Leverage: a financial problem symptom

Seeking Alpha considers a Solution to Our Economic Mess? Limit Leverage!

the problem isn’t that investors buy MBS and lose their money. The problem is that investors can put up $100MM in capital and buy $3B of MBS with someone else’s money – that’s called leverage, and that 30-1 ratio was not at all uncommon.

Leverage, on its own, is not a bad thing. It is the crucial benefit in any loan situation. Where it can be the source of a problem is when it is not balanced with the risks involved in the loan.

The Great Depression was, in part, due to the assumption that banks were safe but the banks were investing their deposits in adventures whose risk was out of line with their leverage. A result was that the feds insured the ‘little guy’ with the FDIC.

The current finance problem is similar. Houses used to be a safe asset but then the political establishment decided home ownership was good and make it easier to buy houses. That created market pressure that, in turn, inflated housing values. Then folks started leveraging their house values to obtain loans. Those loans were, in turn, massaged by third party firms into financial instruments that isolated those who invested in those instruments from the actual value of the housing asset. The leverage was such that it only took a small bump to blow the whole scheme out of the water.

The answer is simple: if you cannot value the security, you should not buy it. You don’t “trust the middleman,” – you buy something else.

If you don’t follow this guide, then the suggestion is that

The Fed’s role should be to prevent systematic risk – in other words, it doesn’t matter if you lose all your money, but there should be regulations to make it so that you cannot put the financial system at risk

That brings up the issue that political policy should be towards protecting the system and not particular individuals (company, corporation, or whatever). The “too big to fail” mantra is being applied where individual and system become too interdependent. One suggestion about this was that “too big to fail” meant that the individual needed to be made smaller so as to be able to keep the political focus on the system independently. This then can inhibit the impact of broken leverage on the system and, perhaps, stimulate more effective due diligence on the part of investors.

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