LEVERAGE AND EXUBERANCE….A couple of days ago I read someone, somewhere, suggesting that the problem with Wall Street these days is that it’s just too damn easy to make money. Practically anything you put your hands to generates wild truckloads of cash, and this promotes reckless behavior.

Thanks to my rapidly declining brainpower, I don’t remember where I saw this. Which is too bad, because I wanted to write a post saying that I think it’s wrong. In fact, I suspect it’s 180 degrees wrong. It strikes me that the real problem is that in recent years markets have become so hyper-efficient that it’s really hard to make lots of money from purely financial transactions. The competition is too good, spreads are too thin, computers are too powerful, and trading windows are too short. So what to do?

Two things. The first is to rely on absolute mountains of leverage. If a particular kind of hedge offers a potential spread of, say, 0.1%, then you need to invest a billion dollars to even begin to make any serious money. Obviously this makes the downside risk enormous if your bet turns out to be wrong.

The second is…..what to call it? Not fraud, certainly. Not that. Perhaps hocus pocus? Agressive salesmanship? Exuberance? Whatever.

Over at Calculated Risk, Tanta picks up on this theme, arguing that our current credit crisis isn’t really due to the rocket-science complexity of CDOs and SIVs, but rather due to excessive leverage and excessive, um, exuberance. The problem is that Mortgage Backed Securities are, fundamentally, sort of boring and low yielding, so something had to be done about that:

The lurking concept here is “leverage.” You want to make the big bucks investing in MBS? You leverage them. That’s where those CDOs came from. A whole lot of this complexity is driven by the “need” to goose the yield, not by some essential opacity of the underlying credits….The complexity came in because you can’t get a tranche paying 12% out of a bunch of loans that pay 8% unless you create complex cash-flow structures hedged by complex rate swaps leading to re-securitization of tranches in new vehicles (parts of the MBS become CDOs, for instance).

Of course, a mania for leverage is nothing new: the stock market crash of 1929, for example, was partly fueled by low margin requirements that caused investors to take huge losses when the market started to tank. (Margin requirements were eventually raised after the creation of the SEC in 1934.) More recently, the collapse of the hyper-leveraged hedge fund Long Term Capital Management in 1998 prompted the following warning from Alan Greenspan and Robert Rubin:

The events in global financial markets in the summer and fall of 1998 demonstrated that excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole….Although LTCM is a hedge fund, this issue is not limited to hedge funds. Other financial institutions, including some banks and securities firms, are larger, and generally more highly leveraged, than hedge funds….The near collapse of LTCM illustrates the need for all participants in our financial system, not only hedge funds, to face constraints on the amount of leverage they assume.

Well, perhaps Wall Street did need to “face constraints” on their use of leverage, but it turns out that a stern talking-to wasn’t enough to get their attention. And so we end up where we are today. We still need to restrain the use of leverage among our exuberant friends on Wall Street, and considering the price we’re paying for all this leverage and exuberance, this time the restraint needs to be a little more concrete. This is why, at a minimum, we need new regulations requiring consistent capital requirements among all financial institutions.

And the “exuberance” part of all this? Well, that’s where the rating agencies come in. For more on that, check out this post from Bruce Carruthers at Crooked Timber.

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