Conventional wisdom says that the mess that the banks are in is due to a lack of regulation, which meant that banks did things that they shouldn’t really have got involved with. And they did these things with lots of leverage, just for good measure. This widely held view is true, but rather understates matters. Banks have been building up leverage for not just the last few years, but arguably for ten or even twenty years. Higher leverage was made possible by the issuance of things like Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS), which in reality were just another way for banks to issue more debt, but under a different name. The concept of ABS and MBS was peddled as a new, uncorrelated asset class. Products such as CDOs were created over a decade ago, and these invested in things such as ABS and MBS. Huge demand for structured credit enabled banks to issue more and more of the stuff.
People have balked at just how much leverage banks and investment banks managed to take. Officially, a number of investment banks have leverage of some 20 times, so the value of their assets is 20 times as big as the equity that is supporting it. To put this in perspective, for a company that is 20 times levered, it only takes a 5% fall in the value of the assets for the equity to be worthless and the bank to be insolvent. (Anyone buying a house is in a similar position – if you buy a £300k house with a £60k deposit, you have £60k of equity and £240k of debt, so you are 4 times levered. If the value of the house falls by £60k, or 20% in value, then your equity is wiped out and you’re in negative equity, ie technically insolvent). It’s worth adding that the banks’ scary official leverage figures grossly understate their true positions – once you add back all the off balance sheet vehicles, some banks (who’ll remain nameless) are more than 50 times levered, so it takes less than a 2% fall in the value of their assets to make banks rush to markets for more equity (and if they can’t raise money, they go under).
The other very big part of the story revolves around how monetary policy is set. Banks were encouraged to lend even more aggressively by monetary policy being incredibly lax in 2002-2006. Central banks kept interest rates too low for too long, because they were worried about deflation. The consequence of their actions, though, was that in keeping rates artificially low to prevent deflation, central banks encouraged rampant borrowing, and caused an excessive boom in economic activity, resulting in huge bubbles in housing and commodities.
I agree that inflation is bad, and monetary policy should prevent it from becoming entrenched. However the global dynamic 5 years ago was for prices to fall, which was a direct result of the opening up of China’s economy and the dramatic fall in the prices of manufactured goods. Central banks should have let inflation fall to zero or below. By not letting that occur and keeping rates artificially low, they helped to cause both the big boom of 2003-07 and the big bust we’re now experiencing. They were petrified of the ‘Japan scenario’ of a decade of deflation and weak growth, but Japan’s decade of deflation followed their own huge real estate and stock market bubbles.
Time will tell, but in trying to prevent a Japan scenario, there is a very real risk that they have ironically caused one. The huge deleveraging that is going on right now will cause economies to shrink, and inflation to sharply fall. Ben Bernanke and the Federal Reserve have got it right – interest rates have to be slashed to avoid a depression. UK and European central banks need to follow suit, and the longer they wait, the deeper the pain.