Excessive Leverage Helped Cause the Great Depression and the Current Crisis … And Government Responds by Encouraging MORE Leverage
It is well known that excessive leverage was one of the primary causes of the Great Depression. Specifically, many people bought stocks on margin, and when stock prices dropped, they were wiped out and their lenders got hit hard.
Banks also used leverage in the Roaring Twenties, but things have only gotten worse since then. As David Miles – Monetary Policy Committee Member of the Bank of England – noted this week:
Between 1880 and 1960 bank leverage was – on average – about half the level of recent decades. Bank leverage has been on an upwards trend for 100 years; the average growth of the economy has shown no obvious trend.
Indeed, as the New York Sun pointed out in 2008, the former director of the SEC’s trading and markets division blamed repeal of leverage rules as the cause of the Great Recession:
The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.
The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC’s trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.
“They constructed a mechanism that simply didn’t work,” Mr. Pickard said. “The proof is in the pudding — three of the five broker-dealers have blown up.”
The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets’ market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.
The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.
Many economists recognize the danger of excessive leverage. For example, on April 18th, Anat R. Admati – Professor of Finance and Economics at the Graduate School of Business at Stanford University – wrote:
Housing policies alone, however, would not have led to the near insolvency of many banks and to the credit-market freeze. The key to these effects was the excessive leverage that pervaded, and continues to pervade, the financial industry. The [Financial Crisis Inquiry Commission] reports mention this, but they fail to point out how government policies created incentives for leverage, and how the government failed to control it before and during the crisis. Excessive leverage is a source of great fragility. It increases the chances that an institution goes into distress, which interferes with credit provision. And, particularly in the presence of any guarantees, high leverage encourages excessive risk taking.
We must focus on developing a healthier system with better incentives, being mindful of unavoidable frictions and constraints. Addressing excessive leverage and controlling the ability to use growth and risk to take advantage of guarantees should be the first and most critical step.
As I noted in 2009, top Federal Reserve officials have said the same thing – that excessive leverage destabilizes the economy – while actually doing everything in their power to encourage more leverage:
The New York Federal published a report in July entitled “The Shadow Banking System: Implications for Financial Regulation”.
One of the main conclusions of the report is that leverage undermines financial stability:
Securitization was intended as a way to transfer credit risk to those better able to absorb losses, but instead it increased the fragility of the entire financial system by allowing banks and other intermediaries to “leverage up” by buying one another’s securities. In the new, post-crisis financial system, the role of securitization will likely be held in check by more stringent financial regulation and by the recognition that it is important to prevent excessive leverage and maturity mismatch, both of which can undermine financial stability.
And as a former economist at the New York Fed, Richard Alford, writes today:
On Friday, William Dudley, President of FRBNY, gave an excellent presentation on the financial crisis. The speech was a logically-structured, tightly-reasoned, and succinct retrospective of the crisis. It took one step back from the details and proved a very useful financial sector-wide perspective. The speech should be read by everyone with an interest in the crisis. It highlights the often overlooked role of leverage and maturity mismatches even as its stated purpose was examining the role of liquidity.
While most analysts attributed the crisis to either specific instruments, or elements of the de-regulation, or policy action, Dudley correctly identified the causes of the crisis as the excessive use of leverage and maturity mismatches embedded in financial activities carried out off the balance sheets of the traditional banking system. The body of the speech opens with: “..this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.”
In fact, every independent economist has said that too much leverage was one of the main causes of the current economic crisis.
Federal Reserve Bank of San Francisco President Janet Yellen said today it’s “far from clear” whether the Fed should use interest rates to stem a surge in financial leverage, and urged further research into the issue.“Higher rates than called for based on purely macroeconomic conditions may help forestall a potentially damaging buildup of leverage and an asset-price boom,” Yellen said in the text of a speech today in Hong Kong.
And on September 24th, Congressman Keith Ellison wrote a letter to Bernanke and Geithner stating:
As you know, excessive leverage was a key component of the financial crisis. Investment banks leveraged their balance sheets to stratospheric levels by using short-term wholesale financing (like repurchase agreements and commercial paper). Meanwhile, some entities regulated as bank holding companies (BHCs) used off-balance-sheet entities to warehouse risky assets, thereby evading their regulatory capital requirements. These entities’ reliance on short-term debt to fund the purchase of oftentimes illiquid and risky assets made them susceptible to a classic bank panic. The key difference was that this panic wasn’t a run on deposits by scared individuals, but a run on collateral by sophisticated counterparties.
The Treasury highlights this very problem in its policy statement before the recent summit of G-20 finance ministers in London. To address this problem, the Treasury advocates stronger capital and liquidity standards for banking firms, including “a simple, non-risk-based leverage constraint.” The U.S. is one of only a few countries that already has leverage requirements for banks. Leverage requirements supplement risk-based capital requirements that federal banking regulators have in place pursuant to the Basel II Accord, an international capital agreement. While important features of our system of financial regulation, leverage requirements only apply to banks and bank holding companies and therefore have not covered a wide array of financial institutions, including many that are systemically important. Moreover, leverage requirements have generally not captured the considerable risks associated with off-balance-sheet activities …
On November 13th, Bernanke responded to Ellison (I received a copy of the letter from a Congressional source):
The Board’s authority and flexibility in establishing capital requirements, including leverage requirements, have been key to the Board’s ability to require additional capital where needed based on a banking organization’s risk profile.
We note that in other contexts, statutorily prescribed minimum leverage ratios have not necessarily served prudential regulators of financial institutions well.
The current authority and flexibility the Board has to establish and modify leverage ratios as a banking organization regulator is very important to the successful participation of the Board in the process of establishing and calibrating an international leverage ratio.
[In other words ... buzz off. We want flexibility, so that we can allow more leverage.]In reality, the Fed has been one the biggest enablers for increased leverage. As anyone who has looked at Bernanke and Geithner’s actions will tell you, many of the government’s programs are aimed at trying to re-start securitization and the “shadow banking system”, and to prop up asset prices for highly-leveraged financial products.
Indeed, Bernanke said in February:
In an effort to restart securitization markets to support the extension of credit to consumers and small businesses, we joined with the Treasury to announce the Term Asset-Backed Securities Loan Facility (TALF).
And he said it again in September:
The Term Asset-Backed Securities Loan Facility, or TALF … has helped restart the securitization markets for various types of consumer and small business credit. Securitization markets are an important source of credit, and their virtual shutdown during the crisis has reduced credit availability for many borrowers.
The Fed talking about reducing leverage is like a crack cocaine dealer handing out “just say no” stickers.Indeed, the central bankers’ central banker – BIS – has itself slammed the Fed:
In a pointed attack on the US Federal Reserve, [BIS and its chief economist William White] said central banks would not find it easy to “clean up” once property bubbles have burst…
Nor does it exonerate the watchdogs. “How could such a huge shadow banking system emerge without provoking clear statements of official concern?”
“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low,” [White] said.
The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning…
“Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.
“To deny this through the use of gimmicks and palliatives will only make things worse in the end,” he said.
As Spiegel wrote in July of this year:
[BIS] observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market …In January 2005, the BIS’s Committee on the Global Financial System sounded the alarm once again, noting that the risks associated with structured financial products were not being “fully appreciated by market participants.” Extreme market events, the experts argued, could “have unanticipated systemic consequences”.
The head of the World Bank also says:
Central banks [including the Fed] failed to address risks building in the new economy. They seemingly mastered product price inflation in the 1980s, but most decided that asset price bubbles were difficult to identify and to restrain with monetary policy. They argued that damage to the ‘real economy’ of jobs, production, savings, and consumption could be contained once bubbles burst, through aggressive easing of interest rates. They turned out to be wrong.
(Large amounts of leverage increase bubbles, and so the two concepts are highly interconnected.)
Remember also that Greenspan acted as one of the main supporters of derivatives (including credit default swaps) between the late 1990′s and the present (and see this). Greenspan was also one of the main cheerleaders for subprime loans (and see this). Both increased leverage, especially since the shadow banking system – CDOs, CDSs, etc. – were largely stacked on top of the subprime mortgages.
In fact, as I’ve repeatedly pointed out, Bernanke (like [all of the government economic leaders]), is too wedded to an overly-leveraged, highly-securitized, derivatives-based, bubble-blown financial system. His main strategy, arguably, is to re-lever up the financial system.
As former head BIS economist William White wrote recently, we have to resist the temptation to re-start high levels of leverage and to blow another bubble every time the economy gets in trouble:
Forest fires are judged to be nasty, especially when one’s own house or life is threatened, or when grave harm is being done to tourist attractions. The popular conviction that fires are an unqualified evil reached its zenith after a third of Yellowstone Park in the US was destroyed by fire in 1988. Nevertheless, conventional wisdom among forest managers remains that it is best to let natural forest fires burn themselves out, unless particularly dangerous conditions apply. Burning appears to be part of a natural process of forest rejuvenation. Moreover, intermittent fires burn away the undergrowth that might accumulate and make any eventual fire uncontrollable.
Perhaps modern macroeconomists could learn from the forest managers. For decades, successive economic downturns and even threats of downturns (“pre-emptive easing”) have been met with massive monetary and often fiscal stimuli…
Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the credit-driven expansions that fuel asset bubbles and unsustainable spending patterns. Recent reports from a number of jurisdictions with well-developed financial markets seem to agree that regulatory instruments play an important role in leaning against such phenomena. What is less clear is that central bankers recognise that they might have an even more important role to play. In light of the recent surge in asset prices worldwide, this issue needs urgent attention. Yet another boom-bust cycle could have negative implications, social and political, stretching beyond the sphere of economics.
The Fed may be talking like Smokey the Bear, but it continues to hand out matches trying to increase leverage.
Indeed, as I pointed out last year:
On February 10th, Ben Bernanke proposed the elimination of all reserve requirements:
The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
If reserve requirements are eliminated, or even significantly reduced, banks could hypothetically loan out hundreds of times their reserves, subjecting them – and the entire economy – to gargantuan risks.
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