Saturday, April 30, 2011
Deja Vu all over again...
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.