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Leverage is the killer app of financial reform

Here's something that no amount of financial regulation will fix: bubbles. Bubbles have always been with us and they will always be with us, at least unto the seventh generation of cyborg-humans. Yea, verily. And there's nothing really wrong with that: The bursting of the tech bubble didn't damage the economy so much as it brought it back into line with its fundamentals. But you can't say the same for the housing bubble. The difference, as Joseph Gagnon argues, was leverage:

Bursting bubbles are economically harmful only to the extent that they bankrupt investors or raise fears that investors will go bankrupt. Bankruptcy imposes deadweight losses on society, resulting from the resolution process and the delays and uncertainty associated with it. Fear of a counterparty's bankruptcy causes financial markets to freeze, disrupting overall economic activity. Lenders also appear to alternately underestimate and overestimate potential default losses and these swings undoubtedly are costly.[...]

The way to reduce the cost of a bursting bubble is to reduce leverage. In a world of unleveraged (or lightly leveraged) investors, falling asset prices would not bankrupt anyone and thus would not raise fears of bankruptcy. In such a world, there are no welfare costs of a bursting bubble, at least as long as the central bank acts nimbly to keep the economy on track. It is true that investors suffer a decline in wealth, but only from a level that was not fundamentally correct to begin with. For example, the technology bubble of 2000 burst with no apparent ill effects because it was not leveraged to any significant extent and there were no government bailouts. The recession of 2001 was very mild and probably was unavoidable given that GDP was above potential in 2000 and inflation was rising.

The next bubble won't be the tech bubble. Or structured debt products. But it's a pretty safe bet that it's going to happen anyway. Humans are still humans, and America is still where the developing world parks its cash. Trying to fine-tune financial regulations so this won't happen again won't prevent something else from happening instead. What we need is to stop this sort of thing from mattering as much.

Take, for example, the FDIC. The Great Depression was the last of a long series of financial crises characterized by bank runs during the end of the 19th Century and the beginning of the 20th. The different crises had difference causes, but they had a similar effect: Word would spread of a financial problem and then people would run to their banks to get their money out because no one knew whether their bank was afflicted. This, in turn, would make banks collapse, even when they'd been totally fine.

Dealing with this by regulating against whatever sparked that bank run wasn't very effective. What was effective was the FDIC, which insured deposits up to $100,000 and convinced consumers that it didn't matter if their bank was screwed, because their money was safe either way.

Sharply regulating leverage would do something similar. It wouldn't mean that investments stop going bust and banks stopped making bad decisions, but it would mean it mattered less when they did. When Lehman went bust, they were leveraged at 44:1. That meant their investments were 44,000 percent more important to the economy than they'd have been in the absence of any leverage at all, and all of that money was coming from elsewhere, which meant Lehman could make other firms go bust, too. But since no one knew which other firms would go bust, professional investors began taking their money out of the system as a whole.

What you want to do is interrupt that dynamic. That could mean insuring the loans that professional investors make to other investors, as Gary Gorton has suggested. It could mean putting such sharp limits on leverage that the failure of one banks doesn't have the potential to take out five others. But this is really the game. Making Wall Street work better is fine, but making it less dangerous is necessary.

By Ezra Klein  |  January 6, 2010; 9:18 AM ET
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Leverage of 44:1 = 44,000 percent? Seriously?

Posted by: retr2327 | January 6, 2010 4:52 PM | Report abuse

even the correct "4,300 percent" isn't really good usage I think. I'd prefer "44 times as"

About regulating leverage, or capital requirements, or capital reserves...the regulator need a specific broad authority to interpret the amount a leverage in a derivative. Any derivative can potentially be a form of leverage, etc. So the language has to be broad or it will simply be side stepped.

Posted by: HalHorvath | January 6, 2010 4:59 PM | Report abuse

Sharply regulating consumer leverage on home loans would have made a big difference too. It's one of the few places where you can make a fairly large leveraged bet as a retail investor, since the collateral is right there. On the other hand...FHA is still giving out 3.5% loans and you and I are gifting $8000 to first time buyers. Too much leverage.

Posted by: staticvars | January 6, 2010 5:22 PM | Report abuse

FDIC insurance *by* *itself* only trades one problem for another. Bank insurance gives customers an incentive to look for banks paying higher interest, even if this done by making highly risky, highly profitable loans. If the loan defaults, the government covers the losses; if it doesn't the bank (and the customer) get the profits. See the 1980's S&L debacle or (only slightly different) the problems with Wall Street's "too-big-to-fail" firms. What makes FDIC insurance work is that there is also *bank* *regulation*, which makes it hard or impossible for a bank to indulge in such highly risky loans.

Leverage, like many other things, is good in moderation, but can be overdone. Like the ban on buying stocks "on margin", one can imagine sensible regulations that control this without handicapping the financial system.

Posted by: adonsig | January 6, 2010 6:26 PM | Report abuse

There were no major market-destabilizing bubbles from the 1950's through the early 1980s. Yes, there were some smaller bubbles and overheated segments of the economy ("one word. Plastics."), but you simply didn't see the kind of insane "ohmigod we have all this cash what can we invest it in to make our quarterlies????" panic that has characterized US investment activity since the mid-1990s.

Leverage is part of a larger systemic problem: too much money is going to the top tier, which means too much money is going into private investments. Leverage exacerbates this fundamental problem, but we won't have a healthy economy until people start buying houses because they want a house and they earn enough money for a house, as opposed to buying a house because there is virtually unlimited capital for them to do so due to a dysfunctional private capital allocation market.

In broad strokes, our economy's fundamental weakness is that it allocates too much money to Wall Street for private investment and too little for consumption and too little for public investment.

Shrinking leverage will help with that bubble problem. But it will not solve it. And frankly, well-paid bookkeepers have a way of getting around limits on leverage.

Posted by: theorajones1 | January 7, 2010 9:44 AM | Report abuse

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