The Fed Talking About Reducing Leverage Is Like A Crack Cocaine Dealer Handing Out "Just Say No" Stickers → Washingtons Blog
The Fed Talking About Reducing Leverage Is Like A Crack Cocaine Dealer Handing Out "Just Say No" Stickers - Washingtons Blog

Tuesday, November 17, 2009

The Fed Talking About Reducing Leverage Is Like A Crack Cocaine Dealer Handing Out "Just Say No" Stickers

The New York Federal published a report in July entitled "The Shadow Banking System: Implications for Financial Regulation".

One of the main conclusions of the report is that leverage undermines financial stability:

Securitization was intended as a way to transfer credit risk to those better able to absorb losses, but instead it increased the fragility of the entire financial system by allowing banks and other intermediaries to “leverage up” by buying one another’s securities. In the new, post-crisis financial system, the role of securitization will likely be held in check by more stringent financial regulation and by the recognition that it is important to prevent excessive leverage and maturity mismatch, both of which can undermine financial stability.

And as a former economist at the New York Fed, Richard Alford, writes today:

On Friday, William Dudley, President of FRBNY, gave an excellent presentation on the financial crisis. The speech was a logically-structured, tightly-reasoned, and succinct retrospective of the crisis. It took one step back from the details and proved a very useful financial sector-wide perspective. The speech should be read by everyone with an interest in the crisis. It highlights the often overlooked role of leverage and maturity mismatches even as its stated purpose was examining the role of liquidity.

While most analysts attributed the crisis to either specific instruments, or elements of the de-regulation, or policy action, Dudley correctly identified the causes of the crisis as the excessive use of leverage and maturity mismatches embedded in financial activities carried out off the balance sheets of the traditional banking system. The body of the speech opens with: “..this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.”

In fact, every independent economist has said that too much leverage was one of the main causes of the current economic crisis.

Federal Reserve Bank of San Francisco President Janet Yellen said today it’s “far from clear” whether the Fed should use interest rates to stem a surge in financial leverage, and urged further research into the issue.“Higher rates than called for based on purely macroeconomic conditions may help forestall a potentially damaging buildup of leverage and an asset-price boom,” Yellen said in the text of a speech today in Hong Kong.

And on September 24th, Congressman Keith Ellison wrote a letter to Bernanke and Geithner stating:

As you know, excessive leverage was a key component of the financial crisis. Investment banks leveraged their balance sheets to stratospheric levels by using short-term wholesale financing (like repurchase agreements and commercial paper). Meanwhile, some entities regulated as bank holding companies (BHCs) used off-balance-sheet entities to warehouse risky assets, thereby evading their regulatory capital requirements. These entities’ reliance on short-term debt to fund the purchase of oftentimes illiquid and risky assets made them susceptible to a classic bank panic. The key difference was that this panic wasn’t a run on deposits by scared individuals, but a run on collateral by sophisticated counterparties.

The Treasury highlights this very problem in its policy statement before the recent summit of G-20 finance ministers in London. To address this problem, the Treasury advocates stronger capital and liquidity standards for banking firms, including “a simple, non-risk-based leverage constraint.” The U.S. is one of only a few countries that already has leverage requirements for banks. Leverage requirements supplement risk-based capital requirements that federal banking regulators have in place pursuant to the Basel II Accord, an international capital agreement. While important features of our system of financial regulation, leverage requirements only apply to banks and bank holding companies and therefore have not covered a wide array of financial institutions, including many that are systemically important. Moreover, leverage requirements have generally not captured the considerable risks associated with off-balance-sheet activities.

Of course, the Administration looks to address the shortcomings in the existing regulatory system through a proposal to regulate large, systemically-significant financial institutions as Tier 1 Financial Holding Companies (FHCs). Building upon its existing authority as the consolidated supervisor of all BHCs (which includes FHCs), the Federal Reserve would be responsible for overseeing and regulating the Tier 1 FHCs under the plan. In the legislative draft of the proposal, the Federal Reserve would have the authority to prescribe capital requirements and other prudential standards for these institutions that are stronger than those for all other BHCs. To that point, the text specifically says, “The prudential standards shall be more stringent than the standards applicable to bank holding companies to reflect the potential risk posed to financial stability by United States Tier 1 financial holding companies and shall include, but not be limited to—(A) risk-based capital requirements; (B) leverage limits; (C) liquidity requirements; and (D) overall risk management requirements.”

The application of leverage limits – as advanced by the Treasury’s G-20 policy statement and by the Administration’s financial regulatory reform plan – is a simple and elegant way to limit risk at specific financial institutions (and within the overall financial system). The financial crisis has underscored the importance of leverage requirements and manifested the problems associated with relying upon risk-based capital requirements alone ...

Nevertheless, there are some open questions regarding exactly how a leverage requirement should be applied. Some scholars and policy experts have advocated putting in place a leverage requirement for banks and other financial institutions that is set in statute. As Congress moves forward on comprehensive financial regulatory reform, it may consider such a requirement. I would therefore be interested to hear your views regarding the wisdom of such an approach.
As you know, setting capital standards requires decisions regarding what institutions would be covered, how capital would be defined, and what levels the requirements would be set. In light of that, what specific difficulties would you anticipate Congress facing with respect to specifying such a requirement? In addition, would a statutory requirement be too inflexible and place too many constraints on regulators with respect to refining regulatory capital requirements and negotiating with bank regulators from other countries?
On November 13th, Bernanke responded to Ellison (I received a copy of the letter from a Congressional source):

The Board's authority and flexibility in establishing capital requirements, including leverage requirements, have been key to the Board's ability to require additional capital where needed based on a banking organization's risk profile. One of the lessons learned in the recent financial crisis is the need for financial supervisors to have the ability to react quickly to changing circumstances, as in the capital assessments conducted in the Supervisory Capital Assessment Program. The Board and other federal banking agencies initiated this program to conduct a comprehensive, forward-looking assessment of the capital positions ofthe nation's 19 largest bank holding companies (BHCs). The Board's authority to mandate specific levels of capital was critical to this exercise because each BHC had a unique set of risks and circumstances that demanded careful supervisory scrutiny and evaluation in order to identify the amount of capital appropriate for its safe and sound operation. The Board required corrective actions on a case-by-case basis and continues to assess the capital positions ofthese institutions as well as all others under its supervision.

We note that in other contexts, statutorily prescribed minimum leverage ratios have not necessarily served prudential regulators of financial institutions well. Previously, the minimum capital requirements for the housing government-sponsored enterprises Fannie Mae and Freddie Mac (collectively, "GSEs") were fixed in statute; the risk-based capital requirement for the GSEs was based on a stress test that was also set forth in statute; and the GSE's regulator, the Director ofthe Office of Financial Housing Enterprise Oversight (the predecessor agency to the Federal Housing Finance Authority) did not have the authority to establish additional capital requirements for the GSEs. This limitation was different from the authority that the federal banking agencies have to set the leverage and risk-based capital requirements for banking organizations. In 2008, Congress enacted the Housing and Economic Recovery Act of 2008, which created FHFA and empowered it to establish additional minimum leverage and risk-based capital requirements for the GSEs.

With regard to the Board and other U.S. banking agencies' efforts to join with international supervisors to strengthen capital requirements for internationally active banking organizations, the Basel Committee is working on proposals for an international supplement to minimum risk-based capital ratios. While this work is in process, it is likely that these efforts will take the form of a minimum leverage ratio. It will be important for the international regulatory community to carefully calibrate the aggregate effect ofthis initiative, along with other efforts underway that are intended to strengthen capital requirements, to ensure that they protect against future financial crises while not raising capital requirements to such a degree that the availability of credit to support economic growth is unduly constrained. The current authority and flexibility the Board has to establish and modify leverage ratios as a banking organization regulator is very important to the successful participation of the Board in the process of establishing and calibrating an international leverage ratio.
The Supervisory Capital Assessment Program Bernanke refers to were the infamous "stress tests". There's just one little problem: the stress tests were a complete complete sham.

In reality, the Fed has been one the biggest enablers for increased leverage. As anyone who has looked at Bernanke and Geithner's actions will tell you, many of the government's programs are aimed at trying to re-start securitization and the "shadow banking system", and to prop up asset prices for highly-leveraged financial products.

Indeed, Bernanke said in February:

In an effort to restart securitization markets to support the extension of credit to consumers and small businesses, we joined with the Treasury to announce the Term Asset-Backed Securities Loan Facility (TALF).
And he said it again in September:
The Term Asset-Backed Securities Loan Facility, or TALF ... has helped restart the securitization markets for various types of consumer and small business credit. Securitization markets are an important source of credit, and their virtual shutdown during the crisis has reduced credit availability for many borrowers.
The Fed talking about reducing leverage is like a crack cocaine dealer handing out "just say no" stickers.

Indeed, the central bankers' central banker - BIS - has itself slammed the Fed:

In a pointed attack on the US Federal Reserve, [BIS and its chief economist William White] said central banks would not find it easy to "clean up" once property bubbles have burst...

Nor does it exonerate the watchdogs. "How could such a huge shadow banking system emerge without provoking clear statements of official concern?"

"The fundamental cause of today's emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low," [White] said.

The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning...

"Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.

"To deny this through the use of gimmicks and palliatives will only make things worse in the end," he said.

As Spiegel wrote in July of this year:

[BIS] observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market ...

In January 2005, the BIS's Committee on the Global Financial System sounded the alarm once again, noting that the risks associated with structured financial products were not being "fully appreciated by market participants." Extreme market events, the experts argued, could "have unanticipated systemic consequences".

The head of the World Bank also says:
Central banks [including the Fed] failed to address risks building in the new economy. They seemingly mastered product price inflation in the 1980s, but most decided that asset price bubbles were difficult to identify and to restrain with monetary policy. They argued that damage to the 'real economy' of jobs, production, savings, and consumption could be contained once bubbles burst, through aggressive easing of interest rates. They turned out to be wrong.
(Large amounts of leverage increase bubbles, and so the two concepts are highly interconnected.)

Remember also that Greenspan acted as one of the main supporters of derivatives (including credit default swaps) between the late 1990's and the present (and see this). Greenspan was also one of the main cheerleaders for subprime loans (and see this). Both increased leverage, especially since the shadow banking system - CDOs, CDSs, etc. - were largely stacked on top of the subprime mortgages.

In fact, as I've repeatedly pointed out, Bernanke (like Summers and Geithner), is too wedded to an overly-leveraged, highly-securitized, derivatives-based, bubble-blown financial system. His main strategy, arguably, is to re-lever up the financial system.

The financial system is undergoing a period of deleveraging that cannot be stopped. For example:

  • Barrons is running an editorial entitled "The Crash Must Come: Intervention can't stop the business cycle".
  • The Economist writes, "Once started, the process [of deleveraging] is hard to stop."
  • The Financial Times quotes the Bank of Tokyo-Mitsubishi in saying, "There seems little what the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time".
As derivatives expert Satyajit Das writes:
Ultimately, “all the king’s horses and king’s men” cannot prevent the de-leveraging of the financial system under way.


Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.
As former head BIS economist William White wrote recently, we have to resist the temptation to re-start high levels of leverage and to blow another bubble every time the economy gets in trouble:

Forest fires are judged to be nasty, especially when one’s own house or life is threatened, or when grave harm is being done to tourist attractions. The popular conviction that fires are an unqualified evil reached its zenith after a third of Yellowstone Park in the US was destroyed by fire in 1988. Nevertheless, conventional wisdom among forest managers remains that it is best to let natural forest fires burn themselves out, unless particularly dangerous conditions apply. Burning appears to be part of a natural process of forest rejuvenation. Moreover, intermittent fires burn away the undergrowth that might accumulate and make any eventual fire uncontrollable.

Perhaps modern macroeconomists could learn from the forest managers. For decades, successive economic downturns and even threats of downturns (“pre-emptive easing”) have been met with massive monetary and often fiscal stimuli...

Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the ­credit-driven expansions that fuel asset bubbles and unsustainable spending patterns. Recent reports from a number of jurisdictions with well-developed financial markets seem to agree that regulatory instruments play an important role in leaning against such phenomena. What is less clear is that central bankers recognise that they might have an even more important role to play. In light of the recent surge in asset prices worldwide, this issue needs urgent attention. Yet another boom-bust cycle could have negative implications, social and political, stretching beyond the sphere of economics.
The Fed may be talking like Smokey the Bear, but it continues to hand out matches trying to increase leverage.


  1. The term "capitalism" indicates that in this economic system capital as one of the three factors of production is favored over land and labor. Under laissez-faire neoliberalism, labor is considered a commodity on the level of other commodities. It's state is considered much less important to the system than capital.

    The result is that the system is ordered toward the formation and preservation of capital. Therefore, most of the action now is in the direction of preserving capital as capital destruction threatens.

    With capital disintegrating owing to debt deflation, the priority is capital preservation, and the government is the preserver of last resort, on the thinking that if capital collapses, a capitalist country is toast. Everything else is on the back burner in comparison.

    In this view, the financial sector is not receiving "special treatment" under the present economic model, where politics is equated with neoliberal economics as the generator of national prosperity, which is equated with GDP irrespective of wealth and income distribution. Capital is king.

    The problem that Bernanke faces is having only a blunt instrument with which to work. Moreover, political leverage is not available to control the TBTF's that effectively control the economy and are holding the country hostage.

    Raising rates would have a very deleterious effect on an economy in the grip of deflation. But the explosion of asset prices in relation to value based on fundamentals is concerning, especially when risk appetite is increasing and leverage is heavily involved.

    I am against the neoliberal capitalistic system to the degree it is imbalanced in favor of capital, but I am not anti-capital or anti-market as long as they are conceived in terms of a holistic model. Market economies operate best based on positive reinforcement through incentives and negative reinforcment through disincentives.

    Instead of attempting to use interest rates as a policy tool in a liquidity trap, incentives and disincentives need to be brought into play, especially since the TBTF has created virtually infinite moral hazard in an environment in which total derivative exposure is over a quadrillion dollars. Even a small portion of that going south would overwhelm the system.

    What is needed is a mix of disincentives to curb the speculation incentivized by a sea of liquidity meant for lending, extraordinarily low interest rates, a dollar trade, and increased moral hazard due to the TBTF doctrine. This would be closer oversight using existing regulation and tighter regulation as required, as well as taxation as a disincentive for high-risk behavior regarded as a threat to the system. There is ample incentive for lending as long as lending doesn't have to compete with surer gains from high-risk speculation in securities and commodities (Goldman is holding shiploads of petroleum), since there is no real downside given TBTF. The market is just doing what one would expect with the incentives in place.

    Instead addressing this problem holistically, the president and his advisors, Geithner, and Bernanke are dithering as unemployment begins to cause social unrest and dangerous asset bubbles are building as they try desperately to preserve capital from destruction. What is happening is that the country is being set up for a bigger fall. Bad scene.

  2. The Crack Addict analogy is quite fitting. It is very hard to change an economy that has become addicted to high doses of credit. How do you go through withdrawal without killing the patient in the process?

    I would assert that cold turkey is not the answer because of the devastation to individuals and the permanent destruction to viable organizations well beyond the norms of creative destruction. Rather the best path just might be a slow and mildly painful process where imbalances get balanced, government debt steps in while banks reduce leverage, the dollar loses value, standards of living fall and we experience our version of a lost decade or two.

    Our anger should be reserved for those who put us in this predicament and who seemingly are personally immune to any of the fallout that the rest of us will shoulder.

  3. Re: Fed as enabler of securitization (which, per se, isn't a bad thing all by itself) -- one important enabling device was the Fed's choice to reference credit ratings by NRSROs in so many of its regulations and operating practices. Ratings on securitized debt, for example.

    The Wall Street Journal had a wonderful lead editorial a few months ago stating that the Fed and the SEC had effectively outsourced capital regulation to the credit rating agencies. Oops.

    And watch what happens to you if, in 2003, you were working in the Fed and raise that point and propose a project exploring how to eliminate references to credit ratings by NRSROs in Fed regulations. They just sneer at you, and tell you to stop working on that project. Then you get in trouble for other things you are proud of.

  4. Full disclosure and complete transparency - this is the absolute law of our land in the UCC, and therefore in consumer protection/rights, not to mention the US Constitution which is still good law.

    The problem is how all these world governments line-up their world idea of how to have their people more in lock-step, than what can be allowed as unalienable rights.

    America, wake-up. This is about the slow but sure demise of the way of life to support more of what the others live like, and we consumers are the low hanging fruit.

    We purchased DEBT, not credit. Then, we purchased it by way of paying compound interest on the debt adding this insult to the fact, that, credit scores of high numbers were used and all for that matter (social security numbers, credit scores, etc. you name it whatever digit could manufacture MORE), produce and therefore, manufacture more debt digits for more borrowers to borrow more debt peonage.

    We in America without agreeing were stolen from, everything that we worked for and were born with - inalienable/unalienable.

    Should we be Chinese right now we'd have more rights and could sue as investors.

    To the courts, we the people and pro se is going to have to do since the class of white collar criminals own at this time, our country.

    Biloxi Marx


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