Cause of Meltdown: Massive Leverage

It is fairly clear that massive leverage was the primary cause of the financial collapse of July 2007 to January 2009. Companies like Merrill Lynch, Lehman Brothers, Bear Stearns, and various home mortgage lenders levered up their balance sheets in order to take advantage of historically low volatility in interest rates. By gearing their operations at 25 to 40 to 1, and adding other mechanisms on top of that leverage, they were able to make grand bets using the classic late night TV show trick called OPM, "other people's money."

It really shouldn't be a mystery to anyone, especially federal regulators and legislators, that this is what caused the crisis. Nearly all financial crises have too much debt and borrowing as the causative factors. All of the stomping around and looking for scapegoats just serves to deflect the public's attention away from the fact that regulators failed to apply sound financial management in their regulatory roles.

Which brings us to an especially important subject: Bailouts and moral hazard.

Bank insurance, government backstops, and similar special funds may actually make the next financial crisis worse, not better. The problem is that if the market perceives that Government has a special way to remove risk from a segment of the financial market, then participants will fail to exercise diligence in examining their counterparties and checking on their risk exposure. A consumer who believes that their money is insured by FDIC will not check on management's probity. A bond buyer lending money to Freddie Mac will accept a smaller coupon on the expectation that the Federal Government is backing the loan. If you encourage, or force, lenders and financial consumers to consider soundness of their counterparty, then everyone is going to be a lot more careful.

It reminds me of a saying that I believe is attributed to Robert Heinlein: "An ARMED society is a POLITE society."

The more consumers are discouraged from exercising their judgment about selecting sound institutions, the more the marginal institutions will use the cover of government bailout agencies like the FDIC to skate close to the edge. Blowups like Washington Mutual, Wachovia, Freddie Mac, and Fannie Mae wouldn't have been nearly as bad had they been required to trade on their full market risk.

In short, Government backstops that are funded with cash are a bad idea. Government financial regulation needs to focus more on information flow, especially sniffing out easily understood financial soundness measures of the lending and deposit-taking institutions. Shoveling financial data and telltales to the market will correct future problems before they happen, and with much more soundness than any cash-based bailout fund.