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:
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:
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."
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
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:
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.
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:
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
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
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:
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:
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?"
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.
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
"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 ...
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
The head of the World Bank also says:
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
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
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
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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