Lowering The Boom On Financial Leverage

This guest post is by David Moss, the John G. McLean Professor at Harvard Business School and the founder of the Tobin Project.  (See his previous guest post here.)

The struggle for financial regulatory reform in Washington will fail if the debate continues to focus mainly on the bookends of the crisis – the original subprime shock and the eventual federal bailout.  Although both were very serious problems, even more serious was the near collapse of the American financial system that came in between. 

A healthy financial system would have been able to absorb the subprime shock, like a well-conditioned fighter who’s able to take a punch and remain standing.  But our financial system, wildly overleveraged, crumpled after just one blow.  If we don’t fix the leverage problem, everything else will be for naught.  

Over the past several decades, rising debt levels characterized just about every part of the American economy.  But total debt outstanding rose particularly fast in the financial sector, surging from $578 billion (21% of GDP) in 1980 to $17 trillion (118% of GDP) in 2008.  In the years leading up to the crash, moreover, financial firms increased their leverage to dizzying heights, piling ever more debt on a dangerously thin foundation of capital.  Among domestic investment banks, gross leverage ratios grew from about 23-to-1 in the first quarter of 2001 to over 30-to-1 in the fourth quarter of 2007.  And that’s just what was visible on their balance sheets.  Off-balance-leverage rose dramatically higher, with contingent liabilities (including AIG’s notorious credit default swaps) inflating hidden leverage to truly extraordinary levels.

Greatly compounding the problem was that much of this leverage was based on very short-term debt, creating the potential for bank runs if confidence ebbed.  Much of the leverage was also concentrated at firms that had grown spectacularly in a short time.  Bear Stearns, for example, had grown its assets more than 10-fold from 1990 to 2007. 

Unfortunately, it was the biggest (and most highly leveraged) financial institutions that played the greatest role not only in inflating the bubble on the way up but also in driving the panic on the way down.  As asset prices started to fall as a result of the subprime mess, many of these super-sized financial firms had no choice but to sell – and sell massively – to keep their already thin capital base from vanishing altogether. 

Had the large financial firms been better capitalized to begin with, the catastrophic fire sales that brutalized the markets in 2008 could well have been avoided, or at least kept to a minimum.  But in companies that were so highly leveraged, even small losses on their overall portfolios could wipe out their capital – a prospect that left them no choice but to intensify their selling as the subprime turmoil deepened.  Indeed, had the terrifying downward spiral not been stabilized through aggressive federal action, the nation’s financial system might have collapsed altogether, greatly worsening the recession and driving unemployment even higher – and perhaps far higher – than what we’ve experienced so far.

What will it take to prevent such a calamity from ever happening again?  We should certainly address the bookends of the crisis: common-sense regulation of consumer and mortgage lending would help to prevent another subprime fiasco; and the creation of new tools for dealing with major financial firms that fall into distress could reduce the need for another bailout.  These are critical steps.  But by far the most important thing we can do is make our financial system strong enough to withstand a significant shock, and that means limiting leverage, particularly at the nation’s largest financial firms.

Fortunately, the House bill passed in December already contains language capping the leverage of “systemically significant” financial institutions at no more than 15-to-1.  (Full disclosure: I suggested the provision, and worked with Representative Jackie Speier who shares my concern about leverage and sponsored the relevant amendment in committee.)  It is now imperative that the Senate adopt this provision, or even tighten it, perhaps taking the limit down to 10-to-1.  

Congress should also impose strict limits on these firms’ short-term borrowing and off-balance-sheet activity, and require them to maintain sufficient liquidity as well.  Combined with a tough leverage cap, such rules will help ensure that an unexpected shock – whether from the mortgage sector or someplace else – will never again threaten to bring down the broader financial system and inflict so much pain on the America people.

For those who worry that limiting leverage is somehow inconsistent with American tradition, it is worth remembering that the nation’s founders strictly limited bank leverage in their own time, frequently at less than 4-to-1.  Although bank runs remained a problem in early America because of the absence of deposit insurance, the dangers of high leverage were already well appreciated.  Let’s not lose sight of that wisdom now.

36 responses to “Lowering The Boom On Financial Leverage

  1. Took a quick look at The Doomsday Cycle.

    This should give Per Kurowski a sense of vindication:

    “That has been the path of successive Basel committees, which are now designing comprehensive new rules to ensure greater liquidity at banks and to
    close past loopholes that permitted banks to reduce their core capital. We both worked for many years in formerly communist countries, and this project reminds us of central planners’ attempts to rescue their systems with additional regulations until it became all too apparent that collapse was imminent.”

    This won’t:

    “If we triple core capital at major banks to 15-25% of
    assets, and err on the side of requiring too much capital for derivatives and other complicated financial structures, we will create a much safer system with less scope for ‘gaming’ the rules.”

  2. apologies … above comment should have been posted at another story

  3. To me currently the whole thing boils down to investors slowly grasping that their states are NOT going to ever repay the debt they bought in bonds and therefore will ever more look to invest “close to maturity” only. That curtails all big states’ ability to ever again stage a bailout of considerable proportions, i.e. everyone knows it is just up to the central banks to create that next moneyfrom thin air.That exacerbates the problem as this dilutes the value of any asset in the respective currencyeven further. So stateswill not be able to refinance current debt, but equally cannot rely on an ever-shrinking tax base. Investors getting wise to that will not invest in public debt and that’s the end of it.

  4. I believe the founding fathers had it right. 10-1 leverage is still waaaay too high when you consider the speed at which things can unravel these days. I believe 4-1 is even too high. In fact, I believe 3-1 is pushing it.

    If we tighten leverage to 2-1 (the same leverage that consumers are entitled to in a basic brokerage account) and bring all derivatives onto exchanges then we will have basically eliminated the potential for systemic risk.

  5. Do you beleive it to be feasible to implement such a suggestion without pushing banks to go on a complete regulatory arbitrage frenzy?

  6. “…states are NOT going to ever repay the debt they bought in bonds.”

    Long term bond yields are stable at around their historical average, hardly an indication that default or hyperinflation is around the corner:

    http://finance.yahoo.com/q/bc?s=^TNX&t=my&l=on&z=m&q=l&c=

    “…everyone knows it is just up to the central banks to create that next money from thin air. That exacerbates the problem as this dilutes the value of any asset in the respective currency even further.”

    This is not an accurate description of the Federal Reserve’s current unorthodox monetary policy commonly referred to as quantitative easing. Quantitative easing does not involve the creation of new “money,” it is only a swap of one asset class (bonds and other types of long term securities) for another (currency). The purpose of quantitative easing is to spur investment by flattening the tail end of the yield curve. However, it is very unlikely that quantitative easing will succeed in spurring investment because it operates under the mistaken assumption that banks are reserve constrained. They are not. Banks do not “loan out,” their reserves. In fact, it is just the opposite; loans create new deposits. What banks are currently lacking are credit-worthy customers to provide investment opportunities. All of the extra liquidity Chairman Bernake has provided our nation’s largest banks has just been sitting on their balance sheets and will continue to do so until aggregate demand returns to its pre-crisis levels. Right now the U.S. economy needs an injection of new money to cushion the collapse in aggregate demand. In our current deflationary environment it is highly unlikely such an injection will cause inflationary pressure. The ten year bond rates, TIPS spreads, and recent announcement of negative core-inflation rates are evidence of this. Unfortunately, quantitative easing will not lead to the creation of new money so it seems we are doomed to repeat the same mistakes Japan made in the 1990′s.

    “So states will not be able to refinance current debt, but equally cannot rely on an ever-shrinking tax base.”

    Taxes do not “finance,” current debt or any other type of spending. The purpose of taxation is to reduce the purchasing power of the non-public sector and hence dampen aggregate demand. Spending is a separate and independent process from taxing. In fact, if the federal government did not spend first the private sector would not have money to pay its tax obligations. Spending comes first, taxation is an afterthought.

  7. “Indeed, had the terrifying downward spiral not been stabilized through aggressive federal action, the nation’s financial system might have collapsed altogether, greatly worsening the recession and driving unemployment even higher – and perhaps far higher – than what we’ve experienced so far”
    —————-

    Liar and fear monger. Go back to Harvard professor, where the elites gladly pay you for your BS

  8. Umm … you do realize the lower the leverage, the more you have to pay for banking, right? “Utility” banks can get away with a lower return on equity than “exciting” ones, but they still have to earn a return.

    What is the rate of return that would induce you personally to invest in a bank? Take that rate, divide by the leverage, add a charge to cover the cost of doing business (that will be higher if banks are broken into smaller pieces) and defaults (if all of the bank’s customers pay back their loans, the bank isn’t lending enough.) The result is the spread between what the bank will pay you to borrow from you and what it will charge you to lend to you. At 3:1 leverage you can look forward to paying over 8%.

  9. Professor McLean,

    Thank you for your efforts to document and address the dangers of excessive leverage in the financial sector. I think you will find much of the Baseline Scenario community in agreement with your recommendation to mandate higher capital requirements for our largest banks. While I agree that reducing the gross leverage ratios of large firms has the potential to significantly mitigate systematic risk in the financial sector, I fear it does not do enough to address the root cause of the private sector’s growing dependence on credit to finance basic expenditures. Your colleague Elizabeth Warren is justly well-regarded for her tireless efforts in bringing to light how insufficient and inefficient government investment in infrastructure and human capital has resulted in the hallowing out of the once formidable United States middle class. Stagnating wages and relentless increases in the cost of non-discretionary expenses (health care, education, rent, healthy food, etc…) has forced middle class households to increasingly rely on debt to maintain their standard of living. This process accelerated under the presidency of George W. Bush, but it has its origins in President Clinton’s attempts to balance the budget. For some reason few seem to be able to make the connection between efforts to balance the federal budget and the increasing debt load of the private sector. It is important to realize that the relentless pursuit of balanced budgets has come at the expense of needed investments in the infrastructure and human capital necessary to support a dynamic twenty-first century economy. Until the public sector stops squeezing the private sector of liquidity and squandering its funds on largely unproductive investments (the military budget is the most obvious example of unproductive mal-investment, but large parts of the health care, education, and energy/transportation budgets are also spent rather unwisely) dangerous levels of leverage will remain the prevailing norm in the United States, herculean efforts at financial reform notwithstanding.

  10. Precisely why we have to first break the power of the largest banks to control the money supply. A regular commentator on this website, StatsGuy, has repeatedly made the point that if we go forward with regulatory reform without first increasing the money supply it will be like jumping off a bridge with a noose around our neck. mv = pq; any decrease in v has to be offset by an increase in m, otherwise we are bound to fail.

  11. A very good summary of Modern Monetary Theory which boils down to so much hocus pocus and leaves everyone but the giant monopoly capital predators at the mercy of the corporate nannay state, because only the giant monopoly predators are indeed credit worthy, as anyone who has fancied himself an individualist entrepreneur will soon be finding out if he has not found out already.

    To say that QE does not involve printing money when it involves exchanging worthless mortgage drek for reserves on which the Fed pays a higher rate of interest than anything obtainable from any activity other than overnight hedge fund lending is indeed a marvel of newspeak.

    Taxes do not finance anything but the rape of those individuals, increasingly few and far between, who manage to earn a surplus over the cost of survival and debt service.

    Shame on you NKlein1553 for propagating this rubbish.

  12. Nklein,

    The whole charade started with John Foster Dulles, who conceived the cold war as a lever to pry away the wage gains of unionism and return them to the financial class through the military industrial complex of which Eisenhower warned us, although the warning came a little late. Dulles ushered into the permanent war economy, which has continued pretty much uninteruptedly since 1950. While our highways and bridges and tunnels and cities have degraded to the point of collapse, our military enjoys an enviable array of impressive toys and weapons which will probably come in handy when civil disobediance again becomes a serious problem as it did briefly in the late sixties and early seventies. Don’t expect much help from the Harvard Business School, or the Harvard Law School either. Both have been and continue to be prime enablers of the Washington Consensus which has gotten us where we are. Little teeny weenie restrictions on leverage will do as much good as drawing a mustache on Bernanke.

  13. Some very interesting aspects of leverage applied to any one nation are silently passed over. That $17 trillion of debt is ultimately, first of all, based on the stored wealth of living persons. Secondly, the total debt is horribly hypothecated a number of times. That is the debt of A and B, is sold again as a package of debt based on AB, which is sold again as the debt of AB’ and so forth.

    The total US debt in 1980 was hypothecated too but on a very minor scale compared to the present era of securitization.

    The other complication is the extent that increased borrowings are sourced from outside the US. What is the percentage owned by foreign living savers? For example, the US might have only borrowed from American’s. That policy would naturally have damped down or prevented the gross debt bubble that Professor Moss discusses.

    The poison to the overindulged child here was globalism.

    Someone’s debt is another person’s asset. Thus, much of the debt actually functions as money supply in the real world. If the total debt were massively paid off, money supply would decrease. After all, when I pay off a loan, the money get’s lent to someone else. Paying off government debt would be a disaster even if it were possible.

    Debt bubbles kill. Then, just what is a bubble but the carelessness arising from lack of lending prudence? Everyone hated the stingy banker. Now they hate the profligate banker turned grifter for fees.

  14. Jake, when I say QE does not involve “printing money,” all I mean is that QE will not result in a significant amount of new money entering the economy. The fact that the largest banks have kept their newly found liquidity on their balance sheets seems to bear this out. Therefore, I do not see how QE will directly lead to hyper-inflation, as the term “printing money,” seems to imply. This should not be taken as an endorsement of QE in any way. In fact, like you I believe bailing out the financial sector in the manner the Bush and Obama administrations has done is a shameful and ineffective use of our nation’s resources. However, that does not stop me from being able to accurately describe what QE is and what it entails. Likewise, my description of spending and taxation should not be taken as an endorsement for any particular level of government involvement in the economy. Taxation is clearly a separate and independent process from spending. With the exception of some portion of FICA the money the government collects through taxation does not go anywhere. However much you might want it to, the government does not save for a rainy day like a private household does. If you could pay the IRS in cash, the IRS would thank you for your payment and then promptly proceed to throw your money into a shredder. However, this does not mean the government should spend as much as it wants whenever it wants. Clearly spending beyond the domestic economy’s capacity to produce real goods and services can lead to inflation. But with the amount of under-utilization of resources in the economy now I do not see inflation as a credible threat. I also strongly believe that how the government spends any newly created money is of vital importance. I have in the past on this website argued that it is important to distinguish between TARP spending and Stimulus spending. The former I consider to be mostly wasted, while I was by and large happy with the latter (with a few exceptions). However, I admit that it is possible I am wrong about the capacity of out economy to absorb additional government spending and would be happy to see hear the reasons why you think inflation is just around the corner. What I’m less interested in is emotional attacks that assume things about my ideological preferences which are not in fact true. Contrary to what you seem to think, I prefer a small government that undertakes basic functions (like managing the money supply) the private sector is manifestly unable to perform.

  15. Great factoids. Can you please post the sources for the information i.e. 17 trillion and the 4:1 founding leverage restriction?

  16. Non leveraged banking has existed, and was practiced for millennia.

    The present highly leveraged private banking makes bankers into those who truly create money, historically, a regalian function. Second only to creating an army.

    There are then two ways to look at this; either, and it’s the present point of view, the bankers are kings.

    Or, and more correctly, bankers are civil servants. Corrupt, very corrupt civil servants, but still civil servants.

    Simply nobody noticed that, that bankers are servants, because bankers have distributed enough money around for nobody to notice. Modern banking is thus equivalent to the system of “tax farming” that existed in France under the Old Regime. What we have here is money farming. And those farmers are all powerful, as the fermiers generaux used to be in Old France. It is exactly the same thing, just more outrageous now. The fermiers generaux were guillotined during the Revolution. (Including the founder of chemistry, Lavoisier discoverer and creator, among other things, of the gas and name: oxygen.)

    PA

  17. Clearly, slowly lowering the level of debt (both financial and non-financial) relative to GDP is an imperative. And eventually achieving some sustainable level (to be established so get cracking gurus).

    But economists, development gurus and policy makers also need to urgently consider, that given the rapid growth in private debt (relative to GDP) in the last few decades, GDP growth was relatively meager. At least in comparison to the 1950′s through the 1970′s. Without the debt “stimulus”, would there have been any growth?

    So how do we restructure our economy in the future, to achieve growth (sustainable at that) without the debt stimulus? Time to get cracking.

  18. I wrote Professor McClean, but I should have written Professor Moss. My apologies.

  19. The foreign borrowings of the US started out largely as borrowing back consumption dollars of the US sent overseas. This was and is the heart of Petrodollar Recycling. Just think how much less debt would be circulating in the US had we eighties the Us was a net creditor nation.

    Petrodollar recycling was the perfect way to cover US deficits without raising taxes. US refiners send dollars to Saudi to pay for oil imports. Those dollars derive from US domestic purchases of refined products. Saudi Arabia, by agreement, deposits the refiners funds in the US and eventually buys Treasuries. The US sells Treasuries only to cover the shortfall between payouts and tax receipts. Thus, there are no Treasuries for SA to buy if the US never had a deficit.

    What could be more perfect for the military industrial complex and those that otherwise would pay higher taxes than Petrodollar Recycling?

    Debt is cumulative, so a very fair portion of total foreign holdings of US State debt today derived from oil and other essential imports.

    All I am doing here is applying cash flow understandings and principles an accounting clerk uses in keying off accounts receivable payments to the detail of the balance due.

  20. Oops, a small piece of my prior post was truncated.Much less debt would be circulating in the US had we solved our oil import problem in the eighties. Cheap oil has been a disaster in very complex and interdependent ways.

    Anyway, the problem has grown exponentially
    by exporting goods manufacture as we all know.

  21. Well, NKlein1553, there is the problem in a nutshell. When you endorse government spending as a panacea you turn the reins over to Harry Readem (and Weep), Nancy Preposterous, Barney Fumble, et. al. You get high speed trains to Disneyland and leaf raking and census taking and bogus plans for energy independence courtesy of Al Gore, who wants everyone to wipe with one square while he jets around with the latest Kennedy dope addict instructing people how they should live in a world of diminishing resources. Meanwhile, some guy in California seems to have invented a fuel cell with potential (he claims) to eliminate the electrical grid, halve the electrical cost of home ownership for those willing to pony up a $3,000 investment. Whether the thing works or not we will have to see, but notice that it was not developed at the Department of Energy or at GE either.

    The reasons for distrusting government are historic and pervasive and they apply equally to distrusting corporate monopolies and financial oligarchies. It is more important to destroy concentrated power than to produce a handfill of time serving jobs which ultimately will only make people more dependent and functionally useless, spiritless and pathetic.

    Sorry you view this as an emotional attack. I am personally tired of all the respectable arguments for encouraging slavery to an amoral corporate state run by nincompoops and supported by toadying academics.

  22. Good job! Interesting data.
    There is also a very interesting argument of Prof. James Galbraith in a essay in Guardian that the deficit hawks who are now consistently calling for a reduction of of government spending never warned against the danger of excessive private debt. Cause their interest is clear: they profit from private debts.

  23. I believe that the calamity will in fact happen again. Nothing has changed on Wall Street. Or, it has gotten worse. How could they make record profits in the midst of an economic catastrophe? Answer: they are doing more of the same. The next crash will finally produce the overhaul of the financial system that this one should have.

  24. markets.aurelius

    The measure of power on Wall St. is money. The measure of power in Washington is what does not get done — the most powerful people are able to make sure that nothing that disturbs their interests is enacted.

    It’ll be interesting to see what does not get done. We’ve gone almost 2 years and nothing’s been done at all to rectify the situation. That’s power.

  25. The 4:1 leverage restriction was historically a statutory asset holding requirement put in place by the states. For much of US history , banks were state chartered. Many states required banks to hold 25 % of deposits as specie, Notes or Treasuries in the vault. ( A century ago there were eight kinds of notes and specie. I saw bank notes circulating as a kid.) The requirement was lowered to 10 % for much of the 20th century for both state and federally chartered banks.

    The states in the 19th century were very stringent about reserve asset holdings . That led to the Trust Company which was not a bank and could hold no reserve assets if it wished. The Panic of 1907 wrote finis to trust companies which were forced to become legal banks.

    Later on the trust company notion was cleverly put back in play by the money market fund. In the fall of 2008, the MMF blew up just as the Trust Companies did a century earlier.

    States also rigidly controlled permanent capital of a bank. It is a no brainer that bank owners were at risk for losses first but were buffered by the reserve asset requirement. Banks in the 19th century could be private banks like Brown Brothers. That is partnerships. Either way the bank owners were subjected to capital calls or assessments on the stock of the bank they owned.

    If you could never loan out more than 75 % of your deposits , you also practically limited leverage of permanent capital and retained ” surplus” earnings. Then, private banks also were backed by all shareholder assets. Chartered banks had limits on total capital calls from shareholders.

    In Jefferson’s day most if not all banks were private banks with unlimited claims on the assets of the banker/ partner. The banker was the partner in the bank. An employee could not be a banker. Employees were clerks.

  26. There are two ways to spend more money now than you receive in income, thereby magnifying your growth – for a while.

    The first is to spend money you have saved in the past. This magnifies twice, because in addition to spending more than you currently earn, you also are spending all that you earn, as contrasted with the prior period of saving when you spent less than you earned. The results feel quite good. The U.S. non-public sector experienced this from 1945-1968, as it was spending down its savings that had been accumulated between 1930-1945.

    The second is to borrow money to spend. At this point, no explanation is required of this process. These results also feel quite good. The U.S. non-public sector experienced this from 1982-2008.

    One common denominator of both paradigms is a period of high growth, low inflation, and low interest rates – that’s why it feels so good. The other common denominator is the temporary nature of the cycle. You can’t spend down your prior savings indefinitely, and you can’t borrow indefinitely. In the U.S. the period 1968-1982 (low growth, high inflation, high interest rates) was the adjustment period from the “spend the savings binge”, and the period 2008-? will be the adjustment period from the “borrow and spend” binge.

  27. It seems crazy that people are allowed to sell mortgages. sorry this seems basic and people take that for granted, but that seems like the most BASIC level of accountability is lost! If you don’t hold the mortgage, you have little incentive to make sure it’s a good loan.

    Let’s just ban selling mortgages.

    Whatever on this leverage stuff… just don’t let people re-sell loans they originate. I’m sure credit is much tighter, but we could use some rigor here!

  28. Of course you need to deleverage banks… that is once you start moving out of the crisis…. to do it now is to be pro-cyclical in the midst of a crisis… something that only fanatic new born Puritans could be asking for.

    But even more important than deleveraging, is to stop discriminating the capital requirements for different types of bank assets based on perceived risks, because it was the discrimination that created the largest confusions in the market and caused the crisis.

    And you still have discrimination! A bank lending to the government needs zero capital!

  29. Keep things simple…anything more than 10 to 1 leverage is asking for future trouble.

  30. I am not a financial genius, but it seems to me that the entire reason for the development of ever more complex derivatives is to make leverage very difficult, if not impossible, to discover or police. The complexity of these is a mathematical model developed by geniuses on computer modeling, and, in and of themselves these devices seem almost completely toxic, except as hedges against perceived leverage failures. The problem, as with all obfiscatory practices, is that these instruments expose the general economy to potential losses. I have heard that the value os all derivatives may be as high as $600 trillion dollars. Our lax regulatory system and laws has permitted this to happen. Its no wonder that the financial oligarchs are fighting so hard to keep their system in place. Even if leverage is limited to 20 to 1, it would seem that it might take years, if not decades for the megabanks to bring their portfolios into compliance, although I must say it would do my heart good to know that if such an anti-leverage regulation is strictly enforced, the bonus grabbing executives in the megabanks may be going without their multimillions for decades. You can believe that with the Supremes opting to give them unlimited access to campaigning for their favorite elected (and therefore by extension, appointed) officials, their war coffers are running over with millions (or even billions) to fund aggressive campaign advertising. I might even be so bold to predict that they may attempt to buy some of the more major media outlets to control public opinion (currently very much against them).

  31. Aside from the question of the merits of the financial reforms proposed by Professor Moss, there is the question of their political feasibility: Given the political composition of the Congress and Obama Administration, what is the likelihood that Moss’s proposals will be realized? –Moss expends not one word on this issue.

    I might urge, with the Pope, that everybody be nice, soon; but nobody would take me seriously, just as nobody takes the Pope seriously, since the question of political feasibility is not even raised. (This is sometimes called the “agency problem”: Who will accomplish these fine ideas?) Why is this standard not applied to discussion of financial reform?

    When the relevant discipline was called “political economy,” the political dimension of proposals was naturally included in their discussion. We moderns have gotten beyond all that. We are professionals, you see, professors of economics, finance, theology, and so on. And we are paid to keep our specialties untouched by what in the past was quaintly called “civic virtue.”

    If Prof. Moss’s proposal is worth a damn, my bet is that it won’t get past either the cabal of senatorial corruptionists who protect Wall Street from Main Street or the Geithner-Summers-Bernanke team, charged with the same task.

  32. Simple and equal! The same leverage for everything.

    Why on earth should a bank´s relation with those who are perceived as having lower risk of default generate especially favorable low capital requirements? Are those perceived as presenting lower risk of default not already benefitting enough through the lower rates applied to them by the market?

    There is not enough of real risk free AAAs to go around, so do not create especial incentives for the banks to look for those AAAs because, most likely, what they will then find, are fake AAAs.

  33. Keeping leverage low so as to stop the bank executives from appropriating an indecent share of the financial margins is a suicidal revenge when in the midst of a crisis we need the banks to be able to lend.

  34. Jack, you attacked so many quarters with such vehemence that it is simply too difficult to know what your point is.

    Are you saying that government is the problem and that private business should be given free range? Except that you also seem to lambast the influence of private business (at least the large corporations).

    Indeed, the problem is that large corporations have actually had virtually free range over the last couple of decades and the result is precisely the current break down. The government did not force Wall Street to do anything. Under Greenspan and company it was the exact opposite. He even resisted investigating otu and out criminal fraud. If your complaint is de facto government interference (and not government corruption), it seems similar to the “teabag revolution” and equally mystifying. They vehemently complain about what private business has produced and then demand that private business go untouched.

    Or, are saying that there is no problem in the current system (there was never a bubble or meltdown) and government should just stay out of the way? Except that you do seem upset about the current state of things.

    Or, are you saying that only smaller businesses without undue influence should be the base of all economic – and, perhaps, social – answers? But then who will keep them from growing too big?

    Are you saying that any institution is a violation of what is essentially human (something that is implicit, it seems, even if not recognized, in a radical libertarian positions)? But then who will keep institutions from forming?

  35. This post brings to light a very real and serious issue that the country is facing now. Why has the Fed been working overtime on remedying the “bookends of the crisis”, but not giving the same effort on rebuilding the fundamentals of the financial system? I find your entry to be very informative, and your concluding statement also addresses the key issue that the United States generally have, that leveraging expenses has been an American tradition that it has now been used to. The rule of investment says that to enjoy greater returns, more risks, including the risk of bearing debt to finance current capital acquisitions, must be taken. However, I agree with your idea of putting a cap on the amount of leverage that a firm could have. Without limits, companies’ debts could dangerously spiral out of control and bring about negative consequences, just as the current economic crisis has shown. As such, I share your belief that “catastrophic fire sales that brutalized the markets in 2008 could well have been avoided, or at least kept to a minimum”, had the large financial institutions been “better capitalized to begin with.” You have also mentioned that the United States has managed to survive on a leverage cap ratio of 4-to-1 in the past, which is encouraging as it shows that more debt does not necessarily lead to greater success. Since the current cap that the government has imposed is only at a ratio of 15-to-1, do you think it would be wise if a similar 4-to-1 cap be implemented instead? If it has worked in the past, what current events do you think would prevent the same cap to succeed in present conditions?

    I also liked your mentioning of the need to establish “new tools”, aside from bailouts, to deal with major financial firms that fall into “distress.” Personally, I believe that excessive bailouts could become a liability to the recovery of the current economy. Companies like General Motors and Fannie Mae have requested for increased government aid than the Treasury originally assigned. Could it be that these companies are relying too much on the prospect of government bailouts to save them, rather than implementing policies to change wrong business practices that in the past? Nevertheless, I agree with your view that current economic conditions could have been far worse if not for the “aggressive actions” taken by the Fed. But, do you think that the Fed could have done more to ensure that taxpayers’ money are only spent necessarily? Because, according to one of Time’s article, executives have received huge bonuses from the bailout funds, even if they were the ones that had made past decisions that led to the dire economic conditions now.