Thursday, February 19, 2009

The 2004 Leverage Regulation

I did have the chance to ask a retired risk officer from a major bank his views on the 2004 leverage regulation change.

To brazenly and hopefully honestly summarize, he definitely lays a fair amount of blame on that change. Not everything, of course, and there are some caveats. Somehow he was even able to pick the firms that he thought would have shown the biggest response to it, and his predictions pretty well matched up with the Wikipedia graph noted in earlier posts and comments.

It still surprises me that the binding constraint on risk was a government regulation. I would have thought that the folks whose livelihood depended on survival of the firms, as well as counterparties, would have induced a more conservative stance than the loose regulations allowed. Lesson learned.

7 comments:

Kevin said...

Why are you surprised? Don't you remember LTCM?

Duffer McDinner said...

Thanks for following up, Professor Hansen. I appreciate your willingness to allow contravening facts to sway a published opinion-- the Internets need more of this!

Kevin said...

It's noteworthy that the US consumer was equally as guilty as the investment banks, and we (collectively) made the same mistakes. Borrowed too much on credit cards/HELOCs, made stupid 'investments' in housing, and many of us took too much risk in our 401k's. So, this isn't just an IB thing - it's a human psychology thing.

Anonymous said...

Yeah - libertarian philosophy failed all over the place on this one. (But, I still think that it has a place in our society - like gay marriage. I think we should let them do it up. Aint gonna hurt me at all.)

Anonymous said...

Bob,

Your comments reflect the fact that you already know the outcome and benefits form 20/20 hindsight.

The reality is that both management and regulators had under-estimated liquidity risk and the potential for a meltdown as we had. They both had lived through a period of great capital market liquidity and that influenced their decisions. If management had any thought that potential survival was at stake, they of course would not have increased their leverage nor would they have more importantly mismatched the duration of assets and liabilities. I am sure that they believed that the capital markets were such that they could finance themselves forever, and the SEC agreed with that. They made the same mistake that others have made. Had the SEC not increased the leverage, they would have figured out a way of doing it anyway through other means because they believed the risks were low

What often brings down financial institutions is mismatch of the duration of assets and liabilities. In periods of euphoria of credit markets, they think they can do that with impunity and for many years and many bonus cycles it did until the music stopped. Had the duration of the liabilities been matched with the assets, the problems would have been significantly less. .

Regulators do not know any better than management what is happening at any point in time. Increasing disclosure and transparency, providing liquidity to non-bank financial institution is only part of the solution but human nature will not change.

I am not sure how the comment of libertarian philosophy failed all over the place is accurate. Shareholders lost a ton of money, many of the banks have lost over 90% plus of their value.

It seems to me libertarian philosophy is working well. Libertarian philosophy is never meant to avoid bubbles or mistakes. You have the proof that regulators did not know any better and in fact may have exacerbated the problem with FNMA, Freddie,the community reinvestment act. You have many countries with more regulatory oversight than the US and they have the same issues. We will learn from the mistakes until human nature becomes complacent again and the memory of recent events get displaced by other more recent ones.

AK

Anonymous said...

Of course we are discussing with 20/20 hindsight! With that hindsight, the Professor started the convo by saying he did not think the de-leveraging rule was at fault. (But, to his credit, he has since backtracked on that.)

Mortgage brokers, real estate agents, investment banks, and consumers screwed up and are at the root cause of this financial crisis. The financial crisis is affecting everyone in this world and not just those that made stupid investments and have been punished by losing "over 90% plus of their value." This should give libertarians cause for lots of introspection.

Community reinvestment act is also a cause. Democrats should think long and hard about that one, too.

By the way, if the SEC did not engage in this deregulation, what means would the investment banks have used to increase their leverage any way?

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