The Solution – Limit Leverage!

My friend Eric emailed me regarding my post “Skin in the Game,” noting that I made some good points, but asked me what my solution would be. He suggested limiting leverage, which I agree with completely, and I realized that the Bernanke quote I liked so much from yesterday’s post is illustrative of exactly this concept.

“October 15th, 2007 – Bernanke: “It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.”

See, the problem isn’t that investors buy MBS and lose their money. The problem is that investors can put up $100MM in capital and buy $3B of MBS with someone else’s money – that’s called leverage, and that 30-1 ratio was not at all uncommon. The Fed’s role should be to prevent systematic risk – in other words, it doesn’t matter if you lose all your money, but there should be regulations to make it so that you cannot put the financial system at risk. Examples of things that put the financial system at risk, in case you’re unaware, are described by the Top Gun quote: “Your mouth’s writing checks your body can’t cash,” aka, the AIG problem – selling insurance (credit default swaps) you can’t make good on.

Allowable leverage ratios can and should be different for assets with different risk profiles: if you have 30-1 leverage, a decline of roughly 3% would wipe out all your capital, so you’d better be buying very safe assets. But herein lies the rub: you may have heard of LTCM – a hedge fund that blew up about 10 years ago. The problem was that LTCM, and the banks they dealt with, thought that the trades LTCM was making were very safe – and allowed LTCM to amass massive positions with minimal capital – they had leverage of up to 100 times. This meant that if LTCM put up $10Billion in capital, they could control $1Trillion in assets. At this ratio, all it takes is a 1% decline in the value of LTCM’s positions for them to get wiped out.

Well, the recent crisis was similar – investors were massively levered in AAA rated, “safe” mortgage backed securities, which turned out to be not safe at all. Interestingly, this time there was no big hedge fund like LTCM that threatened the health of the financial system by levering up and risking the capital of a number of banks – the problem we saw was that banks did this themselves – they figured instead of earning small returns, they could lever up and earn bigger, still “safe” returns by buying these new products like CDO’s and MBS.

So as we can see there are two problems – the leverage allowed, and the misjudging of the safety of the assets. Since we’ve proven again and again that we (“we” being everyone) cannot accurately assess the risk of severe downturns in asset prices, the solution should be to limit leverage across the board.

I want to address two similar comments that I’ve had from two different people regarding my analogy in the “Skin in the Game” post where I asked, rhetorically, why underwriters aren’t being asked to hold 5% of equity offerings or corporate bond offerings.

The problem with IPOs as an analogy is that an IPO represents one security, which the buyer has a reasonable chance to analyze thoroughly. With an MBS package, the buyer has no chance to analyze the quality of the multitude of underlying mortgages. “

If I’m buying a share of a mortgage-backed security, I can’t get info about the people whose mortgages I own pieces of. I *have* to trust the middleman, because that’s who (hopefully) met these people, that’s who read their tax forms, that’s who got their credit reports. If I can’t check on that info myself, then there is a higher burden, both on the original lender, and on the rating agency.

This attitude is perfectly illustrative of why we’re in this mess. The answer is simple: if you cannot value the security, you should not buy it. You don’t “trust the middleman,” – you buy something else.


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