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%?