Leverage was not the problem. Incentives were…and still are…
According to the Atlantic's William D. Cohan one of the most seductive
narratives about the recent financial crisis is that it was caused by dizzying
increases in the amount of leverage on the balance sheets of Wall Street firms,
leaving the financial system virtually no margin for error. Leverage, we’ve
been told repeatedly, went from about 12-to-1 in 2004 to 33-to-1 in 2008.
(Leverage is the ratio of debt or assets to equity; at 33-to-1 leverage, a mere
3 percent drop in the value of a firm’s assets can wipe out its equity.) The
reason for the increase, so the story goes, was an underappreciated change, in
April 2004, to an obscure Securities and Exchange Commission rule, which let
Wall Street off its short leash and allowed unprecedented risk-taking. If not
for that, according to the popular press and many accomplished scholars, the
crisis might not have happened. The acceptance of this thesis has colored not
only how we think about what happened but also the new laws that were designed
to prevent the next crisis. The problem is, it’s flat wrong. And because we
have misunderstood the facts, we may now be trying to cure the wrong disease.
The spread and evolution of the idea that the financial
crisis was caused by a giant increase in leverage, enabled by the SEC, bears a
passing resemblance to the old-fashioned, elementary-school game of ….
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