Hypothetical Financial Crisis in a World with Low Leverage
So leverage is always correctly discussed as a major cause of the financial crisis. Yet by definition, levered securities are only a problem if the underlying is losing money; if the underlying is gaining you would want to be as levered as possible.
We know that there were some terrible inefficiencies in the underlying MBS market that caused the bubble in the mortgage market in the first place, even when we ignore leverage completely. On the investor side, securities were principle protected which made them infinitely more attractive as the investor could pretty much ignore default risks. And on the mortgage-holder side, mortgage terms became too complicated for buyers to actually know what they were getting into with fixed-for-float, balloon, and other structures. Sellers of MBS buying too many mortgages because they don't know how much they'll have to pay in the long run and buyers of MBS buying too much because of the implicit guarantee=disaster.
The hypothetical I want to propose is what the crisis would have been like if banks were then leveraged to the degree they are today. It seems to me that there would still be a bubble in mortgage-space, but the severity of the overvaluation and subsequent crash would have been more manageable. The question is how bad would it have been.
What are all of your thoughts?
Presence of leverage can easily spark massive selloffs. Imagine someone levered 10:1, ie has 10 mil of equity for 100 mil of assets. Now lets say he needs to keep a constant 10:1 ratio or less. Now if the asset value falls to 95 mil (only a 5% decrease), he needs to sell 45 million of the asset.
If you take that one step further, you are threatening the livelihood of firms. If your assets fall another 5 million before you can de-leverage (which could be in part caused by the selloff) then all of the sudden you risk going under and that's when the effects become more widespread.
So, I think in a de-leveraged environment there still would have been big losses, but those would have been absorbed by the stockholders of the respective firms, and as long as these firms could stay afloat you don't have all of the same counterparty issues from CDS. It certainly would have inspired some sort of panic, as people are always fearful of the next Great Depression or S&L crisis, but not to the level we saw.
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Right. I was trying to create the hypothetical that ignores this phenomenon and focuses on the underyling bubble.
Still, this is an interesting point. We have companies that are required to maintain a ratio of Assets/Equity that is constant, but assets and equity are oviously not independant variables. Maybe there are better methods/ratios to enforce that do not have this cyclical effect?
If the car in front of you slams on his breaks, it's better to be going 30 than 55. You might not avoid a crash, but it might be difference in life or death
speaking of de-leveraging... are there any firms/HF's sticking to 100% equity and using zero leverage? is it seen as more ethical in todays standard to do so?
Firms, yes. I don't believe Google, for example, has any debt. There are other firms (I feel like I've seen some Cramer articles on CNBC.com highlighting them). As far as HFs, I would doubt it, but I'm not sure. I say I doubt it because it would put them at a severe competitive disadvantage. As far as being more ethical to do so, I wouldn't say that. If you are truly keeping in mind the stockholders' best interest, it often makes sense to use some debt in order to increase returns, as long as you do it in a responsible and manageable way.
The 40x or so that some of the banks were leveraged at going into this crisis does not qualify as repsonsible or managable.
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