By J. Morton Davis
When purchasing a business, real estate or shares of stock, buyers often invest little of their own funds and borrow as much as they can to maximize returns. If the investment is successful, they multiply the amount they earn on the appreciated asset, as they are rewarded not only on the minimal equity investments they made, but on the amount they were able to invest as a consequence of the much larger amount they borrowed.
If the investment turns bad, then the investor only loses the small amount he actually invested and the lender is stuck with the loss. This kind of default, when it happens in individual cases, only hurts the limited parties involved. But when there are many incidences, borrowing and leverage can unleash economic breakdown and disaster, as we saw in 2008.
Yet, perversely, government policy provides incentives for borrowing and excessive leverage by treating interest on debt as tax deductible. And the leverage that emanates from such borrowing significantly magnifies risk — or more accurately, debt magnifies the consequences of a decline and increases the defaults.
In the event of any disappointing or unexpected negative occurrence, it makes the eventual triggering of defaults and insolvency to both the borrower and the lender more likely. Debt can adversely affect the stability and health of the economy — as is now clearly evident from the bursting of the housing bubble and the overwhelming mortgage defaults that ensued — at a potentially immense cost to taxpayers.
Operating with too much debt and far too little equity, the banks and other financial institutions did immense harm to the country and its economy. As a direct result, the banks themselves became insolvent because their holdings decreased in value to where their entire 5 percent to 8 percent equity and even more was wiped out. If the stimulative TARP program did not rescue them (together with the fact that they were permitted to avoid writing down their holdings to their actual market value), almost all of the “too big to fail” banks and financial institutions would have been history. Astonishingly, Bear Stearns and Lehman Brothers were so leveraged it’s questionable that they even held 2 percent of their own equity relative to their enormous holdings. In other words, they were borrowing almost 100 percent.
In an effort to prevent the recurrence of such dangerous economic practices, the Dodd-Frank financial reform law would require that these” too big to fail” financial institutions maintain capital ratios of 13 percent or more. Had these financial institutions had such minimum capital (and I believe that amount is still hardly anywhere near enough), the debacle that unfolded could have been avoided.
Shockingly, these very same institutions are aggressively lobbying against the introduction of any safety measures because, it appears, they would like to continue operating on a capital shoestring so they can maximize the return on their invested equity. They insist it’s not a good time to hamper the economy.
Greedily, these institutions prefer to continue to enhance return on invested equity capital by enjoying the maximum leveraging through debt, while demonstrating indifference to the enormous economic damage this behavior has inflicted already and could do again, if left unchecked. They like it when it is heads they win, and tails the taxpayers lose.
Obviously, in light of the existing tax system, which favors debt over equity, the policy is unwise and encourages practices that expose the economy to collapse. The banks and institutions pushing for the repeal of Dodd-Frank are, after all, the very same activists that successfully pushed for the elimination of the Glass-Steagall Act that worked so beneficially ever since the Great Depression, as it kept traditional banking safer by keeping it separate from far riskier trading and investment activities.
Glass-Steagall’s repeal contributed to the current financial mess. Freed from the regulations and restrictions of Glass-Steagall, banks increased their risk and inflated the bubble, triggering the crash and almost leading to their own demise.
While debt prudently incurred can be useful, it should not get special favors in tax law. It’s hardly worthy of being favorably incentivized by our tax laws.
Wouldn’t it make far more sense, and be far safer and healthier for the financial system, to incentivize equity investments and, to the maximum extent possible, minimize debt? Instead of interest on debt being tax deductible, dividends should receive that preference. The more equity a bank, corporation, private business or individual has put up, the less chance there is of forced insolvency. In fact, if equity constituted the entire capitalization of every investment on every balance sheet, insolvencies — and the overwhelming disastrous fallouts that emanate from such adversities — would all but disappear.
Were that the case, the catastrophic housing bubble could never have come to pass, nor would the banks, nor indeed the entire U.S. financial system, have been placed in jeopardy. There would have been no need for TARP or the other gigantic government expenditures to save the “too big to fail,” or the resultant excruciating crash.