mediocre differences between Hack A and Hack B. I can't remember the last time I was happy with any candidate running for either state or national office.

Republican or Democrat seems to make little difference. both parties have long ago sold out to special interests.

This lack of quality in leadership choices is going to lead us to something akin to revolution if it doesn't improve very soon.


On Jun 19 08:45 AM Paul in Texas wrote:

> It's interesting to note that 4 of the 5 comments so far have complained
> about the government. If you want to start fixing the problems,
> change the people in government. Actually look at the way your Congressmen
> have voted. If they voted contrary to your wishes/values, vote for
> someone else in the next election.

Jun 19 08:52 PM

[Donkey Kong:]

Good article. I'm not sure why people can't get there hands around this basic concept - leverage magnifies returns! Therefore, it's huge tailwind on the upside and crushes you like a bug on the downside. It doesn't matter if its MBS, or LBOs or a broker-dealer balance sheet. Also, buying assets yielding 6%, financed at 5% and leveraged 30 times is NOT an investment strategy. Employee stock options are just another leveraged investment vehicle as well. Restricted stock with long holding periods is probable. Public and private sector debt has soared from 100% of GDP to 350% of GDP. Shows that much of the "robust growth" of the 80s and 90s was simply the result of increased leverage. Not a good long-term investment strategy.

Jun 19 09:03 PM

[Boot:]

I agree that this problem is deep. On a macro and micro scale. Greed comes in both country size and personal size issue.
Until we integrate our need, and put a cap on our greed, leverage will continue to reflect our youth. What can one do?
I will be responsible with my money. I will separate what I truly need from what I want. No debt. I will remove fear from any purchase. I will be patient. What can countries do?
If it's good for the goose, could it be good for the gander?

Jun 21 12:25 PM