The meltdown explanation that melts away

By Bethany McLean
March 19, 2012

Although our understanding of what instigated the 2008 global financial crisis remains at best incomplete, there are a few widely agreed upon contributing factors. One of them is a 2004 rule change by the U.S. Securities and Exchange Commission that allowed investment banks to load up on leverage.

This disastrous decision has been cited by a host of prominent economists, including Princeton professor and former Federal Reserve Vice- Chairman Alan Blinder and Nobel laureate Joseph Stiglitz. It has even been immortalized in Hollywood, figuring into the dark financial narrative that propelled the Academy Award-winning film Inside Job.

As Blinder explained in a Jan. 24, 2009 New York Times op-ed piece, one of what he listed as six fundamental errors that led to the crisis came “when the SEC let securities firms increase their leverage sharply.” He continued: “Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking?”

More recently, Simon Johnson, a former chief economist at the IMF, said last November that the decision “by the Bush administration, by the SEC to allow investment banks to massively increase their leverage … in terms of the big mistakes in financial history, that’s got to be in the top 10.”

It is certainly true that leverage at the investment banks zoomed between 2004 and 2007, before the near collapse. And this narrative of the rule change has plenty of appeal — it serves up villains. Stupid SEC people! Greedy bankers! It also suggests regulators were in the pockets of the big banks, and it offers support for the narrative of financial deregulation that many put at the center of the crisis.

There’s just one problem with this story line: It’s not true. Nor is it hard to prove that. Look at the historical leverage of the big five investment banks — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley. The Government Accountability Office did just this in a July 2009 report and noted that three of the five firms had leverage ratios of 28 to 1 or greater at fiscal year-end 1998, which not only is a lot higher than 12 to 1 but also was higher than their leverage ratios at the end of 2006. So if leverage was higher before the rule change than it ever was afterward, how could the 2004 rule change have resulted in previously impermissible leverage?

The blame-the-2004-rule position made its first appearance in August 2008, when a former director of the SEC’s trading and markets division named Lee Pickard wrote an op-ed in the American Banker arguing that the SEC contributed to the crisis when it changed something known as the “net capital rule” in 2004. The net capital rule, which governs how much capital broker-dealers have to hold and how that capital is measured, is technical, but Pickard made it simple: Prior to 2004, the broker-dealers’ debt had been limited “to about 12 times its net capital,” but thanks to the change, the investment banks were now able to avoid “limitations on indebtedness.”

That October, the New York Times ran a front-page piece by Stephen Labaton entitled, “Agency’s ’04 Rule Let Banks Pile Up New Debt.” Labaton wrote that the big banks had made an “urgent plea” to the SEC that would exempt their brokerage units “from an old regulation that limited the amount of debt they could take on” and would “unshackle billions of dollars held in reserve as a cushion against losses.” This was essentially what the banks demanded in exchange for submitting their holding companies to oversight by the SEC. Previously, there had been no oversight, but the European Union was threatening to impose its own regulations unless the U.S. did so. With the loosened capital rules, billions could then “flow up to the parent company,” enabling increased leverage. Indeed, Labaton wrote, “Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measure of how much the firm was borrowing compared with its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.” There were 157 comments on the Web version of this piece, most along the lines of remarks by a “Vietnam-era vet” who called the 2004 rule change “the financial equivalent of Patient Zero.”

On Jan. 3, 2009, at the annual meeting of the American Economic Association, Susan Woodward, a former SEC chief economist, highlighted the rule change in a presentation, a slide for which read:  “2004 — SEC eliminated capital rules for investment banks” and “Average I-bank ratios of capital to assets: before 2004: 1 to 12. After 2004: 1 to 33.”

A number of prominent academics who were there went on to repeat a version of Woodward’s claim. They include Robert Hall, who was then the incoming president of the American Economic Association, Ken Rogoff, and Alan Blinder. In the highly regarded book This Time is Different, which Rogoff co-authored with Carmen Reinhart, the authors write that “huge regulatory mistakes” like the “2004 decision of the SEC to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital) appeared benign at the time.”

Other prominent people who have blamed the SEC’s 2004 rule change for the increase in leverage at the (former) big five investment banks include historian Niall Ferguson; Joseph Stiglitz, who wrote in his book Freefall that “in a controversial decision in April 2004, [the SEC] seems to have given them [the big investment banks] even more latitude, as some investment banks increased their leverage to 40 to 1”); and Nouriel Roubini, who with his co-authors wrote in their book Crisis Economics that “investment banks reacted to this [2004] deregulation by massively increasing their leverage … to ratios of 20, 25 or even more…”

Thus did the “fact” become part of the conventional wisdom about the crisis.

***

Jacob Goldfield, a Harvard physics major turned Goldman Sachs partner (he left in 2000) noticed the claim that leverage had been limited to 12 before 2004, and then soared to 33. He thought it was strange that he hadn’t heard of this when it happened. He’d also noticed what he calls “quite a few” other pieces of conventional, but inaccurate, wisdom about the crisis, so he didn’t take for granted that this one was right. Instead, he checked. He looked at the 2003 leverage of two investment banks and found that it was much higher than 12. (In fact, there’s only one firm whose leverage in 2006 or 2007 was higher than it had ever been before 2004, and that’s Morgan Stanley. Nor was the leverage for the two firms that were hit the hardest by the crisis out of historical bounds when the world went to hell: Bear’s leverage (as measured by liabilities over equity capital) at year-end 2001 was 32, versus 32.5 at year-end 2007, Lehman’s at year-end 2001 was 28.3, versus 29.7 at year-end 2007.)

Halfway across the country, a semi-retired lawyer in Chicago named Bob Lockner began reading about the 2004 rule change, too. Lockner, who specialized in commercial bank capital markets activities, was suspicious because everyone kept citing the holding company leverage — but the rule applied only to the broker-dealer subsidiaries, and so didn’t include any international business, over-the-counter derivatives, or holdings of corporate or real estate loans, for instance. He also noticed that the rule hadn’t actually been implemented in 2004. The broker-dealer subsidiaries of Merrill and Goldman began using it in 2005, but the broker-dealer subs of Bear, Lehman and Morgan Stanley didn’t begin using the rule until their fiscal 2006 years. In other words, while leverage at the holding companies had started to climb in 2004 and 2005, the rule change clearly couldn’t be the reason.

After reading the Wikipedia entry for the “net capital rule,” which mostly cited the New York Times piece, Lockner decided to rewrite it, hoping that an accurate version would force people to acknowledge the old version was wrong. When I ask why he spent his time that way, he chuckles and says: “You mean, why am I insane?”

Lockner’s rewrite of the Wikipedia entry, at least as it existed on Mar. 13, 2012, describes in great technical detail the SEC’s net capital rule and the 2004 changes. But there are a few simple points. There was never any explicit leverage limit at the holding company level before or after the rule change. Even at the broker-dealer subsidiaries, a 12:1 limit didn’t exist. Smaller broker-dealers had an early warning at the 12:1 ratio, and an actual limit of 15:1 — but even these ratios didn’t exist in the way the economists seemed to interpret them, because they were calculated in a way that excluded big chunks of debt. In any event, since 1975, the broker-dealer subsidiaries of the big five investment banks had been using a different method, which had nothing to do with 12:1 or 15:1, to calculate their leverage limit. That method was unchanged in 2004. (Interestingly enough, the holding companies for the big investment banks might actually have made it under the 15:1 limit if you calculate the ratios by excluding the debt that the SEC does.)

There is another, more subtle point. The SEC did change the way the big broker-dealers calculated their net capital in 2004 in a way that could have allowed them to reduce the capital they held (by making it easier for them to meet the minimum requirements). This could indeed have had the effect of increasing the leverage, at least at the broker-dealer level. But it’s not axiomatic that that would result in higher leverage at the holding company — and it’s not even clear what the effect of the rule change was at the broker-dealer level.

One way the broker-dealers could have reduced capital would have been, as Labaton wrote, by paying big dividends to the holding company. But when the SEC changed the rule, it also put in place a new requirement that each of the broker-dealers have $5 billion in liquid capital before the major effects of the rule change; the SEC says that would have made it harder for the broker-dealers to pay out big dividends, and in fact, it required one firm to add capital to its broker-dealer. Overall, the SEC says that capital, as measured before most of the expected impact of the rule change, stayed stable or even increased after 2004. Several people at the broker-dealers at the time also tell me that the new rule was totally inconsequential in how they managed their capital levels

Skeptics may discount what the SEC and the broker-dealers say. But the data does show that over the years, the broker-dealers, contrary to perceptions that they must have wanted their capital to be as low as possible, actually kept much more capital on hand than they were required to hold. For example, in both 2006 and 2007, Bear Stearns had seven times the amount of capital that the SEC required, or more than $3 billion in excess net capital. This might suggest that the amount of capital the broker-dealers kept was boosted by factors other than the SEC’s requirements, like business needs, or rating agency and customer demands.

Various measures of leverage at the broker-dealer level do reach fresh peaks subsequent to the rule change. But it’s not obvious that that’s because of the rule change. The increases aren’t big in all cases, nor do they follow immediately after the firms implemented the new rules, and there’s enormous volatility from year to year, which may argue that the driving factor wasn’t the loosening of a preexisting constraint. Interestingly enough, one measure of leverage at the best-performing firm’s broker-dealer — Goldman Sachs — was higher before the rule change than at any other firm’s broker-dealer after the rule change.

***

The funny thing is that this is a mistake that no one has corrected. Although Erik Sirri, who was then the director of the SEC’s division of trading and markets, rebutted the claim in 2009, the New York Times didn’t cover it. Lockner says he wrote to a handful of economists; only Niall Ferguson responded and was chagrined to find out he was wrong. Of the people I cited earlier, only Blinder, Johnson, Kwak and Susan Woodward responded to my calls or emails.  Blinder now says: “It’s true that very high leverage was a big source of the problem, but the net capital rule does not appear to have changed that much.” (The New York Times hasn’t issued a correction to his op-ed.)  Woodward now says that while she doesn’t think the 2004 change is even on the top ten list of the most important contributors to the crisis, it doesn’t really matter, because “everyone agrees that too much leverage was a key cause.” Pickard, for his part, believes that the rule change hasn’t gotten enough blame yet, and he says that if leverage at the holding companies was higher in the 1990s, then the investment banks must have been playing games with their books.

More recently, Andrew Lo, the director of MIT’s Laboratory for Financial Engineering, wrote a paper analyzing 21 books on the financial crisis. In his paper, he pointed out the fallacy of blaming increased leverage on the 2004 rule change. Although Lo’s paper was picked up by the Economist, even that didn’t spur any of the academics who made the mistake to correct it. Why?

The best reason was voiced by James Kwak, who co-authored the book Thirteen Bankers with Simon Johnson. The book also links the increased leverage at the holding companies to the SEC’s rule change (although Johnson and Kwak never say the leverage was limited to 12:1 beforehand.) In a blog response to Lo’s paper, Kwak argues that Lo is making too big a deal out of this, because the rule change “very well might” have played a role in the increased leverage even if “we can’t tell how much.” In a conversation with me, Simon Johnson, Kwak’s co-author, argued that even if the broker-dealers kept excess capital on hand, well, they might have kept more excess capital had the rule change not occurred. This is indeed possible, although over time, the excess capital that the broker-dealers kept varied wildly, making it hard to see that they were targeting a specific amount of excess. In any event, Kwak and Johnson have a point: What happened at the broker-dealer level is murky and should be better understood. But the problem is that saying the rule change “might” have caused increased leverage just at the broker-dealer level is very different from saying it was an important cause of the crisis (especially since Lehman’s broker-dealer stayed solvent after its bankruptcy — it wasn’t the root of Lehman’s problems). At this point, the burden of proof should be on those who have claimed that the rule change was seminal.

Another reason that was suggested to me is that it’s politically incorrect to challenge the conventional wisdom about the rule change, because doing so might be construed as a defense of the SEC or the investment banks. That’s ridiculous: Facts are facts, and those who supposedly traffic in them should have respect for them. In addition, it’s far from a defense of the SEC to say that the rule change has been misrepresented. It may well have had pernicious effects that aren’t well understood yet. The broader context of the 2004 rule change was that, as Labaton pointed out, the SEC agreed to supervise the investment bank holding companies, and it clearly failed in those responsibilities. While the 2004 rule change offered a lovely explanation for that failure — blind incompetence is easily fixable — the real failings might be harder to fix, especially if we’re not looking for them.

A third reason I was given for why this mistake is no big deal is that because high leverage was surely to blame for the crisis, it’s beside the point whether the 2004 rule change made things worse or not. That’s silly — saying cancer killed the patient and saying the water he drank gave him the cancer are two very different claims. And it’s also dangerous, because if the rule change wasn’t behind the increased leverage at the investment banks, or the broker-dealers, then what was? If our goal is to prevent another crisis, isn’t it important to understand what actually happened? Or as Lo said to me: “If we haven’t captured the killer, then the real killer is still out there somewhere.”

PHOTOS: The U.S. Securities and Exchange Commission logo adorns an office door at the SEC headquarters in Washington, June 24, 2011. REUTERS/Jonathan Ernst; Princeton University Professor of Economics Alan Blinder speaks during a presentation at the American Economic Association Conference in Atlanta, January 3, 2010. REUTERS/Tami Chappell

38 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

It is counter intuitive to argue your rather extreme position, that leverage had nothing whatsoever with the financial collapse.

I question your motive for taking this position.

Posted by PseudoTurtle | Report as abusive

i would say that most people look at the glass-steagall repeal as the cause and not the increase of leverage. its not the leverage increase that was the issue. it was what was being purchased with that leverage and the less than accurate ratings behind those assets that banks over leveraged to get

The 1999 repeal of the Glass–Steagall Act of 1933 effectively removed the separation that previously existed between Wall Street investment banks and depository banks.

Posted by billatl3 | Report as abusive

@billatl3 nailed it. the repeal of glass-steagall was probably the biggest mistake the US has made in a long time.

Posted by tmc | Report as abusive

@billatl3 nailed it. the repeal of glass-steagall was probably the biggest mistake the US has made in a long time.

Posted by tmc | Report as abusive

@PseudoTurtle

He isn’t saying that the leverage had nothing to do with it, just that a rule change in 2004 had nothing to do with it. Everyone points at the administration in office in 2004 and this rule change in particular and says that the government let wall street go wild, and that simply is not the reason that everything happened. Banks were leveraging just as much in 98 as they were in 2004 and in 2007. The author is spot on.

I agree with billatl3 the repeal of Glass-Steagall had a lot more to do with the collapse than the leverage rules. However, Bush was not President in 1999, and Clinton can’t be blamed for anything…

Posted by UnPartisan | Report as abusive

“A mistake no one corrected.” Not so much a mistake but a blame to place conveniently on the previous administration to further vilify president Bush and distance president Obama from previous policies. Sleight of hand in politics is all too common, unfortunately.

Posted by triumph900 | Report as abusive

This article is trash. And yes, the repeal of Glass-Steagall is one in a series of walloping mistakes made by the most woeful Presidential Administration EVER. Clinton-Gore.

Posted by GLK | Report as abusive

@AlkalineState

You are right about the Tea Party on this one. Government regulation in SEC is still lax in my opinion. There is too much gambling and playing the markets still. Too much regulation can styfle businesses, but Wall Street is not the same thing as businesses. It is a corrupt system of manipulating numbers in efforts to get rich or ruin or competitors. It is true that speculators can drive prices down, or drive them up, but it is all artificial and it is done for their own interests and no one else’s even though it affects our country and the world as a whole.

Posted by UnPartisan | Report as abusive

If one reads a history of the FED and the big banks going back to 1913 and get a grip on the “Monster” that was created in secret at Jekyll Island off the coast of South Carolina, it will become apparent that the big banks got the U.S. to underwrite their pecadillos. Who lost and who gained on the crisis of ’07? The answer my friends is obvious.

Posted by neahkahnie | Report as abusive

Does this ground breaking information that has been going on for so long now that has took control of our nations currency which has been controlled by a small banking group and they’re beginning to come out of the closet with more and more truth, the question is are there any good American politicians left who will defend their country men and women that want to fix this problem now. The hardest part is to realise this is wrong but we can’t dwell on why it happened and we need to correct this by planning a way to transfer a balance of American currency back into the circulation of the American people. Quit talking and fix it! I’m sure all Americans want their country back the way it was meant when created. It was created for all Americans to have a piece of. when it’s working there would be no need for social programs because when greed is not allowed to grow that big there would be so much more for so many others and having a job wouldn’t replace the American Dream. Right now there’s too much talk!

Posted by grimajo | Report as abusive

What would have happened in 2004 if the SEC had enforced the rule instead of raising the limit? Was the limit raised because of the answer to the first question?

Posted by BLACKWOLF | Report as abusive

UnPartisan writes: “There is too much gambling and playing the markets still. Too much regulation can styfle businesses, but Wall Street is not the same thing as businesses. It is a corrupt system of manipulating numbers in efforts to get rich or ruin or competitors.”

I think that is a good way to put it, and an original observation. A business is someone making something or providing a service for money. Pretty straight-forward. Wall Street is more of a spoiled and parasitic drag on that system.

Brokers and middlemen taking a cut of other peoples’ transactions, gambling shareholder dollars without disclosing that to the shareholders, allowing certain privileged traders to make up to 30,000 trades per hour directly into the NYSE, while not allowing others to do the same. All done legally because their greatest expense is lobbying to keep these rackets from becoming illegal. So far, they’ve succeeded. Whether we continue as a society to allow this ridiculous arrangement is up to us I guess. I have no respect for teh current financial system.

Posted by AlkalineState | Report as abusive

The American President, George Bush, was rather more an opportunistic glory-hound, and it would have been a feather in his cap to have declared that he “helped” business in this fashion. But the decision to de-regulate business has been a long-running policy of his Republican party supporters, and has had cumulative adverse effects on the world markets, as experienced of late.

Posted by nieldevi | Report as abusive

So What Is(was) the Rule?

This article is very unsatisfying in that the author repeats often enough with presumably some data backing her, that the 2004 rule change did not change leverage. Unfortunately though, she never tells us what the rule actually said which makes the whole discussion appear to leave the realm of the real world with only one foot left barely brushing along on the ground. More meticulous attention to the facts will be necessary if the country is going to deal with any of its problems.

Posted by St.Juste | Report as abusive

Really? Let’s just avoid the obvious…fundamentally, the basis for the financial crisis was poor lending standards.

Once the loans went sour, regardless of how they were packaged and on-sold, how much leverage was employed to buy and sell them, if the underlying asset is worth less than you paid for it, then that’s your problem.

And perhaps the most commonsense way to avoid this in the future is to make the lenders maintain responsibility for the loans they make rather than just them packaging up and selling them on to make a fast buck.

Posted by LondonObserver | Report as abusive

Overall this is a decent article, however fudging numbers the other way does not lend to the argument against fudging the numbers. The facts are loud and clear: over-leverage had a big part in the meltdown. So what if Bear had 3 billion more than required? That just illustrates the fact. Unfortunately, the way this is written, it would appear to be absolving the Bush administration and its policies.

Posted by BakoD | Report as abusive

Blaming the Collapse on something innocuous like leverage is safer than placing the blame where it really belongs… widespread fraud.

Posted by breezinthru | Report as abusive

The meltdown was not caused by technical trading issues, policy decisions, or the personalities of people in power. No more than the continuing financial and economic crises are caused by those factors. Perhaps readers would be better served following the money. Where has finance and productive capital been flowing and what effect does it have on the basic economy? It is not too difficult to realize that the return on investment is higher in China than it is in the the so-called West. Corporations who have reaped trillions in super-profits off their movement of capital to China and other low-wage areas have kept those profits largely off shore and un-reinvested. Not only are the profits not reinvested in “the West” but they are removed from circulating capital and hoarded. The reason for this is evident: those investments had already achieved maximum return and investment in the West would bring lesser returns. Thus we see corporations like Apple sitting on tons of uninvested cash garnered from workers who have protested in dramatic form. The wealthy have searched for the lowest wage and environmental bottom and found it. Now they even turn to the public treasury to boost profits, especially in the war industries.

Posted by Eustacius_Elder | Report as abusive

Presumably neither banks nor Wall Street traders purposely invest in bad assets, so lack of knowledge is a key problem. (Which is not to say they are reluctant to sell bad assets of course.) The growth of banks must have contributed to the problem to some extent, since they has long since lost track of the local markets they serve and end up buying (and selling) junk. John Huntsman made some proposal to put limits on bank sizes or areas that unfortunately were not given much airing in the campaign before he left. Do you suppose the bankers were reluctant to contribute?

Posted by Jim1648 | Report as abusive

The market would have collapsed if the ratio of 12 was enforced in 2004. Leaving the regulation in place would potentially criminalize an entire industry (except MS). So instead the SEC accomodated market practice? Fed Chairman Alan Greenspan was apparently not a big fan of capital adequacy ratios imposed by the Fed.

The market collapse started in 2006 when mortgages had been granted to the last American who could sign papers. Leverage under these conditions was just one issue – that is just poor engineering — saving on materials and other resources. Still, you need a trigger, and perhaps a set of conditions coinciding, leading to disaster. It is easy to use the label “fraud”, but I suggest another definition: When the market participants are doing something else in fact than they are reporting – how does regulatory action and credit ratings interact with phenomena not observed, declared or understood to create a bomb? “Toxic mortgages bundles”, and the inappropriate assumption of counter-positions by the banks selling the “investments” caused a domnino effect of tsunami force in the global economy. The sanctions imposed on the trespassers were negligible, so the ones who pushed most of us into economic difficulties are free to do it again.

Derivatives reporting, monitoring and regulation and its relevance to individual institution and systemic solidity was hardly complete in 2004, and I am not sure that it is better today. The various products relied on transparency and ratings that were corrupted by the gap between what the institutions said they were doing, and what they actually were doing. We can then ask ourselves if they were dumb, unfortunate or deliberate in their actions as institutions and system. The man in the street would not care if it is one or the other, and require sanctions. The few instances of sanctions reported all indicate that the SEC are reluctant to represent the man in the street view, offering leniency and settlements disproportionately mild. Hence, we end up with an Occupation movement that should give raise to pause in an election year – in the US and elsewhere.

Posted by BLACKWOLF | Report as abusive

I have heard that years ago, the Japanese once told a group of American businessmen (possibly from the auto industry) that the difference was that we Americans look to fix the blame, and they look to fix the problem. Andrew Lo, as described by the author, essentially reinforces that. Since big gov needs big banks as much as big banks need the Fed.(as correctly pointed out by neahkahnie, above), it is unrealistic to expect any effective solution, or return to what worked. Politicians are not economists, but believe they can solve by decree. Dodd-Frank has onerously wrecked havoc on small customer-oriented banks such as Hudson City (symbol HCBK) and similar others, and Fed policy effectively discourages savings, which may only result in big banks being the only survivors to play ping-pong with the Fed, using electronic capital (digital entries). Playing blame and shame has not fixed the problem yet. Nor have we yet found any mechanic who can (or will) fix it. If problems wait for the solution, be prepared to be very patient (and save your breath)..

Posted by Annalysses | Report as abusive

A penny saved is a penny earned

Posted by whyknot | Report as abusive

So because a clear and historically prudent federal limitation on leverage was already being violated, the only conclusion we draw is that the changed limitation was irrevelant. I conclude that those individuals who – with the knowledge of the current financial situation in 2004 and the knowledge that this historically prudent limitation had already been violated – decided upon relaxation of the law rather than a federal enforcement campaign, were doing the bidding of those who knew what was coming and of course were looking to cover their actions with federal legitimacy. Rules by themselves are pointless – this is a failure of enforcement – again.

Posted by the99 | Report as abusive

Bunk. I distinctly remember in the early 2000′s Stan O’Neal, the nefarious CEO bond broker golfer at ML in group meetings waxing poetic about how it was time to leverage up the balance sheet. Pretty much agree with Dr. Lo; leverage as leverage did not create the failure. The poor administration and positioning of leverage by self congratulatory (i.e. delusional)promoters found a new way to establish rapid reversion.

Posted by RDTJR | Report as abusive

Excess leverage is a potential problem that manifests itself when the underlying security tanks. Leverage was an exacerbating factor when the root cause, sub-standard mortgages, began to fail.

Without the subprime mortgages, there would have been no meltdown. Without excess leverage, the meltdown would have been less critical, but would still have occurred. So the lowering of mortgage standards by the GSE Act of 1992, and the subsequent HHS mandates that Fannie & Freddie process substandard mortgages, is a more fundamental cause than was excess leverage.

Posted by geezer117 | Report as abusive

Determining the investment firms’ true capital is like trying to measure degrees of insanity – it is just frustrating. WHy? Because so much of the firms’ true risk was off the books in off balance sheet items. Even if those items were added into the liabilities side of their balance sheets, the pricing of these securities was completely hocus pocus.

As we now know, the pricing of non-exchange derivatives is anyone’s guess. THerefore, the CDS, SVUs, LCs, etc. were piled onto the off-balance sheet and no one could determine what was the true value of the total liability that these instruments represented.

Why do you think MBIA and AMBAC and AIG collapsed. They had underwritten CDS without the necessary capital. Lehman the same way.

So saying that the firms’ leverage was not at an extreme is showing how naive the writer of this article is about the basic accounting, esp. off balance sheet items.

Posted by Acetracy | Report as abusive

Greed and corrupt politicians is what the problem is.
Corporations must have a set lifespan. Otherwise the playing field is never leveled. If Warren Buffett lived for 300 years he would own everything. It’s quite simple.

Real Name: Doug Pederson AKA SpectateSwamp

Posted by bloggerswamp | Report as abusive

Yes corporations could have a limited lifespan. But even more effective, they could also be limited in size. This would limit the power they have to distort the system in their interest.

Posted by guibar | Report as abusive

So basically what I am interpreting is that since leverage didn’t cause the meltdown something else did… Was that something else the fact that we had a massive bubble in Real Estate (failure of the FED and the FDIC to regulate Banks) coupled with the massive manipulation in crude oil prices which in turned siphoned off Billions and Billions of Dollars in consumer spending dollars? So what fueled the massive bubbles..? So if leverage didn’t cause the meltdown it was the incredible amount of fraud in the Mortgage Originations Markets via loan officers, appraisers and regulators, excessive speculation in 2008 levels in the oil markets with a few players manipulating the oil prices to extortion levels (failure of the CFTC) and the failure of the Federal Reserve to raise interest rates to control rampant speculation beginning in the housing market in 2004 which in turned fueled rampant speculation in the security markets…

Posted by ChuckeB | Report as abusive

excellent article. I beleive that the collapse had to do with socialist progressive policies of the democacratic controlled congress starting in 2006. Barney Frank and Chris Dodd were instrumental in the housing bubble, forcing banks to make risky loans so that their “constituents” would vote for them. The remainder of the economic collapse that occurred during the next 6 years was the election of a democrat controlled congress and president, which promptly instituted programs consistent with socialist progressive doctrine. These moves scared the socks off anyone who is an employer, so that they quit hiring employees, resulting in a pullback. We need to get rid of the progressive/socialist/democrats in the next election cycle and then the economy will recover.

Posted by zotdoc | Report as abusive

Why waste a whole Reuter’s article refuting the press’ explanation of the causes of the meltdown?

The Stigliz Report was the product of a team of economic experts who analyzed the crisis on behalf the the UN. It basically said that neoliberal economic policy – unrestrained trade and deregulation – was the cause. That would be a better starting point for debate.

Posted by tcolgan001 | Report as abusive

Seems to me that when discussing systemic danger it’s the gross amount of leverage that is dangerous, not the leverage ratios of a particular institution. If my capital base is $1 and am able to borrow $100, I am no danger to anyone. If my capital base is $10 billion and I lever at 30:1 and things go terribly wrong, there is a $290 billion hole out there, and that’s bad. If my capital base is $100 billion and I am levered 15:1 that’s $1,400 billion hole that I need to fill if things go wrong, and that’s even worse. In the 9 years after the repeal of Glass-Steagall, the capital base of financial companies grew massively into the 2008 crisis. Any leverage rule needs to take into account what the gross equity of the borrower and that one size does not fit all. Given the growth of financial companies from the late-90′s and their increased proportion in value of the S&P 500 into the 2008 crash, it seems that it was incredibly unwise to loosen leverage rules. If systemic regulators had been looking at gross leverage, perhaps rations would have been tighten in 2004. The primary systemic regulator of the banking industry is the Fed, and why it was left up to the SEC to set leverage rules for IBs was at best an artifact from the Glass-Steagall days.

Posted by salr_ldn | Report as abusive

How about instead of blaming the Glass-Steagall on Clinton, we look at the legislation that actually repealled the Glass-Steagall Act (put in place after the Great Depression to prevent savings banks from using consumer funds in investments, thusly losing savings money). It was the Gramm-Leach-Bliley Act of 1999. Do your homework.

http://en.wikipedia.org/wiki/Gramm-Leach -Bliley_Act

Posted by DuhyerMaker | Report as abusive

Please stop using all these financial euphemisms; it’s borrowing, not “leverage”, and gambling with borrowed money was one of the prime causes of the Great Depression and stock market crash. IMHO if we knock it off with these too-clever-by-half euphemisms, we’d go a long way toward solving the financial problems of our country.

Posted by borisjimbo | Report as abusive

When I look at the 10K filings for Lehman Brothers, I have to conclude leverage went up dramatically from 1998 to 2006. I am not sure why but its hard to argue that it was the same.

Here are the numbers from Lehman Brothers 10K

11/30/98

Total Assets 41,907
Toal Equity 5,413
Assets to Equity 7.74

11/30/2006

Total Assets 503,545
Total Equity 19,191
Assets to Equity 26.23

Posted by StephenN | Report as abusive

It’d the “GSE Business Model” that is responsible. Look no further, Treas Sec Hank Paulson said it best “fatally flawed”.

Posted by Richard_Davet | Report as abusive

Wait, what? Leverage was not the problem? Let me put it this way – leverage does not create the problem, it multiplies it. So in effect leverage was 30 times a bigger problem than underwriting standards or the housing slump. Housing was the trigger, leverage was the A-bomb that got detonated.

Rule changes in the SEC are irrelevant since no one is actually enforcing them for the last 30 years. That is why “the killer” is on the loose, because the moment he gets caught, all we can hope for is a slap on the wrist on off he/she goes.

Break up the monopolies, put those who break the law in jail along with those who fail to enforce it and you will start fixing the problem. However, that is politically and economically impossible at this point, because it would expose a huge part of the economy as a running fraud.

Posted by hedonistbot | Report as abusive

Hedonisbot is 100% right.

Posted by missprism | Report as abusive

[...] Huberman points to an article on the financial crisis by Bethany McLean, who writes: lthough our understanding of what instigated the 2008 global financial crisis remains at best [...]

[...] In the post 2008 disaster analysis, Alan Blinder,a former Federal Reserve Vice-Chairman, blamed the SEC for allowing the Banksters to increase their leverage and further stated “Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking?”, here. [...]

[...] In the post 2008 disaster analysis, Alan Blinder,a former Federal Reserve Vice-Chairman, blamed the SEC for allowing the Banksters to increase their leverage and further stated “Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking?”, here. [...]