Too Much

I didn't blog yesterday, because I felt to do so would have required comment on the financial crisis and, well, I wanted to make sure I understood the what hell was going on before I did. There has been a tremendous amount of commentary on it, of course (it's the blogosphere after all) and some very smart and knowledgeable people have been parsing the events of the past few days. Also, luckily for me, we have here in the Washington bureau Bill Greider, the guy who, quite literally wrote the book on the Fed, a totemic 800-page history called Secrets of the Temple. If you don't own it: buy it.

Throat clearing = done, I wanted to take a shot at trying to tentatively sketch out the root causes of the financial crisis and by that I mean more than just AIG's collapse or Bear Sterns. Or Lehman Brothers. Or Indy Mac. But the entire panic and implosion that's taking place in global financial markets. The unavoidable fact, when you try to dive into this stuff is that the causes are complicated. Really complicated And at a granular level - why did Lehman Bros fail on the day it did as opposed to a week earlier -- nearly impossible for non-experts to discern. But to zoom way out to very abstract long-term, global view I (tentatively) want to propose the two main reasons we're in this crisis are these: too much capital and too much leverage. Since the latter is less controversial and more obvious let me take that first.

Too Much Leverage

Leverage is just the ratio between how much you owe in debt to how much you have in assets. Banks create money by lending more than they have, but they're leverage is capped by regulation at about 10:1. They can only lend out ten dollars for every dollar they have. But in what's come to be called the "shadow banking" industry, the various and sundry types of financial institutions that act like banks but aren't regulated like banks, there's (mostly) no such limits: you can leverage 50:1 or 100:1.

Now the reason it's called "leverage" is because it works like a lever: it allows you to lift more than you could by yourself. Let's say you have a $100 million and you invest it in a nice safe security that yields 8% a year. Sweet! After twelve months you're $8 million richer. But you could be doing So. Much. More. Let's say you have $10 million, use it as collateral to borrow another $90 million, and invest that. And let's say you manage to borrow that money at 7% interest. After the year's up you have $108 million. You owe $96.3 million to your lender ($90 + interest) and you keep the difference. You've now turned $10 million into $11.7 million, which is a 17% return on your original investment. Why settle for paltry 8%?

That's the miracle of leverage, and so, it's clear to see why such a thing would be, um, tempting.

The more leveraged you are, the more money you make.

Also, though, the more exposed you are to insane, nightmarish, catastrophic risk.

Imagine this scenario, but without the fixed time period of one year to pay everything back. What if temporally, you weren't quite sure when the folks who kindly lent you that $90 million might need it back in a year or five months. And let's say they run into some severe crises (What I'm describing here is necessarily over-simplified, but perserves the fundamental dynamic), and all of sudden they need their 96.3 million. You, of course, don't have it. But you lent out some money yourself and so you go calling your borrowers and telling them they need to pay you back, like, yesterday, and they do the same to everyone they lent money to and pretty soon you get a big, nasty, crisis.

This is what Paul Krugman has dubbed a "post-modern bank run."

So why was there too much leverage? Lots of reasons. Bubble psychology led traders to think housing prices would keep going up, so that awful-to-contemplate-day, when you're lender comes knocking on your door looking for that $90, would never happen. Another reason there's too much leverage is because there was too little regulation. Barry Ritholtz noted this gem this morning:

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.

You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.

As Mr. Pickard points out that "The proof is in the pudding -- three of the five broker-dealers have blown up."

In other words, the SEC let these firms hang themselves. But more broadly than that the pace of regulation and the leverage requirements simply didn't keep pace with the rapid financial innovation. It's tremendously ironic that now the only relatively healthy financial firms are those with a large commerical banking component, where they have lots of depositor's money that, thanks to good old New Deal-era regulation, capped their leverage and thus their exposure.

Too Much Capital

This insight isn't mine. It comes largely from an episode of This American Life called The Global Pool of Money (an absolute can't miss episode, the best explanation of the whole crisis I've encountered.) This is a strange way to think about the problem, perhaps, but it's illuminating. The entire amount of capital that needs to find a home in the financial markets is roughly $70 trillion (in fixed income securities). But here's the thing, the size of this pool in 2000 was just 36 trillion. As Adam Davidson says in the TAL: "It took several hundreds years to get to 36 trillion and then it took six years to get to another 36 trillion."

Much of what's gone so wacky is simply that there's too much money chasing too few good investment opportunities and that's led to lots of risky schemes. Now, there's a lot of reasons for all this capital suddenly appearing, but at least one thing to consider is that the distribution between labor and capital is totally skewed, and if labor were capturing more of profits, they'd be consuming, and saving in (relatively safe) commercial enterprises. Which is to say, broadly distributed economic growth is more stable and better over the long-run, than sharply unequal growth.

More on this anon.

Comments (14)

1. Wait a minute.....

   Are you telling me I'm not going to be able to pay my one million dollar note on my $20,000/year salary??

   But, but, but, but.......

   Posted by bleedingheart at 09/18/2008 @ 5:08pm

2. "More on this anon."

   well no shit sherlock!!! of course its the leverage and capital!!!

   sheesh!

   har har...good bloggery, chris. and what enabled this?

   almost 28 years of extreme "gubbament bad, bizness good" deregulation and setting foxes to watch over the henhouse?

   Posted by dexter666 at 09/18/2008 @ 6:01pm

3. Nice Chris, those exemptions are the key here, the very things they taught us never to do in my MBA class '88 or on the NASD tests were made commonplace by the SEC and Phil Gramm-led deregulators including McCain.

   Big surprise now that the bill has come due, and rumblings say we aren't done with bailouts yet.

   Posted by MajMike at 09/18/2008 @ 7:37pm

4. Very educational. When laid out in this way this whole mess seems more like a gambling addiction. These people are sick. Why is it that the usual suspects are always in the lineup and yet we continue to let them walk? What is it that we now get in return for trusting these honorable institutions with our money? What exactly did the Fed and the government just do for us except socialize the risk that these greedy douchebags knowingly took on?

   Is this what the republicans who comment here are referring to as the hard work that the poor are unwilling to do in order to "make it"? This isn't hard work. Its theft.

   Posted by HAL9000 at 09/18/2008 @ 7:54pm

5. *And as of today, the weather has official gone to shit in Seattle. Summer is over. BLAH.

   Posted by Zero at 09/18/2008 @ 8:25pm*

   Please continue that negative press Zero. The last thing I want is for our state to become a popular place to live. ;)

   Posted by yutsano at 09/18/2008 @ 10:50pm

6. Cheney-Palin-McCain-Hagee-Grahm

   want "transparency"? Idiots. No liars. No duh... But it's fun to point out. The transparency claim doesn't pass the wimpiest transparency test. Look at Cheney-Palin-McCain-Hagee-Grahm, all they are and do flies in the face of capitalism. Dick "We have to work the dark side" Cheney. Smoke and mirrors accounting, investment vehicles, nothing more than unregulated, free market snake oil. That's gold metal capitalism baby! Look at the how these neoconartists have run the investment houses, the whitehouse, the war, their hottubs, their campaigns. You think the gazillionaires of Bear, Lehman, IndyMac are bleeding heart liberals?? CindyMac's $ is not transparent. Troopergate, the 'Energy Task Force'. It's all capitalism. Secrecy city, warrantless spying, lies, preemptive strikes aren't exactly announced beforehand, occupation, torture, asymmetrical air power - everything - to gain power to gain money to gain power.

   Posted by winyahn at 09/18/2008 @ 10:59pm

7. Obama and economic leader? Duh, couldn't find two things more opposite than this. What does he know, the community organizer, besides preaching (well, the public want to separate Church and state) and firing at his former pastors?

   ----------

   How Obama Can Demonstrate Real Leadership on the Economic Crisis

   by Arianna Huffington:

   Wall Street is melting down, and McCain and the GOP have no credible response. Indeed, McCain is so clearly clueless on this issue, the current battle over who is best suited to deal with the financial crisis should be a rout. And, so far, Obama has shown not just an incomparably greater grasp of the situation and substantive policies to deal with it, but a real fire in the belly in going after McCain's vulnerable flank. But for Obama to show the kind of transformational leadership the crisis demands, he needs to do what so many of his critics have chided him for not doing: take a stand that puts him at odds with the establishment of his own party. He did it in 2002 with the war in Iraq. He can do it in 2008 with the economy.

   Posted by HelenDAO at 09/19/2008 @ 12:06am

8. Is this what the republicans who comment here are referring to as the hard work that the poor are unwilling to do in order to "make it"? This isn't hard work. Its theft.

   Posted by HAL9000 at 09/18/2008 @ 7:54pm

   You said it Hal. What is Dave (the rethugs) doing?

   There's a pretty good book called the Shock Doctrine by Naomi Klein. After reading that, I wonder what these neanderthals are up to now?

   Everyone is in "shock" over our current financial woes. A republican administration bailing out the banks and AIG with federal money?! Something smells bad here folks. Perhaps the neocon model of the way of privatizing everything, including the government isn't such a grand thing afterall.

   The only way to cover this up is to infuse a shitload of cash from the U.S. government back into the private sector. The government is on the hook as far as bailing these assholes out, and the bankers walk away unscathed. Pretty sweet deal for them don't you think?

   If you default on your car or home loan, they kick you out of your home and take your car away. These jackasses have made millions by "leveraging" money they don't have, but aren't going to be held accountable? Yep, that's good, hard honest work. Republicans = neocons = hypocrits = self serving sob's.

   Posted by Wolfgang1 at 09/19/2008 @ 07:18am

9. Wall Street needs the ability to take risks. Business ownership is risk."

   http://tinyurl.com/3phfnu

   Posted by lvliberty1 at 09/18/2008 @ 11:42pm

   Liver, You are an idiot. Here's why people bought houses they couldn't afford.

   Take a young couple just out of college who have never purchased a home before. Say they make $120k between the two of them and are debt free.

   They go to their realtor and the realtor starts showing them houses in the price range between $200k and $500k. Nobody warns them in the house buyting process that if one of them loses their job, they are still going to have to make that house payment. The realtor wants to close the deal fast as does the seller. The young couple are pressured to buy the house and they also fall in love with their "beautiful mansion" and buy in over their heads.

   At the end of the day, the realtor got their percentage of the deal, the bank gets it's percentage via interest rates, and all is well, as long as both are working an can afford that $4000 per month payment on that $400k home. But, the economy goes sour and one of them loses their job. That beautiful home is now something they are responsible for financially and can't unload on the market.

   Eventually, said couple defaults and their credit is ruined and the property is now on sale for half or less what it was before (the real value of the property). In steps a development corporation that purhcases the property and will hold onto it for when the economy turns around. The couple ends up with nothing, but paid 5 years of payments worth $240,000 plus and own nothing. They probably paid for the real value of the home, but the interest alone means they didn't even gain any equity in the house. The bank got bailed out though.

   Posted by Wolfgang1 at 09/19/2008 @ 07:32am

10. They probably paid for the real value of the home, but the interest alone means they didn't even gain any equity in the house. The bank got bailed out though.

    Posted by Wolfgang1 at 09/19/2008 @ 07:32am

    Here's the million dollar question. Where did the $240K go? Who go the lions share of those home payments?

    Posted by Wolfgang1 at 09/19/2008 @ 07:43am

11. Please continue that negative press Zero. The last thing I want is for our state to become a popular place to live. ;)

    Posted by yutsano at 09/18/2008 @ 10:50pm

    Hey, that's why Starbucks is so successful in Seattle. The fire place inside is the closest you'll get to seeing anything resembling the sun for about 6 months.

    It gets down right depressing when it rains 2 months straight and all you get is sun breaks. For those of you out there who don't know what the term sun break is, that's is when the you can barely see the sun through the gray clouds and ever lasting mist of light rain.

    Seattle is a cool town to be sure, but the constant drizzle is depressing.

    Posted by Wolfgang1 at 09/19/2008 @ 07:56am

12. "Deregulation didn't push homeowners to take on mortgages they couldn't afford"

    Posted by lvliberty1 at 09/18/2008 @ 11:42pm

    Perhaps not, but it did open the door for banks and investors to take on more debt than they could possibly cover should the economy start to sour. All of this talk of regulation bad, risk good is bullshit. The bottom line is that regulation protects Joe Public from Joe Gambling Addiction.

    Posted by HAL9000 at 09/19/2008 @ 08:13am

13. Posted by HAL9000 at 09/19/2008 @ 08:13am | ignore this person | warn this person

    all those irresponsible borrowing schmuks would never have been able to take out loans PROFESSIONAL lenders KNEW they probably could not pay back...for overpriced property in a market that built next to no affordable housing and forced the average joe/jane into this bind.

    and the lenders were lending a mint to anybody...why????

    because in the smoke and mirrors world of amoral satano-aynrandian business practice and finance...the futre is just a nebulous concept and with poor (or cooperative) regulation, who cares?

    well they care now...and we, the lazy shiftless, querelous, wussy, schmuks will hold the bill!!!!

    get these goddamned incompetant criminal satano-aynrando rightwing criminals out of the house!!!!

    Posted by dexter666 at 09/19/2008 @ 09:11am

14. Here's a little food for thought. Say you are a property developer and you come a with a grand scheme to make a ton of money.

    Step one. Establish a cozy business relationship with the local banks.

    Step two. Establish a cozy relationship with the local realtors.

    Step Three. Get people to buy in over their heads at highly inflated property values. If you get people who can actually afford the property, you can't sell it again and again. So push people into buying homes they can't afford. That's the model.

    You make more money, the bank does and so do the realtors. If the person can't afford the house, that's fine, the bank reposesses the house and you buy it back from the bank and get to put it back on the market again. Wash, Rinse and repeat.

    Remember that the bank loan was money the bank didn't have in the first place, so the bank isn't out anything anyway. Everyone wins except the poor bastard buying the house he couldn't afford in the first place. He actually worked for money, made payments but eventually defaulted.

    This comes very close to legalized extortion and usary.

    Posted by Wolfgang1 at 09/19/2008 @ 09:30am