Why such extreme leverage?

What evidence do we have that it was a reasonable expectation that the government would bail out the company should it become insolvent? I understand this argument for Freddie/Fannie, but why would the CFO of Bear Sterns implement this in his risk analysis for the company? Do you have any evidence of any company employing this as part of their risk analysis?

It isn't clear to me from this publication what the required percent was ** before ** this regulatory change.

Can anyone fill in that part of the puzzle?

Obviously, it will make a big difference in the forcefulness of this argument if this was a change from, say, 2.6% to 1.6%, than if it was from 8% to 1.6%. A lot of commenters seem to be assuming the latter, and to me, this document doesn't say that.

"Why such extreme leverage?"

After listening to the most recent edition of Bill Moyers Journal ( http://www.pbs.org/moyers/journal/01082010/watc... ) it seems questions like these and the debates and discussions we have here are so meaningless and insignificant. The players on Wall Street who wanted increased leverage know exactly what they are doing. They leave us peons here to discuss the issues as if any of our discussion matters for what they do. There really is a degree of servitude going on here that libertarians and progressives like myself have no immediate answer for. A recent article in the FT suggested America would be best off if it just went bankrupt and the sooner the better.

http://www.ft.com/cms/s/0/a8486284-fee9-11de-a6...

There are always insane drivers who go at 200mph the real dangers are when sane drivers are induced to drive at 200mph because they have been told it is safe by those they have all the right in the world to presume sane… how was the world supposed to kopnw that the Basel Committee members and their risk measuring assistants the credit rating agencies, all were insane?

There are always insane drivers who go at 200mph the real dangers are when sane drivers are induced to drive at 200mph because they have been told it is safe by those they have all the right in the world to presume sane… how was the world supposed that the Basel Committee members and their risk measuring assistants the credit rating agencies, all were insane?

Gee PK most cars can't 320 km/h. Besides any ratbag who drives that fast outside a racetrack deserves to go to jail or have their car crushed into a cube.

Absolutely! But what about those who set up the “This is a racetrack” and the “200mph” signs? Are they just some innocent adolescents fooling around?

I am reminded of Hans Monderman's work with how people drive when there are no traffic signs: they slow down, are more mindful of pedestrians and as a result traffic flows more smoothly.

Thanks for the great Deloitte document.

I disagree with your analysis that the reason for the recklessness was that banks expected to be bailed out. There is no indication they were counting on on the government to bail them out, and it didn’t---it bailed out the bond holders, not the shareholders. Indeed, many of the top people at the largest banks had most of their net worth in the stock of their own companies. They simply did not understand the risks they were taking. If they had, Dick Fuld (CEO of Lehman) and James Cayne (CEO of Bear), to use two of the most prominent examples, wouldn’t each have about $1 billion in their own stocks. Many of the senior people in these two companies also had most of their net worth in their stock, and they all got decimated.

Besides, companies don’t “think” or "expect". The people in those companies do. And the people were incentivized to lever up because there was so much upside for them personally, and the upside was disproportionate to the downside. If their gamble worked, they'd be billionaires. If it didn't, they would lose most of the paper profits but still get to keep the cash compensation, which wasn't minuscule. But I really don’t think they understood the risk, or they wouldn’t have so much personally riding on the stock. All indications are they were confident, but ofcourse galactically stupid.

Regarding the April 2004 SEC ruling, investment banks were always levered, way before this ruling. In December 2003 Goldman Sachs was levered abut 20:1 (in June 2007, at the peak of the bubble, leverage was 24.8:1). The other investment banks had similar capital ratios.

Russ has addressed this elsewhere. They did have a large amount of company stock that lost major value, but they couldn't really access that value for various reasons. Cayne may have lost $1B on paper but was still worth $600Million after the collapse from all the salary and bonus money from the times he was
taking massive risk with other people's money. Some here can give you the link.

This is a precursor to Basel II which entered into effect when the G10 minister signed off on it in June 2004… and that is when the chase after the AAAs, anywhere, false or true, really took off.

I was and I am still screaming bloody murder at the thought that an ordinary citizen or an unrated entrepreneur or small business has to cover the cost of 8 percent in bank equity while something which has been rated AAA and which already benefits from being perceived as a lower risk only has to pay the cost of 1.6 percent of required bank equity. And then to make it even so much worse an AAA rated government has to pay for zero bank equity!

You write “If you lift the speed limit from 65 miles per hour to 200 miles per hour and someone crashes going 195, it would be strange to blame the crash on the change in the speed limit. The question remains as to why someone would be so reckless.”

This is, I am sorry to say, a real stupid question. If you have enforced speed limits signs (credit ratings) which state you can drive 200 miles an hour you are expected to believe it is safe enough to do so. I as a Venezuelan have been taught by experience never to trust other to stop when the lights are red and so I automatically slow down creating havoc in the US traffic where everyone assumes everyone stops when the light is red.

Is the problem excess leverage or that the higher leverage was not applicable across the board to more kinds of investment opportunities? By limiting the investment and lending instruments that were available for the increase in the higher leverage amounts, the rules did not allow the banks to diversify their risk. The leverage rules allowed the increase in assets, and also limited the category of assets, which in of itself increased the riskiness of the portfolio and the banks. More bank asset diversification would have prevented the financial crisis.

Additionally, even if bankers knew that ratings from the credit rating agencies were incorrect and that the expected risk was much higher than the ratings, the banks did not have alternative non-government investment opportunities with the same low capital requirements.

Furthermore, why did banks increase the assets subject to higher leverage instead of returning capital through stock buybacks or through increased dividends to the shareholders?

Banks have a cashflow from the incoming payments on their existing loans and investments that they could have reinvested into the higher leverage assets. It would allow banks to keep their total asset base at the same level and under the lower capital rules allow the banks to decrease their equity, increase their payouts to their shareholders, and increase their ROE due to the higher leverage. Bankers would still generate new high leverage business, meet their new business targets and receive their incentive compensation, but shareholders would see an additional return of their invested capital.

Was the financial crisis really a change in preference of the equity shareholders for retained earnings and an increased capital base over dividends, which backfired because of the limited ability to diversify?

Alternatively, was the financial crisis a willingness to forego investment and portfolio diversification? While we understand little about the co-movements of asset class prices, could there have been fundamental changes in price correlations that minimized the value of diversification of bank investments, caused possibly by the lower GDP volatility of the Great Moderation or by the prospects of a government bailout.

Believing that the government would bailout bad bank investments is equivalent to buying a put option on those investments and it reduces the further need to diversify the investments. This is in accord with Russ Roberts' statement of why the loans were made, but it does not explain the preference for increasing the asset base as oppose to returning higher dividends or capital through stock buybacks to the shareholders.

Government bailouts occur in various forms and different forms possess different risk for individuals who work at the banks. One option is a forced merger with another institution. Bankers faced uncertainty as to their job preservation or particular bank survival as the dominant organization in a merger.

The potential for a government bailout attracts new funding but it does not explain taking the amount of risk that the bankers took. Bankers put their job survival and careers at risk. Bankers' actions are not explainable by TBTF or other government bailouts. It is more of an organizational and continued funding ability explanation than an explanation of a banker's behavior.

Maybe this is way off, but I think it's important to account for the effects of operating under heavy regulations on human behavior. Overtime, it's natural for people to begin to think that anything allowed by a regulation must be okay because otherwise, government wouldn't allow it. If government opens up the capital requirements, it must be okay to take them to the extreme, otherwise why would they do it?

I think living under regulations causes people to develop unrealistic faith in the ability of those regulations to protect us from any and all risk (especially among those who want government to regulate any and all activities they deem unsafe). It's the legacy of being over nannied--you forget how to think for yourself and judge risk appropriately.

In this case, I don't think it would necessarily be strange to blame the crash on the new speed limit because the fool who drove 195 mph probably thought it was okay to do so based on a developed dependency on government (or someone) telling him what to do.

You describe people who believe freedom to mean being free from responsibility and consequence.

What is even more interesting is that banks like BB&T (managed by Ellison who is a believer in Ayn Rand by the way) and virtually all the Canadian banks consciously stayed away from these instruments, judging them as too risky for both buyer and seller.

It's also interesting that Canadian regulation did NOT follow Basel, and none needed bail-outs. So some banks got it right. Of course they weren't consulted on the nature of the bail-out.

Finally, the question must arise, as Mr. Boudreaux is fond of pointing out, as to whether transnational rules and standards actually increase risk. For then the inevitable weakness of the regulation is spread across a larger area, magnifying the fall-out.

Your last paragraph makes a good point, Jim. You could take it in another direction too: if everyone has to follow the same rules, how do you separate the good from the bad? If banks are free to set their own leverage, you'd get separation because customers would be able to choose with whom they would prefer to bank - fast and loose or slow and steady.

Well, in theory you are right, which would be great. Unfortunately the derivatives market makes it almost impossible to read a Balance Sheet anymore.

The issue of derivatives for me is not their nature; it is that the way they are measured obscures information, which free markets depend on to work. In fact for that reason alone, I suggest there must be a separation of 'hedge fund' activity and banking.

We need dull, easy to read banking for capitalism to work as well. And since it is not immediately obvious that we can clean up the derivatives market, then we must separate them altogether from those Balance Sheets. We need simple, transparent markets, especially in banking. We do not have them.

It goes without saying that that is very dangerous.

http://www.securitization.net/pdf/dt_recourse_1...


A slash was dropped out of the posted link.

"If you lift the speed limit from 65 miles per hour to 200 miles per hour and someone crashes going 195, it would be strange to blame the crash on the change in the speed limit. The question remains as to why someone would be so reckless."

I think you could blame the speed limit change--people regularly assume that what is posted must be safe/right.

They'd be right because there are no speed signs going that ridiculously high.

If another person is reckless and drives about at 195mph, I could get hit and killed even if I am being safe. So, that analogy is not really very fair, simply because issues of life and death cannot always wait for the self-regulation of a free society based on risk and benefit. What say?

I agree. And even when it was 60 I'm sure there were a lot of drivers on the road that thought that they would be perfectly safe drivers at 200.

If I fill a chamber with air it is quite possible for any particular molecule to move to the right side of that chamber simply through random motion. Finding a molecule on the right side, then, doesn't call for an explanation. If all the molecules in the chamber move to the right side and leave the left side a vacuum, I am entitled to ask why.

Russ can you repost the document? the link is not working

Regards.

Fixed, I think, thanks to Milton Recht's proof-reading.

RE: "Without the prospect of being bailed out by the government, it is hard to understand why such loans took place."

Why in the world are you so willing to accept that a human being employed by the federal government is so easily capable of making decisions based on hubris, but that a human being employed by Bear Stearns isn't? In other words, why do you even have to ascribe it to "stupidity" or circuituously find a way to blame the government?

The answer is as simple as it is symmetric, Russ. Stop looking for government boogeymen. People can be irrationally exuberant, and people can be over-confident in their own abilities, particularly when the market is good and they ascribe it all to their own intelligence and prowess. Of course many governmenet mistakes lead to this crisis. But it's comical to watch you wrack your brain to try to explain "how they could have done something so stupid". Humans often fall victim to hubris. It's not a quality that is suddenly exhibited when you take a job with Uncle Sam, and it's not a quality that's dependent on your expectations of Uncle Sam. It's an innate trait.

And please, please, please don't dismiss this point as me ranting about "greedy bankers". Greed and these class warfare arguments have nothing to do with it. What's relevant is how human beings act under conditions of uncertainty. All human beings. You don't need a "greedy banker" to tell the story I'm telling.

That's right, Daniel. There is another explanation based on human frailty. The problem with that explanation is that the greedy bankers weren't irrationally exuberant with their own money. Only with other people's. They were prudent with their own money as I show in my essay that is coming soon.

Russ - Do you explain in your paper why the other people weren't prudent with their own money?

Yes. Those people were imprudent because they expected to get bailed out. And they were for the most part. So they really weren't taking as much risk as it appeared.

I'm not sure what frailty or greed has to do with it. It has more to do with how we process information. I'll wait for the "prudence with their own money" until it comes out, I suppose, but that's not really very surprising. They don't have to satisfy shareholders with their own money, if by "their own money" you mean their personal investments. If by "their own money" you mean the money of non-leveraged or less leveraged firms, then you've got a major endogeneity problem. Firm's who aren't "irrationally exuberant" aren't going to leverage precisely because they aren't irrationally exuberant if you don't have high expectations of your payoff you're not going to make a leveraged bet on it. If that's your justification, then I hope you explain that endogeneity problem - you can't just compare leveraged firms with less leveraged firms. Of course you are less likely to borrow money to finance an investment that you're less confident in. That's practically tautological. It doesn't say anything about the psychology of credit induced bubbles and it certainly doesn't prove anything about the degree to which an implicit federal guarantee contributed.

Okay, I'll bite, and try to paraphrase Russ' point.

This has little to do with employees' hubris, on either side. Russ is saying the following (apologies to Russ if I get it wrong): when the costs of leverage are reduced, then optimal leverage increases since the benefits stayed the same. In this case, the costs of leverage were reduced by the implicit federal guarantee that any losses would be limited by federal intervention.

Now, regarding hubris suddenly being displayed by government employees - I don't think I would say this, and not sure Russ is either. But, if there is a difference, it probably is a self selection bias.

Yes, it definitely has to do with the costs of leverage being reduced, inducing more leverage on any particular investment than there would have been otherwise. But the reduction came from the allowable leverage ratios. I'm not sure what the implicit federal guarantee was, but if there was one it certainly didn't change recently. It's always a nebulous deus ex machina response that certainly makes sense and contributed, but never seems to be a proportional explanation to me. It's a very convenient explanation insofar as you can't measure or prove anything about it, and it requires that you assume that these institutions were even thinking about the prospect of their failure. For the most part, I don't think they were. And even to the extent that they were, I doubt they knew how systemic the problem was. Which raises another problem with relying too heavily on this "implicit federal bailout" explanation. Would the federal government have bailed these institutions out if the crisis didn't prove to be systemic? I highly, highly doubt it - and I think they would doubt it too. So if these institutions were betting on a bailout you have to assume they knew it would be a systemic failure. I don't think you can assume that.

I add this comment in connection with danielkuehn's "prospect of failure" observation. Many of the AAA ratings were a function of either actual insurance or credit default swaps. Typically these products do not provide for acceleration in the event of default so the default worst case scenario would be that the issuer (of insurance) would only step up for each periodic default payment---not a problem for well capitalized entities, e.g., AIG. Of course, the collateral call risk was present (and became reality) but that required an appreciation of systemic risk which plausibly may not have been perceived.

Interesting - thank you. I also think the implicit bailout argument only makes sense insofar as they appreciated the systemic risk. There's no reason to expect a bailout without that element. So yes, the implicit bailout may cause leveraged firms to discount the costs they associate with the risk of a systemic problem. But is the discounting of that cost really going to lead them to take the risks that they did? The fact that the failure of the financial system might be a little less painful than it otherwise would have been? I doubt it was a major motivating factor. I'm guessing classic credit-induced bubble psychology had much more to do with it than any implicit guarantee that would have been to a large degree contingent on the existence of systemic problems.

Fannie Mae and Freddie Mac were being naughty :)