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March 20, 2009

Too much leverage is a bad thing

there is just too much leverage in the financial system. Banks, dealers, hedge funds and private equity firms. Too much leverage. The big U.S. investment banks were, by far, the worst offenders followed closely by European banks.
In April 2004 the SEC granted the five big U.S. investment banks virtually unlimited leverage.
Following this decision, the assets and leverage ratios of the five firms exploded.
In just the four years to the end of 2007, the aggregate assets of these five firms doubled from $2.1 trillion to $4.2 trillion and the average leverage ratio, as measured by total assets to common equity, increased from 23 times to 33 times.
These ratios were “off the charts” – especially when you consider these weren’t investment banking firms at all.
Over a decade these firms had morphed into being gigantic hedge funds, dealing in risky assets and they were financed largely by wholesale money.
They were an accident waiting to happen.
Financial firms love leverage because it can do wonders for your profits and your return on equity in the good times.
Unfortunately, leverage can kill you when business turns down.
Most people do not appreciate the destructive power of leverage. At 33 times leverage, as these five big investment banks were, if your assets drop by just 3.3%, you are out of business. And at 40 times leverage, where some European banks were, if your assets drop by just 2.5%, you are gone. With these leverage ratios, there was zero room for error – no cushion.
Leverage is especially destructive in a deflationary environment.
Asset prices decline, debt remains the same and the equity gets crushed.
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