Thomas M Hoenig: Leverage - the double-edged sword
Written statement by Mr Thomas M Hoenig, President and Chief Executive Officer of the
Federal Reserve Bank of Kansas City, before the House Financial Services Oversight and
Investigations Subcommittee, United States House of Representatives, Kansas City, 6 May
2010.
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Introduction
Chairman Moore, ranking member Biggert, and members of the committee. Thank you for
the opportunity to testify at this timely hearing.
The financial panic of 2008 created the worst recession since the 1930s, sending
unemployment soaring to 10 percent and dramatically changing the landscape of our
financial system. While many factors were responsible for creating this crisis, there is no
doubt that excessive debt and leverage was a major contributor.
Leverage, the ability to use debt to build assets as a multiple of a firm's capital base, is a
double-edged sword. Credit is obviously essential to an economy's growth and prosperity.
But when a tower of debt is built on a foundation of weak capital, the inevitable outcome is a
collapse and loss of national wealth.
Following this most recent crisis, lawmakers and regulators are examining the issues of debt,
leverage and financial strength. We are at a crossroads. The country must again review and
define an acceptable leverage profile for our economy and specifically for financial
institutions. Defining leverage standards too tightly inhibits growth. Defining them too loosely
invites excess risk and crisis.
My views on this topic are based on 36 years of broad experience in the Federal Reserve. As
head of bank supervision for the Federal Reserve Bank of Kansas City in the 1980s, I saw
the damage caused nationally and locally by excessive leverage and bank failures - both
small and large. As President of our Bank over the past 18 years, I've witnessed the anguish
of individuals and businesses as they struggled to manage the downside effects of too much
leverage.
Trends
Over the past two decades there has been a systematic increase in debt and leverage within
the United States, involving all major sectors of the economy. The charts I have included with
my statement show asset-capital and debt-income ratios increasing annually across all
sectors, rising to levels well above long-run trend lines. In hindsight most agree this build up
was excessive and the markets and the regulators should have seen the crisis coming. But
they didn't.
There are three components that we must look at in judging the safety of any level of
leverage: the quality of assets, the quality of capital and the amount of capital. While asset
quality is important, it is the quality and amount of capital that gets a company through
unexpected asset problems encountered during the course of business. For that reason, I
will focus my attention here on the quality and amount of capital.
Stockholder tangible common equity is the strongest form of capital. It is immediately
available to meet creditor obligations and absorb losses. Fundamentally, this is what defines
a meaningful measure of leverage. Other measures of capital include different hybrid debt
instruments or intangibles that attempt to account for potential value and future earnings. For
example, goodwill is an intangible that is not immediately available and evaporates quickly
when a firm encounters asset problems. Trust preferred stock is a hybrid-debt instrument
that carries cash flow demands over the life of the instrument. Thus, I measure leverage as a
firm's total tangible assets measured against tangible common equity.
The leverage at banking organizations has been rising steadily since the mid-1990s. The
increase, however, is not immediately obvious because of the different ways capital and
leverage can be measured (Chart 1). For example, in 2007 just before the crisis began,
leverage for all banking organizations based on total equity capital, which includes common
equity, perpetual preferred stock, and goodwill and other intangible assets, was the same as
it was in 1993, $13 of assets for each dollar of capital.
The story is quite different when you focus on tangible common equity by excluding
perpetual preferred stock and goodwill and other intangible assets. Tangible total assets rose
from 16 times tangible common equity in 1993 to a multiple of 25 in 2007. The increased
reliance on lower quality capital in recent years is clearly seen by the large gap among the
various leverage measures in recent years as compared to the early 1990s when all the
measures were about the same.
Moreover, a closer examination of the distribution of leverage across firms of different sizes
shows that almost all of the increase in leverage is due to the largest banking organizations
(Chart 2). For the 10 largest banking companies, leverage based on tangible common equity
almost doubled from 18 in 1993 to 34 in 2007, and this doesn't include their off-balance
sheet activities. For the rest of the industry, leverage rose from 14 to just 17 (Chart 3). I
would also note that for broker-dealers, which are an increasingly important source of credit
through the shadow banking system, financial leverage rose from 13 in 1992 to 47 in 2007
(Chart 4).
As a result, with twice as much leverage as all other banking organizations, the 10 largest
had much riskier balance sheets at the start of the crisis. The much higher leverage and
greater risk exposure of the 10 largest firms clearly indicates that they had a significant
funding cost advantage over all other organizations, and their creditors believed they had
less exposure to losses.
This increase in financial sector leverage fueled a significant growth of debt in the non
financial sector of the economy and, as it turned out, led to a general excess of credit growth
over the past 10 years (Chart 5). Bank lending rose from 39 percent of gross domestic
product (GDP) in 2004 to 47 percent by the end of 2007, and that figure excludes the rapid
growth in credit from the shadow banking sector and the GSEs, Fannie Mae and Freddie
Mac. While bank loans relative to GDP have declined since 2008, it remains well above the
long-term trend.
The increase in leverage and debt was most prominent in the consumer sector. Consumer
debt as a percent of personal income generally has been rising since the 1950s (Chart 6).
However, it began a rapid acceleration in 2000, rising from 76 percent to 110 percent by the
end of 2007. Non financial business borrowing relative to nominal GDP also has followed an
upward trend since the 1950s (Chart 7). During this most recent expansion, it has increased
from 77 percent in 2004 to 89 percent at the end of 2007.
Finally, and no less importantly, the federal government deficit is at record levels and the
current trend is unsustainable (Chart 8). The increase over the past two years is due partly to
the automatic stabilizers that come in to use during a recession and to additional fiscal
actions taken to restart the economy. These temporary actions will add to an already heavy
burden of various programs that have sharpened the upward trend with no obvious end in
sight.
Effects
Given the levels of leverage in the economy, no one should have been surprised at the
collapse triggered by the housing bubble bursting in 2006 and the rise in subprime mortgage
defaults in 2007.
When housing prices fell, many discovered that they had taken on more financial risk than
they previously assumed and more than their capital levels could support. The institutions
with the highest leverage suffered the most, and, as it turned out, these were some of the
largest institutions in the world. Financial panic quickly followed.
What started as a Wall Street panic soon created regional distress and finally Main Street
suffering. And just like the largest institutions, the regional and community banks that were
most leveraged, were most likely to fail. The wave of losses, consumer foreclosures and
business failures infected every element of the economy.
The deleveraging process commenced as highly-leveraged financial institutions, working with
highly-leveraged consumers and business, had insufficient capital to withstand the financial
blows. Increasing numbers of homeowners were unable to keep up with their mortgage
payments, leading to higher defaults. Mortgage defaults, in turn, sharply lowered the values
of mortgage securities held by financial institutions. These losses led banks to attempt to
reduce their leverage, which required rebuilding tangible capital and reducing total assets
- thus reducing loans. This placed downward pressure on asset values, losses worsened
and the vicious cycle of deleveraging worsened. Homes and businesses were lost to
foreclosure and liquidation, while unemployment climbed.
The large increases in leverage over the past decade have wrecked havoc on our economy
and are responsible for the sluggishness of our recovery. Strong economic growth simply
cannot occur if consumers and businesses must focus on rebuilding balance sheets instead
of on increasing spending, production and hiring of new workers.
Once again we have learned that the double edged sword of leverage is a pro-cyclical
weapon.
Constraining leverage
Today, the largest financial firms are showing a solid recovery. Regional and community
banks continue to show stress but problems may have peaked as they have worked to
reestablish stable capital and leverage levels. The market appears to be correcting and
leverage based on high quality capital is returning to more historic norms. In time credit will
once again expand and the economy will improve. But it won't be quick or easy. Therefore,
we must now turn to actions that will prevent the impulses of consumers, businesses, and
financial institutions from assuming ever more leverage as the expansion becomes a boom.
If we take action now, then when the next economic correction occurs there will be less
devastation to our economy. If we don't change policy now, then this crisis will be
remembered only in text books and leverage will rise again and lead to another crisis.
I strongly support establishing hard leverage rules that are simple, understandable and
enforceable and that apply equally to all banks and bank holding companies that operate in
the United States. As we saw in the years leading up to the current crisis, leverage tends to
rise during economic expansions as investors and lenders forget their past mistakes and
believe that prosperity will continue with no end in sight. Straightforward leverage and
underwriting rules are not procyclical, so that as the economy expands and heats up,
bankers must match increases in assets with increases in capital, which constrains reckless
growth. Thus, such rules would serve to limit growth beyond a prudent level by creating a
counter-cyclical force that moderates booms and provides a cushion to bank losses when the
next recession occurs.
For an example of the power of a hard leverage rule, consider the impact on assets and/or
equity of restricting bank holding companies to holding no more than $15 of tangible assets
for every $1 of tangible equity capital (Chart 9).As I noted, at the end of 2007, the 10 largest
bank holding companies held $34 of tangible assets for every $1 of tangible equity capital. If
the maximum leverage ratio was 15:1, these companies would have had to reduce their
assets by $4.9 trillion (56 percent), increase their tangible common equity by $326 billion
(125 percent), or some combination of the two.
Simple rules also provide examiners with the tools they need to prevent leverage from rising
and underwriting standards from declining. Without hard rules on leverage ratios and lending
standards, bank examiners were disadvantaged in taking actions on rising leverage and
declining loan-to-value ratios because bankers could correctly claim they were following
supervisory guidance on capital levels, and their loan problems were very low, while profits
were strong.
Finally, the rise in leverage in the last cycle was facilitated by the complexity of international
risk-based-capital requirements. In particular, the Basel I risk-based capital standards in
place leading up to the crisis provided very crude measures of asset riskiness, which
increasingly underestimated risk as asset markets deteriorated. Banks also could arbitrage
capital standards and raise their risk-based capital ratios by shifting assets to favorably
treated off-balance sheet vehicles or exchanging assets such as prime mortgages for "lower
risk" subprime mortgage-backed securities. The Basel II risk-based standards, which we
were starting to phase in, would have enabled an even greater amount of leveraging to
occur. These standards, which allow banks to use model-based risk estimates for many
types of assets, actually suggested banks were holding too much capital in the months
leading up to the crisis.
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