04/24/2010 05:12 am ET Updated May 25, 2011

Lowering the Boom on Financial Leverage

The struggle for financial regulatory reform in Washington will fail if the debate continues to focus mainly on the bookends of the crisis -- the original subprime shock and the eventual federal bailout. Although both were very serious problems, even more serious was the near collapse of the American financial system that came in between.

A healthy financial system would have been able to absorb the subprime shock, like a well-conditioned fighter who's able to take a punch and remain standing. But our financial system, wildly overleveraged, crumpled after just one blow. If we don't fix the leverage problem, everything else will be for naught.

Over the past several decades, rising debt levels characterized just about every part of the American economy. But total debt outstanding rose particularly fast in the financial sector, surging from $578 billion (21% of GDP) in 1980 to $17 trillion (118% of GDP) in 2008. In the years leading up to the crash, moreover, financial firms increased their leverage to dizzying heights, piling ever more debt on a dangerously thin foundation of capital. Among domestic investment banks, gross leverage ratios grew from about 23-to-1 in the first quarter of 2001 to over 30-to-1 in the fourth quarter of 2007. And that's just what was visible on their balance sheets. Off-balance-leverage rose dramatically higher, with contingent liabilities (including AIG's notorious credit default swaps) inflating hidden leverage to truly extraordinary levels.

Greatly compounding the problem was that much of this leverage was based on very short-term debt, creating the potential for bank runs if confidence ebbed. Much of the leverage was also concentrated at firms that had grown spectacularly in a short time. Bear Stearns, for example, had grown its assets more than 10-fold from 1990 to 2007.

Unfortunately, it was the biggest (and most highly leveraged) financial institutions that played the greatest role not only in inflating the bubble on the way up but also in driving the panic on the way down. As asset prices started to fall as a result of the subprime mess, many of these super-sized financial firms had no choice but to sell -- and sell massively -- to keep their already thin capital base from vanishing altogether.

Had the large financial firms been better capitalized to begin with, the catastrophic fire sales that brutalized the markets in 2008 could well have been avoided, or at least kept to a minimum. But in companies that were so highly leveraged, even small losses on their overall portfolios could wipe out their capital -- a prospect that left them no choice but to intensify their selling as the subprime turmoil deepened. Indeed, had the terrifying downward spiral not been stabilized through aggressive federal action, the nation's financial system might have collapsed altogether, greatly worsening the recession and driving unemployment even higher -- and perhaps far higher -- than what we've experienced so far.

What will it take to prevent such a calamity from ever happening again? We should certainly address the bookends of the crisis: common-sense regulation of consumer and mortgage lending would help to prevent another subprime fiasco; and the creation of new tools for dealing with major financial firms that fall into distress could reduce the need for another bailout. These are critical steps. But by far the most important thing we can do is make our financial system strong enough to withstand a significant shock, and that means limiting leverage, particularly at the nation's largest financial firms.

Fortunately, the House bill passed in December already contains language capping the leverage of "systemically significant" financial institutions at no more than 15-to-1. (Full disclosure: I suggested the provision, and worked with Representative Jackie Speier who shares my concern about leverage and sponsored the relevant amendment in committee.) It is now imperative that the Senate adopt this provision, or even tighten it, perhaps taking the limit down to 10-to-1.

Congress should also impose strict limits on these firms' short-term borrowing and off-balance-sheet activity, and require them to maintain sufficient liquidity as well. Combined with a tough leverage cap, such rules will help ensure that an unexpected shock -- whether from the mortgage sector or someplace else -- will never again threaten to bring down the broader financial system and inflict so much pain on the America people.

For those who worry that limiting leverage is somehow inconsistent with American tradition, it is worth remembering that the nation's founders strictly limited bank leverage in their own time, frequently at less than 4-to-1. Although bank runs remained a problem in early America because of the absence of deposit insurance, the dangers of high leverage were already well appreciated. Let's not lose sight of that wisdom now.

Crossposted with the Baseline Scenario.