The perils of leverage

by Martin Hutchinson
September 15, 2008

The investment bank Lehman Brothers (LEH) spent last week teetering towards the sort of bankruptcy which like that of Bear Stearns (BSC), Fannie Mae (FNM) and Freddie Mac (FRE), may require a “bailout” by the long-suffering US taxpayer. All four of these institutions shared a common feature: they had far too much leverage, i.e. they had borrowed far too much money to be compatible with their modest capital bases. Excessive leverage is currently a characteristic of the US economy as a whole, and we are in the process of paying the price for it.

Investment banks traditionally had a leverage limit (total assets to shareholders’ equity) of about 20 to 1. That limit was fudged to a certain extent with subordinated debt, but fudging was limited by investors’ unwillingness to buy subordinated debt of such intrinsically unstable institutions. However, while investment bank assets traditionally consisted of commercial paper, bonds and shares that trade every day and can be valued properly, they have now come to include investment real estate, private equity stakes, hedge fund positions, credit default swaps and other derivatives positions that do not even appear on the balance sheet. Thus even 20 to 1 in modern market conditions is excessive. Adding in subordinated debt, and claiming that say Lehman has an “11% capital ratio” works fine in bull markets, but not when things get tough.

Scaling that 20 to 1 up to 30 to 1, as Lehman had at its November 2007 year-end, is asking for trouble. Even if the off-balance sheet credit default swaps and other derivatives don’t lead to problems, and there are no assets parked in “vehicles” that have to be suddenly taken back on balance sheet, an institution that is 30 to 1 levered needs to see a decline of only 3.3% in the value of its assets before its capital is wiped out. Such a decline can happen frighteningly quickly – it represents only a 10% decline in the value of a third of the assets.

Lehman’s leverage is not exceptional among Wall Street investment banks. At the last quarterly balance sheet date (May or June) while Lehman’s leverage had been brought down to 23.3 times through asset sales, Morgan Stanley’s (MS) was still 30.0 times, Goldman Sachs’s (GS) 24.3 times and Merrill Lynch’s (MER) an astounding 44.1 times (or to be fair, 31.5 times at its December 2007 year-end, before new losses appeared.)

The commercial banks are not as leveraged. At the latest quarter-end, Citigroup (C) was the most leveraged at 15.4 times, JP Morgan Chase (JPM) 13.3 times, Wells Fargo (WFC) 12.4 times, Wachovia (WB) 10.8 times and Bank of America (BAC) 10.5 times. That more modest leverage is the advantage of proper regulation. Even Fannie Mae and Freddie Mac, who benefited from a quasi-state guarantee and were dubiously regulated since they held a stick over their regulator in the form of the Congressional Democrat power structure, had leverage ratios of only 21.5 times and 29.4 times respectively.

It is thus not surprising that investment banks have taken on the life expectancy of second lieutenants on the Western Front. Once Lehman has been taken over or forced into orderly liquidation, the speculative spotlight will probably fall on Merrill Lynch, whose share price fell by 12.6% Friday – indeed with Merrill Lynch’s leverage so much higher than its peers I am surprised that it is still in business.

Beyond determined a l’outrance resistance to the inevitable taxpayer bailouts that will be demanded as the investment banks collapse into rubble, it’s not immediately clear what our reaction to the Gotterdammerung of the US investment banks should be.  On the one hand, the modest service-providers of the 1950s and 1960s, resembling London merchant banks but less aggressive and slightly smaller, have long gone and been replaced by these trading conglomerates whose economic purpose beyond self-enrichment is to say the least unclear. In terms of long term market benefit, the conglomerates will be little loss, probably being replaced by a combination of very conservatively run “too big to fail” institutions and aggressively entrepreneurial risk-taking boutiques, the natural destination for those numerate top graduates of more aggression than cognitive depth.

Nevertheless, the short term turmoil and devastation will be huge; you can’t hold fire-sales of $5 trillion of assets without prices collapsing. We are gradually coming to see more clearly the drivers of the currently impending downturn, likely to last the best part of a decade from its onset last summer; there’s no doubt that the collapse of Wall Street investment banking will be one such driver. What has also become clear is that the problem of excessive leverage is not confined to the investment banks, but operates over the US economy as a whole.

That is not surprising; investment bankers (the good ones) are among the most financially and economically sophisticated of mankind, so if they thought excessive leverage was advantageous, that belief was naturally transmitted to other less exalted and less wealthy beings:

• There was the mortgage salesman who bought several rental properties, on the assumption that his income was assured and negative cash flow from the properties didn’t matter in an environment of rising real estate prices.
• There was the yuppie anxious to impress his friends and attract the opposite sex, who bought a flashy and mechanically unreliable a car on a long-term automobile loan.
• There was the two-income professional couple, who thought that by buying a McMansion the size of Chatsworth, their social status would turn into that of the Duke of Devonshire.
• There was the laid-off manufacturing worker, who thought it didn’t matter that he could find no job paying more than half his old union pay scale, because credit cards would allow his family to live the good life.
• There was the low-skill immigrant, legal or illegal, who found the wages he could earn were totally insufficient to fulfill his dreams of life in the bountiful United States, but thought that through liberal use of credit cards and maybe a subprime mortgage, affluence might be forthcoming
• There was the corporate CEO, who understood that buying back stock in his unexciting company and financing the purchase by junk bonds would increase the value of his stock options, but failed to realize that it made long term corporate survival unlikely to impossible.
• Finally, there was the President of the United States, who thought he could pursue an expensive if unsuccessful foreign policy, allow his Congressional colleagues to be thoroughly sloppy on public spending and introduce new social programs that pleased his wife, all without raising taxes.

One has some sympathy with all of these hard cases, but it should be recognized that together they probably form close to a majority of the country, so the idea of imposing additional taxes on the thrifty minority (or on their children through excessive budget deficits) in order to bail them out is both morally abhorrent and fiscally impossible.

Once we recognize that attitudes to borrowing in the US economy have been pathological for the last decade or more, the true culprit for our coming troubles becomes clear. The Federal Reserve, by expanding the money supply at a 4% faster annual rate than output for the 13 years since 1995, has made borrowing both excessively cheap and excessively easy to obtain. Not surprising therefore that the US savings rate has dropped to less than zero.  Fairly unsurprising also that the epidemic of loose money after 2000 spread to the globe as a whole, so that borrowers in Bangalore and Beijing are today as overleveraged and vulnerable as those in Boston.

This isn’t a failure of capitalism; the Fed isn’t a capitalist institution, and the United States hasn’t had a capitalist financial system since it abandoned the link to gold in 1933.  It is instead a failure of government, which established the Fed without adequate instructions as to its proper policy. In a period when, because of the explosive increase in international communication capability, money supply could be increased excessively without producing an immediate inflationary backlash, the Fed under Alan Greenspan succumbed to the temptation of easy popularity and admiring editorials in both the New York Times and the Wall Street Journal. President George W. Bush, not a man to adhere to Republican “sound money” dogma if he could find a more populist alternative, chose the most dedicated inflationist he could find as Greenspan’s successor, and the result was history followed by disaster.

The solution is not a return to the gold standard (impossibly deflationary, given global population growth and economic expansion) but a revised charter for the Fed. Its mandate must no longer be the dual one of quelling inflation and fostering employment; the pressures on the Fed from Wall Street and politicians to expand the money supply are already far too strong. Instead, it must have the sole mandate of ensuring price stability, where prices are defined so as to include asset prices as well as consumer prices. Of course, the Fed cannot govern the world oil market, let alone the US stock market. Nevertheless it must react to signs of “irrational exuberance” in the stock market or excessive OPEC affluence in the world oil market by tightening money forthwith, unless consumer prices themselves are in sharp deflation.

Warning signals of imbalance abounded for an institution whose job had been to look for them. The excessive and unwontedly smooth stock market ascent after 1995 was one.  The behavior of house prices in and after the 2001 recession was another. The ability of economically illiterate dictators such as Vladimir Putin and Hugo Chavez to sustain themselves in power was a third signal that the global economy was out of kilter. The sustained US payments deficit and savings dearth was a fourth.

Tools abound for the Fed to do its job properly. However it needs statutory authority to do so without excessive interference from Congress and a mandate that forces it to take broad monetary aggregates seriously, not sweeping them under the rug as the Fed did with its disgraceful March 2006 abandonment of M3 reporting.

By far the best Fed Chairman since the institution appeared in 1913 was Paul Volcker, whose moral courage overcame opposition from Congress and much of Wall Street to wring inflation out of the system in 1979-87. We can’t produce Paul Volckers on demand; hence the Fed’s revised statutes must force the ordinary slippery and fallible mortals who serve as the Fed’s Chairmen to pursue a Volckerian policy.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ’90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) — details can be found on the Web site www.greatconservatives.com

Disclaimer

The opinions expressed are those of the author and do not necessarily reflect those of www.PrudentBear.com. This is not a recommendation to buy or sell any security, commodity or contract.

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