Mar 5, 2014

Leverage in financial crises

Leverage is a double-edged sword. One acute edge increases returns and amplifies price bubbles, another enlarges losses. When key financial institutions take on too much leverage, even a seemingly localized financial distress can result in a knock-out effect of the entire financial system.

Panic of 1907
In 1906, the ratio of cash reserves to deposits at trust companies - institutions at the heart of the crisis - was 3 percent (Moen & Tallman,1992). Given that trusts' depositors were not secured by a lender of last resort, the ratio of cash reserves to deposits can be translated into a leverage ratio of 33-to-1. In other words, a 3% withdrawal of deposits would have wiped out trusts' capital and sent them to bankruptcy. In 1907, just before the October stock market crash, the ratio of cash reserves to deposits was 8 percent, translating into a leverage ratio of 12.5-to-1. While the leverage ratio in October was much more conservative than the ratio of 2006, it was too late to contain the rising tide of panic.

Source: (Moen & Tallman,1992)

Wall Street Crash of 1929
Stock market speculators were at the epicenter of the 1929 Wall Street crash. Speculators purchased stocks on margin, typically equal to 25% (Galbraith, 2009), implying a leverage ratio of 4-to-1. While 25% percent in equity certainly provided a substantial cushion, the basic point was that the collateral in the form of stock equity used to back a call loan was a highly volatile asset. As soon as the stock market started declining, investors could no longer maintain the 25% minimum margin requirement and were forced to sell their assets. The crash of 1929 represents an example of how a seemingly moderate leverage ratio amplifies financial calamity.

British Secondary banking crisis of 1973–1975
Fridge banks that caused the crisis operated with high, although not exactly known, leverage and retained miniscule reserves.

1980s Savings & Loan crisis
Thrifts had a leverage of 668-to-1 (National Commission on Financial Institution Reform, 1993). The minimal initial capital requirement for starting a thrift at that time was a meager $2.0 million. This amount could be leveraged to a humungous $1.3 billion in assets.

LTCM crisis
By the end of 1997, Long-Term Capital Management hedge fund had a leverage ratio of 28-to-1 (The President’s Working Group on Financial Markets, 1999).

2008-2011 Icelandic financial crisis
The average pre-crisis leverage ratio of three key banks in Iceland was 30-to-1 (Fitch Ratings, 2013).

2007-2008 Financial Crisis
At the beginning of 2008, the leverage ratio of bulge-bracket investment banks was hovering at about 30-to-1 (Lehman Brothers, 2008).
Lehman Brother's ratio was 32-to-1 at the first quarter of 2008, going up to 60-to-1 in between reporting periods.
Northern Rock, the famous British bank, had a leverage ratio of 40-to-1 (Song Shin, 2009).
Fannie Mar was leveraged 69-to-1 at the end of 2007, while Freddie Mac was 81-to-1 (Bass, 2010).
Citigroup's end-of-year 2007 leverage ratio without off-balance-sheet assets was 31-to-1 and 48-to-1 if those assets are included (FCIC, 2011).
Bank of America's ratio at the end of 2007 was 27-to-1 and 34-to-1, excluding and including off-balance-sheet assets respectively (FCIC, 2011).

Conclusion
A very LT investor should thus note that there has never been a time in history when central market participants with a leverage ratio of 30-to-1 or greater were able to withstand a financial calamity in a period when the financial environment was deeply-rooted with structural vulnerabilities.


Sources

Bass, K. (2010). Testimony before the Financial Crisis Inquiry Commission Hearing on The Financial Crisis. Testimony prepared for the Financial Crisis Inquiry Commission.

Financial Crisis Inquiry Commission. (2011). Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Washington, D.C.: U.S. Government Printing Office.

Fitch Ratings (2013). Iceland (Rating report, March 1). New York: NY.

Galbraith, J. (2009). The Great Crash 1929. New York, NY: Mariner Books.

Lehman Brothers (2008). Business and Financial Review Q2 2008. Retrieved from http://www.jenner.com/lehman/lehman/docs/MET%20LIFE/ML-LEH%2000012182-00012246.pdf

Moen, J. & Tallman, E. (1992). The Bank Panic of 1907: The Role of Trust Companies. The Journal of Economic History 52(3).

National Commission on Financial Institution Reform, Recovery and Enforcement (1993). Origins and causes of the S&L debacle: a blueprint for reform (A report to the President and Congress of the United States). Washington, D.C.: The Commission.

The President’s Working Group on Financial Markets (1999). Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. Washington, D.C.

Song Shin, H. (2009). Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis. Journal of Economic Perspectives 23(1), 101–119.

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