Why such extreme leverage?

by Russ Roberts on January 10, 2010

in Financial Markets, Regulation

I want to thank Stephan Cost who found this document for me, an analysis by Deloitte and Touche of the 2001 regulation that changed the capital requirements for various types of investments, taking effect on 1/1/2002. According to Deloitte and Touche, this did indeed loosen the capital requirements for AA and AAA-rated MBS to 60-1.

This regulation, a foreshadowing of Basel II, allowed commercial banks in the US to use extreme amounts of leverage for extremely safe (AA- and AAA-rated) investments.

Unfortunately, this inevitably corrupted the ratings agencies, encouraged the explosion in private label MBS, especially subprime, and appears to have played a significant role in the crisis.

I say “appears to have played a significant role” because without the expectation of creditor rescue by the government, who would be so stupid as to lend the $98.40 that financed $100 worth of “safe” investments?

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.

If banks are allowed to leverage MBS 60-1, that is if banks are required to only put $1.60 up for every $100 of AAA-rated MBS, then why would they be so reckless as to do so and who was so reckless as to finance such recklessness for a fixed rate of interest?

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

What I am still uncertain about is the April 2004 SEC ruling that allowed similar leverage to be used by broker-dealers, the five large investment banks. Some say this had nothing to do with the leverage that took place at the investment banks–they could be highly leveraged before April 2004 and they were.

What restrictions, if any, did Bear, Merill, Lehman, Goldman, and Morgan Stanley face before and after April 2004 with respect to leverage?


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