By Omar El-Sharawy
February 6, 2018
Warren Buffet has cemented his legacy in the financial world as an articulate and calculated investor. Buffet was famously quoted as saying, “Risk comes from not knowing what you are doing”. In modern financial hiccups, speculators time after time have found haven in validating these fluctuations by blaming financial innovations, such as leverage and securitization, as the catalyst for every explosive financial reaction. Yet the question remains: are we blaming the players or the game?
Let’s start by clarifying our definition of “financial leverage” (which is also called financial “gearing” in the United Kingdom and Australia). Financial leverage is defined as the process of borrowing capital to make an investment, with the expectation that the profits made from the investment will be greater than the interest on the debt.
Leverage is a magnifier of returns, both positive returns and unfortunately more common, negative returns as well. In most financial crises, as the prices of certain assets rapidly rise, investors want to take a bite of the prosperity cake and not be left hungry and behind. In the early stages of a financial frenzy, all the stakeholders gain returns. Profits are constantly increasing however, with an eventual plateau approaching, the window of opportunity starts to diminish. Leverage becomes a tool to multiply the returns; a financial embodiment of “high risk, high reward”. Yet when a crash hits the market, all fingers point to leverage as the source of evil; to err is human, to find blame is even more so.
However, leverage is an essential factor to the operation of banks. While banks are among the most leveraged institutions in the United States, the combination of fractional reserve banking (i.e. banks accept deposits and make loans or investments while holding reserves equal to only fraction it’s deposit liabilities) and Federal Deposit Insurance Corporation (FDIC) protection has produced a banking environment with limited lending risks.
Moreover, securitization is labelled as the other half of the evil dynamic duo tearing the financial sector apart. Securitization is a process in which illiquid assets (An asset that is difficult to sell because of it’s expense, lack of interested buyers, or some other reason) that can generate cash flows are pooled together and sold as securities (tradable financial asset). This process can encompass any type of financial asset and promotes liquidity in the marketplace from an illiquid origin.
Any asset that is illiquid and can generate regular cash flows can be securitized. This would include mortgages, student loans, car loans, credit card debt, and even royalty payments. In fact, late singer David Bowie securitized the future revenue from 25 of his albums that were released before 1990. The bonds, named Bowie Bonds, were backed by the royalty payments from 25 albums of the singer, which he forfeited for 10 years.
What are the benefits of securitization, you may ask? The holder of an illiquid asset can receive money upfront, which would be otherwise difficult. The whole idea behind securitization is to create a liquid market for assets that are difficult to sell individually. Securitization was originally started to free up capital at banks that issue mortgages (as banks are legally obligated to maintain a certain amount of capital on their balance sheets). If it were to keep all the illiquid assets on its balance sheet, a bank’s lending capability would be severely limited. With securitization, a bank can free up it’s capital and thus lend more easily.
Neither leverage nor securitization are the main issues to address, It is the abuse of these financial tools that regulators need to focus on. Investors and banks that are allowed to misuse leverage automatically increase the risk for all associated stakeholders. During the financial crisis of 2008, many of the big investment banks were leveraged at a ratio between 30:1 and 50:1. Fannie Mae and Freddie Mac were very close to 100:1. When leverage is abused to such extent, regulators need to address this misuse rather than abolish the system as a whole. Leverage in banking is far higher than in other industry sectors. For example, the average leverage ratio across 10 of the world’s largest listed non-financial companies is 50%. That is, on average these companies fund their assets around 50:50 with debt and equity. In banking, a more common ratio is 95:5.
We cannot ignore that both securitization and leveraging have the potential to immensely backfire on both individual investors and banks. Leverage especially can act as a medical drug, with its initial purpose being the improvement of one’s current condition. However abusing this drug can lead to livelihoods ruined and more financial sickness.
Removing leverage or securitization from the financial world will not create the utopian economic world speculators have for so long wished for. Ensuring effective regulation, where neither tool is misused particularly during volatile markets, is the path forward.