Profit and Leverage

Jon Hilsenrath, Damian Paletta and Aaron Lucchetti, "Goldman, Morgan Scrap Wall Street Model: End of Traditional Investment Banking," The Wall Street Journal, Sept. 22, 2008:

The most fundamental problem is how to generate profit growth in a world that no longer tolerates high leverage.

Comments:

That's odd. Is that your statement? It sounds as if it's public opinion that doesn't tolerate high leverage, but really it just Doesn't Work - if it did then we wouldn't be in this mess.

I'm no economist, but high leverage, it seems, relies too heavily on a constant flow of cash from group to group, without a single card in the house of cards falling down. That just seems unrealistic.

Posted by David Van Couvering on September 22, 2008 at 03:39 AM PDT #

It comes from the reporters, and I think they have got the crux of it. The world can no longer tolerate high leverage. Apparently, some of the banks had a leverage of 1/33. That's like buying your house with about 3% down. High leverage is used to generate higher returns on capital. Again, if you have 3% down on your house and the value of the house doubles, you have made great profit on your 3%. That's how higher leverage leads to great profits when things are going up. The reverse side, i.e. things going down, is what we have now.

Posted by M. Mortazavi on September 22, 2008 at 03:44 AM PDT #

Leverage has worked since it was invented, effectively, by the Medicis (or before -- whatever).

Leverage creates the risk of systemic crisis. The higher the leverage, the higher the risk.

Sounds stupid, doesn't it? But then, we couldn't have the standard of living that we have today, because we couldn't have the degree of economic activity, past and present, without leverage.

So, I say, yay leverage, to a point. And that point is nothing new. Capital requirements have existed for banks for decades for a simple reason: capitalization requirements put a limit on leverage. Now that just needs to be extended to all large financial players, including not just plain banks, but also investment banks, hedge funds, ... -- all that can cause a systemic crisis, the way hedge funds did a decade ago, say.

BTW, the last major crisis to be fobbed off on the taxpayer was the S&L crisis. Not bad then -- about $1 trillion of today's dollars every 20 years is pretty darned cheap for the return that leverage has produced for us all.

Posted by Nico on September 22, 2008 at 06:59 AM PDT #

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