Too Much Leverage Precedes Many Disasters

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David Merkel submits:

There seems to be some confusion over what threatened to cause major banks to fail. Let me go over my list of the risks:

  • Many relied on AIG ( AIG ) to insure their subprime and other structured lending risks. Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, "Sell away to the brain-dead." After it has gone on for a long time, a sea change hits, where they think - oh no, we're the patsies - the industry now relies on the solvency of AIG! Alas for risk control, and the illusion of the strength of companies merely because they are big.
  • As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones. Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets. When the tide goes out - oh well, GE Capital might not have survived without the TLGP program. Another reason why I sold all my GE Capital debt when I was a bond manager. Big companies can make big mistakes. Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
  • Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime. Underwriting standards slipped everywhere.
  • Commercial mortgage lending hasn't yet left its marks - there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
  • In general, banks ran with leverage ratios that were too high. Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc. Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
  • The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004. The only bank to not lever up was Goldman ( GS ); Morgan Stanley ( MS ) did it only a little bit. Guess who survived?
  • The Fed encouraged risk-taking by the banks by not allowing recessions to damage them. They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
  • Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
  • Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
  • State and local governments came to depend on increased taxes off of inflated asset values.

What I don't see is problems from private equity or proprietary trading. These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more. By this, I mean real common equity, not hybrid equity-debt financing vehicles.


I believe that bank risk-based capital structures need to be strengthened. I don't care if it means that lending diminishes for a few years. Far better that we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into. (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains. In the long run, what makes economic sense will prevail, not what scores political points.

See also Wall Street Hearts Fannie and Freddie on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: AIG , GS , MS

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