Of water and leverage

Though there is no way to eliminate completely downturns in markets, the ongoing credit crunch has proven a major truth that ought to have already been known and ought not have been taken for granted: neither borrowers nor lenders can operate without a leverage ratio.

Both consumers and firms use credit to facilitate investment. Basic macroeconomics shows investment provides greater returns than savings. However, there are two competing orthodoxies: savings as collateral provides a good entrepot to a loan, and sometimes borrowing costs alone justify borrowing. In the latter case, if the Federal Reserve lowered interest rates, even if a balance sheet is already heavily geared, there would be a greater economic opportunity cost to inaction. Yet, a steadfast adherence to this aspect of basic economics while ignoring the need for market correction has partly precipitated the current malaise.

For households, debt to income ratios are and have been alarmingly high since the internet bubble days of the late 1990s. To stave off the effects of recession after the market crash in 2001, lowering interest rates kept firms and households afloat, but they had unintended knock-on effects such as flipping the yield curve, perpetuating the cheap money period, which fueled the housing bubble. What are we left with?

A cheap currency, for starters, may be good for boosting exports, but newfound competitiveness of American commodities abroad will never become big enough to dent the trade deficit. Secondly, laxer lending conditions allowed displacement of risk, but a market can absorb only so much wealth or debt. Moreover, even the modelers of fancy financial instruments are not entirely certain about who will be left holding the bag and when. Picture a lake filled with various sized boats. Imagine a fleet of submarines got into the lake and began offensive maneuvers. Pretend all the boats try to tack against the onslaught. Some displacements would naturally be greater than others, and would suck the smaller vessels down into the wake of the largest. If there are enough torpedoes, no ship is too big to sink. That is the extent of the credit crunch.

Perhaps the most alarming thing about the subprime fiasco is that a significant majority of mortgagees pay the banks on time. To put this in perspective, subprime loans, at their height, still amounted to only 2.6% of the aggregate mortgage market. This shows how scary the level of contagion is. What would motivate creditors to loan the money in the first place and then repackage blocks of these loans to hedge the risk of default?

The answer to both questions lies in American bankruptcy laws which favor the borrower over the creditor. However, by trying to displace risk, creditors in essence became borrowers themselves, and this has left some of them scrambling for a spot at the Fed's discount window. For investment and commercial banks, adopting a generally accepted leverage ratio provides institutions with much needed credibility in the wake of misdeeds and bungles of the past fifteen years. Moreover, the ratio provides an objective standard for pricing and assumption of risk.

Innovation of financial instruments is a good thing, on balance. Availability of credit is a good thing, in toto. However, without having if not de jure, at least de facto leverage ratios to provide a necessary constraint, then knee-jerk regulation and government bail-outs are the alternative. Economically, this means death. Without a credible penalty within the market for reckless practices, then moral hazard prevails. To restore economic order, some will lose, few will disproportionately gain. However, the lesson all should learn is that avoiding recession is a quest for the Holy Grail. Rather, the objective all ought to strive for is to become recession proof. That is, to paraphrase Warren Buffett, either not to swim naked in the first place, or at least have the bathing suit we doffed close in hand, because the tide always goes out.