Safe Leverage
From Zanecorpwiki
TODO: needs to be split into three or four very different things.
2010-01-21
Leverage, both physical and conceptual, is always a structural thing. When done correctly, it's a structural advantage. This is entirely my opinion, but I believe a part of the recent economic meltdown was not due to over-leverage so much as non-leverage. In a word, it was really and truly gambling and not classic leverage at all.
Contents |
Two Narrative
The thing about traditional leverage is that it's incredibly beneficial to society because it multiplies the money supply significantly. However, safe leverage doesn't earn a lot of money. In the traditional scheme of things, banks leverage your deposits into a 2 to 5 multiple[notes 1] and earn around 2% points. (TODO: I'm getting better numbers, but waiting for them to come in).
With the repeal of Glas-Stiegal, general deregulation and (entirely underrated) failure to enforce even existing regulation, the to-big-to-fail banks realized that respsonsible lending (i.e., doing their job) would earn them a few million, but gambling could earn billions.
The key was the big banks knew that they could externalize any significant loss (in the form of government bailout) but would almost certainly be able to hold onto any profit. In this environment, it only made (completely immoral and financially reckless but personally beneficial) sense to take on as much risk as possible. Especially when the short term profits looked good and all the risk was in the long term.
Distinguishing between worthwhile and foolhardy risk is actually pretty hard, so it was easy for the executives themselves to delude themselves to some point and trick regulators and the public the rest of the way into thinking that insanity was sound business judgment. Let me be clear, though: the regulators and public were complicit if through nothing else than laziness in all this. The cloaking of insanity really wasn't all that masterful so much as it was easy for us to not question things.
At least that's my narrative that I place in opposition to that told by the "wall street fat cats" (whatever that means). I like to think I'm blaming them because they're guilty, but maybe I'm just jealous of all their blood money and taking this opportunity to take unfair shots at hard working businessmen. I can't deny that my narrative serves my interests better than it does there's. But I will say that this "you're just complaining because you're not rich" argument is the only argument I've heard from those defending the moneyed interests.
"The self-serving argument" counter is not to be dismissed lightly, but on the balance, I believe it can be dismissed in this case. If for no other reason than their own argument is far more self-serving than mine. The Wall Street argument goes something like, "We did everything right, and it's only in hind sight that the problems are obvious. You are incorrect to apply the standards of hind sight to decisions that could not have been made with that benefit."
There is merit to this idea, and in general we must be very understanding of perspective when judging the past. This argument fails on two points. First, we should be suspicious of it for it is a very self-serving argument. Of the two sides, it is clearly more self serving for the banker to say, "I did the best job I could" than it is for me to say, "You did a shitty job you jerk" for by the former the banker adds hundreds of millions of dollars to his personal fortune whereas by the latter I gain only a debatable moral victory nothing of tangible benefit whatsoever.
The second problem is that the Wall Street folk are supposedly paid for expertise. For multi-million dollar bonuses, I would think we should expect that they could see it coming when in fact no one else could. If they cannot, then what are we paying them for?
In reality, I would argue that they could and did see it coming, and in fact more or less created and profited by the economic crisis. Rather than lacking for expertise and inside knowledge, they used it very specifically and intentionally to further their own interests regardless of the cost to the economy as a whole.
Good Leverage
So what does good financial leverage look like? The idea is to spread risk around so that you can safely multiply your dollars. So the first thing to understand is how one can multiply dollars in the first place. Then we can talk about how to do so safely.
Multiplying Dollars
If everyone in America went to the bank on the same day and said, "Give me my money!", what fraction of people would actually get their money? The answer: less than 1 in 20. How can this be? Well, first you must understand that holding your money is a small, and in many ways the least important of a banks job. If you're goal was "to have money on hand" you're much better off buying a safe and stuffing it with cash than putting your money in a bank.
The moder bank's real purpose is to safely multiply money. Imagine two clients and a bank. The first client puts $1,000 in the bank. The bank now lends $900 to the second. There's now $900 more dollars in the world than before.
Why? Because the first person has $1,000. He write a check to anyone for anything and that person has deserved faith that they'll get that $1,000. At the same time, the guy with the loan has $900 he can spend anywhere.
The banks can do this because when you aggregate thousands of depositors, the flow of money becomes predictable. You'll know when you people are most likely to want money and when people will be saving money. On the other side, with thousands of loans, payments and cash availability are also predictable. The more predictable (and the bigger the economy), the less actual cash you need to have on hand at any one time.
It's not magic: the bank effectively owes it's depositors $D. They can come and say, "Give me my money!" and the bank has to do it or they're shut down. It holds $C in cash to pay out those depositors that are expected to come by at any given time. It makes $L in loans. $D + $P - $C - $L = 0, where $P is the profit a banks makes on the spread.[notes 2] In other words, the cash reserves and outstanding loans simply and perfectly offset the banks deposits and profit (or loss if things are managed poorly).
The reserve rate is the percentage of total deposits which the bank is required to hold in cash, ready to pay out when depositors come ask. Banks will typically operate as close as possible to the reserve rate--meaning they hold as little in cash as possible--because every extra dollar they get out in loans means a little more profit. The reserve rate is 3% which means that, more or less, a bank only has to keep 3 cents on every dollar as cash and the rest will go out as loans.[notes 3]
The lower the reserve rate, the bigger the multiplier. Every dollar that goes into a bank immediately adds another 97 cents in the economy. Now here's the part that's even more incredible: Each dollar in the bank actually adds much more to the economy than just 97 cents.
Consider that most loans are deposited back into banks (or other financial institutions). If I give you a loan for $1,000 to start your new business, you're going to put that money in your bank so you can write checks. Maybe it takes you a year to spend all the money I lent you, so there's an average of $500 in that bank account for a year. That's another 48.5 cents your dollar added to the economy for that year.
That's the basic of multiplying money, and naive leverage is nothing more than rinsing and repeating as many times as you like. Add in things other than banks, simple deposit accounts and simple loans, and there's dozens of ways and places that money is multiplied throughout our economy. It all compounds together, and the mind-blowing thing is that if it were perfectly efficient, there's no theoretical reason why you couldn't have effectively infinite money... and the economy would still work just fine.[notes 4]
Safe Sex and Good Leverage
Multiplying money is a form or procreation, like sex. And like sex, it can be very risky. Good leverage is like safe sex. It's never actually risk free, but with the right approach, it's well worth the risk.
The traditional bank as existed in the US between the early 1930s and early 90's) were pretty good at managing this risk.[notes 5] Picking good loans is well understood, and the banks make loans relatively efficiently and manage their risks well with regard to the traditional activities.
Notes
- ↑ I've heard that total dollar multiples are between 6 and 7, meaning that for every "original" dollar in the economy, we end up with 6 or 7 usable dollars. Traditional banking is a big part of this, but I don't recall ever seeing anything that specifies how much of a part.
- ↑ Spread is essentially the difference between what the interest rate the banks pays depositors and the interest charged on loans.
- ↑ In practice, it's a little more complicated. Because banks tread so close to the reserve limit, they're often on the wrong side. In this instance, they end up taking on loans themselves in order to cover the difference.
- ↑ Of course perfect efficiency is impossible, so literally infinite money is impossible. However, I strongly believe that on balance, there's every reason to think that we could achieve an efficiency sufficient for creating an order of magnitude more wealth than exists in the world today.
- ↑ The savings and loan crisis is an example of failure, but S&Ls failed, at least in part, because they were not banks and were limited to to a single type of lending: mortgages. When housing prices went south, the industry collapsed in large part because of inability to diversify.
