Commentary: First, Slap Limits on Bank Leverage

Republicans and Democrats in Congress have been squabbling about whether the new financial consumer protection agency should be housed within the Federal Reserve or as part of an independent body. The watchdog, wherever it ends up, is the linchpin of the emerging financial reform bill, and its premise is that greedy bankers exploiting dumb consumers essentially caused the credit crisis. Stop bankers from selling toxic mortgages and other harmful loans, goes the theory, and we won't have any more meltdowns.

Even though bankers were greedy and many borrowers were naive, this is a simplistic way of viewing the financial crisis. Since mortgage bankers make money from loans, it's tempting to think of them as parasites who prey on customers. But there is no such thing as a smart bank with a dumb customer; if the loan turns sour, the banker was dumb, too. And in the mid-2000s, scads of them were.

Foreclosures by consumers heavily weighed on the economy, but what triggered the credit crunch was the failure (or near-failure) of the banks that issued (or acquired) the mortgages. In short, the root cause of the meltdown wasn't that customers borrowed too much; it's that banks lent too much. Before the bust, champions of the new consumer agency, such as Representative Barney Frank (D-Mass.), were consistent advocates of more loans to subprime borrowers. That's hardly surprising; it's in the nature of folks to want more credit.

This isn't to deny that many subprime loans were exploitative and that customers often didn't understand repayment terms. Nor is it a bad idea to police banks, preventing them, for instance, from charging exorbitant fees.

Yet a sound economy needs healthy financial institutions. Rather than stop lenders from hurting consumers, the aim of regulators should be to force banks to do what is in their own and society's interests: practice sound banking. No consumer watchdog can do this because systemic risk aggregates at the level of the lender. The surest solution is to limit the leverage of financial institutions. Regulators have already moved against dicey products such as no-documentation mortgages ("liar loans"), and ones in which borrowers get 100% financing. And well they should.

But rather than try to make banks perfect, the main goal should be to minimize the damage when they prove imperfect. The way to do that is to limit leverage by restricting their use of debt. Leverage acts like an accelerator, magnifying and spreading losses from one borrower to another. In most meltdowns, this has played a leading role.

In the late 1980s, for example, companies paid silly prices for acquisitions until, in 1990, the mania stopped. Since almost every deal had been financed with boatloads of junk bonds, the crash left business saddled with debt, and banks were stuck with sinking assets. The country went into a recession.

By contrast, investment bubbles that aren't associated with debt are far less lethal. The dot-com frenzy was easily the most flagrant episode of speculation in the last 75 years. Scores of companies with zero earnings sold stock; dozens of these initial public offerings soared in value on their first day of trading.

By contrast, the recent real estate bull market was tame. Home prices doubled over five or six years—impressive, but nothing like the IPO stocks that doubled in a day. Yet when the dot-com bubble burst in 2000, the impact was modest. The country had a mild, brief recession. Unemployment topped out at 6.3%.

The mortgage bubble, on the other hand, was built brick by brick with debt. And it led to the worst recession since the Great Depression, with unemployment over 10%.

U.S. regulators have been reluctant to raise bank capital requirements without a global accord, lest American companies be put at a disadvantage. And the international Financial Stability Board in Basel, Switzerland, has been vowing to raise capital standards. However, the process is slow. Congress should make clear that if the board doesn't act, it will. There can be no going back to 30-to-1 leverage on Wall Street.

Since much leverage today is kept off the balance sheet (via derivatives), any financial reform that doesn't curb the use of such instruments is sorely flawed. Congress should immediately boost the amount of margin capital required to place derivative bets—the equivalent of reducing leverage.

Protecting consumers and breaking up large banks are fine. But neither measure will prevent banks from acting stupidly again. The surest safeguard is to ensure that, when they do, they aren't up to their necks in debt.

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