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.