Too Much Leverage Precedes Many Disasters

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 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; Morgan Stanley 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.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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