Too Much Leverage Precedes Many Disasters

There seems to be some confusion over what threatened to cause major banks to fail.  Let me go over my list of the risks:

  • Many relied on AIG to insure their subprime and other structured lending risks.  Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”  After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!  Alas for risk control, and the illusion of the strength of companies merely because they are big.
  • As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.  Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.  When the tide goes out — oh well,  GE Capital might not have survived without the TLGP program.  Another reason why I sold all my GE Capital debt when I was a bond manager.  Big companies can make big mistakes.  Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
  • Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.  Underwriting standards slipped everywhere.
  • Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
  • In general, banks ran with leverage ratios that were too high.  Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.  Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
  • The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.  The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.  Guess who survived?
  • The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.  They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
  • Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
  • Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
  • State and local governments came to depend on increased taxes off of inflated asset values.

What I don’t see is problems from private equity or proprietary trading.  These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.  By this, I mean real common equity, not hybrid equity-debt financing vehicles.

I believe that bank risk-based capital structures need to be strengthened.  I don’t care if it means that lending diminishes for a few years.  Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.  (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains.  In the long run, what makes economic sense will prevail, not what scores political points.


  • Donald Last says:

    You do talk so much commonsense. Send this to every Congressman.

    You also write plainly. One gets so tired of the tortured, jargonized prose deployed by economists in academia and the banks. Wrapping up simple notions in attentuated language to try to make it sound more profound than it really is.

  • Terry says:

    I’m with you right up to “…what makes economic sense will prevail…” Hasn’t happened yet in the history of the republic and I don’t expect it to happen in the foreseeable future. (Could argue that the New Deal policies were economically sensible at the time, I suppose.) Rightly or wrongly, the political view (right or left depending on time and circumstance) will prevail.

  • “The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004. The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit. Guess who survived?”

    Gotta question your numbers there (and I’m as big a Goldman defender as anyone). Goldman definitely levered up — from 21:1 in 2004 to 26:1 in 2007. And Morgan Stanley levered up more than a little bit — from 26:1 in 2004 to a whopping 33:1 in 2007.

    Now, it’s true that Goldman levered up less than Lehman, Bear, and Merrill, but they definitely levered up. And Morgan Stanley was right in there with Lehman, Bear, and Merrill as well.

    Otherwise, though, I largely agree with all of your points.

  • dlr says:

    Well, he’s not reacting to the fact that it wasn’t proprietary trading that got them in trouble THIS TIME. All those problems happened way back in 2008. He doesn’t care about what caused the banking crisis, and doesn’t have any plans to address it. If he did, he would have done something about it a YEAR AGO, when he came into office.

    No, what he is responding to, right here, right now, is the fact that it is pissing off middle america that the banks are taking TAXPAYER BACKSTOPPED MONEY and GAMBLING WITH IT ON THE STOCK MARKET instead of making LOANS.

    Just like it is pissing off middle america that bank executives are paying themselves huge bonuses ditto, ditto, ditto.

    And, since the defeat in Mass. he has decided to try to mend his fences a little bit with his aggrievied constituency. Plus (my guess) he is hoping that the Republicans in Congress will defend the Wall Street Banks. Whoo hoo, wouldn’t that be sweet.

  • dlr says:

    Although it wouldn’t be accurate to say that proprietary trading doesn’t SOMETIMES contribute to banking crises. See the debacle in Japan 20 years ago. At least part of that was caused by allowing banks to hold massive amounts of (highly overvalued) stock as part of their “capital”. And a little closer to home – how about the Savings and Loan debacle. Some of the worst excessives of that were surely caused by allowing S&L’s to own junk bonds.

    If you ask me, anything, any politician does, ever, for any reason, to rein in the freedom of the big banks is something to celebrate. A bank that has deposits backstopped by the US Taxpayer SHOULD be hobbled as much as we can conveniently arrange – they are playing with other people’s money. In my opinion they should not only not be able to do prop. trading, they shouldn’t be allowed to make markets, or buy cds to offset their risk, or buy stocks, ever, or bonds either, except for Treasury Bonds, and definitely they shouldn’t be able to buy securitized loans, or do underwriting. In fact, about the only thing that they should be allowed to do is clear checks and make loans, and only then with a very considerable cushion of capital – like 20 or 30 percent.

    Wall Street banks think that is too onerous? Ah, how sad. Let them go start their own private banks, without backstops from the US Taxpayer. I don’t care what you do as long as I don’t have to bail you out when you screw up, or when you figure out a way to loot your company and leave the taxpayers holding the bag.

  • Albert says:

    David, as always, thanks for your posts. I agree with many of the points you made, as well as many of the points in the comments section.

    But I do think prop trading did play a role in the crisis. Morgan Stanley took a $7 billion loss on a proprietary position in 4Q07 (dwarfing the nearly $1 billion it lost on its investments in Crescent real estate). While you can argue that this was a result of the crisis, rather than the cause, losing $7 billion certainly didn’t help!

    Additionally, when markets tanked following Lehman’s bankruptcy, MS counterparties had to wonder whether MS might be on the wrong end of another trading disaster, which was a plausible possibility. That only increased the fear that nearly brought the firm down, which eventually led to their bank charter and their current regulatory predicament.

    Thanks again for your post, and hope all is well.