Yesterday, the House Committee on Financial Services held a hearing entitled, “The End of Excess (Part I): Reversing Our Addiction to Debt and Leverage,” to further understand the implications of excessive leverage among individuals, businesses and governments and to assess alternatives for regulating leverage in the future. The following witnesses testified before the hearing:
- Thomas M. Hoenig, President and Chief Executive Officer, Federal Reserve Bank of Kansas City
- David M. Walker, President and Chief Executive Officer, Peter G. Peterson Foundation, and former Comptroller General of the United States
- Orice Williams-Brown, Director, Financial Markets and Community Investment, U.S. Government Accountability Office (GAO)
- John Geanakoplos, James Tobin Professor of Economics, Department of Economics, Yale University
- Viral V. Acharya, Professor of Finance, Stern School of Business, New York University
- David A. Walker, John A. Largay Professor, McDonough School of Business, Georgetown University
In his opening remarks, Chairman Dennis Moore (D-KS) described the increasing debt of the U.S. as a “troubling trend,” the reversal of which will require “bold new steps.” He commented that the U.S. national debt has grown four times faster than the economy since 1978. Ranking Member Judy Biggert (R-IL) noted that Freddie Mac recently requested another $10.5 billion in federal funding, reaching a total GSE loss of $136 billion, and remarked, “The denial in Washington must end. Bailouts and government spending is out of control.” Representative Jackie Speier (D-CA), in her opening remarks, highlighted the role of deregulation in the credit crisis and advocated for legislation that would cap leverage of financial institutions with systemic risk at 15 to 1.
Mr. Hoenig, President of Federal Reserve Bank of Kansas City, focused on the largest financial firms, which in his opinion were the catalysts for the crisis. He explained that these financial institutions increased their leverage steadily since the mid-1990s, but that the increase was not immediately apparent because of the various ways in which leverage is measured. When measured based solely on tangible common equity, the capital actually available to absorb losses, leverage of the ten largest financial institutions increased from $18 of assets per dollar of capital in 1993 to $34 of assets per dollar of capital in 2007, a rate of increase substantially exceeding that of other financial institutions. According to Mr. Hoenig, these institutions’ creditors believed that large financial institutions were too big to fail and continued to provide funding at low rates.
Mr. Hoenig advocated for strong, simple leverage rules equally applicable to all banks. He acknowledged that leverage restrictions will impede growth during a period of economic expansion, but asserted that the restrictions should provide a cushion during economic contractions and therefore are a necessary component of a “sound financial system.”
David M. Walker opened his testimony with a reminder that “not all debt is bad;” problems arise, however, when borrowers “become accustomed to taking on debt in order to finance their ongoing operating costs and current wants at the expense of future needs.” Mr. Walker explained that the “tipping point” in the credit crisis occurred when creditors began to lose confidence in the ability of borrowers to repay. A similar tipping point could occur when the nation’s creditors begin to question the federal government’s ability to repay its debt, the ramifications of which would be devastating. Throughout his testimony, Mr. Walker illustrated that the following elements of excessive leverage among individuals and businesses that precipitated the crisis are also present with regard to the federal government:
- Disconnect between the beneficiaries of leverage and those who bear the burden “when the bubble bursts.”
- Insufficient transparency of the nature, extent and magnitude of the risks.
- Excessive debt and insufficient focus on cash flow.
- Excessive reliance on credit ratings.
- Insufficient governance, risk management and oversight.
By ignoring these indicators, Mr. Walker believes the country is “resting on past success” and its “superpower status” as it continues down an “imprudent and unsustainable path.” The federal deficit in 2009 alone was $1.4 trillion, 10% of the nation’s economy, and the total deficit is 58% of GDP. Within ten years, interest costs will likely be the single largest federal expense. Moreover, Mr. Walker asserts these numbers are understated because, like private institutions, the federal government has its own “off-balance sheet transactions.” For instance, Mr. Walker believes the debt of Fannie Mae and Freddie Mac should be included as federal debt because the government essentially controls the GSEs, a situation which may no longer be considered temporary. In addition, the government does not treat deficits of Medicare, Social Security and other trust funds as debt. If trust fund deficits were counted as federal debt, the nation’s total debt would reach 89% of GDP, and if the debt of Fannie Mae and Freddie Mac were included, national debt would substantially exceed 100% of GDP. Mr. Walker noted that the leverage ratios of the U.S. already exceed those of Britain, Ireland and Spain, where national debt is viewed as a significant concern.
Mr. Walker opined that a leverage ratio of 60% of GDP would be reasonable and sustainable. To reach that goal, he called for statutory budget controls, Social Security reform, increases in savings rates, reduced health care costs, reprioritization and constraint in defense and other spending, and tax reform that will raise revenues and reduce carve outs.
Concurring with Mr. Walker’s opinion regarding tax reform, Representative Steve Driehaus (D-OH) remarked that “back-door” spending, or exclusions, deductions and credits represent over $1 trillion in foregone tax revenues and create a “revenue stream that looks like swiss cheese.” Representative Driehaus and Mr. Walker shared the view that tax increases are inevitable, and reducing back-door spending is the best way to increase tax revenue. Mr. Hoenig cautioned that, due to the political resistance tax increases, the federal government may soon pressure the Federal Reserve to finance the national debt through monetization of debt, leading to inflation.
Though expressed in different ways, one overarching message from the witnesses and the committee members was that reversing the “addiction” to spending and debt will require more than legislation; it will require a cultural change. Both witnesses agreed that the federal government should embark on an effort to educate the public regarding the status of national debt and the consequences of a “tipping point.” Part of these educational efforts, according to Mr. Hoenig, should convey the message that deleveraging will require a “shared sacrifice” applicable to all, including members of Congress.
Ms. Williams-Brown presented a report completed by the GAO in July 2009 on the role of excessive leverage and deleveraging by financial institutions in the credit crisis. In the report, the GAO analyzed the ways in which excessive leverage and disorderly deleveraging could have contributed to the crisis. As a preliminary matter, she argued that leverage should no longer be measured solely by reference to debt, since leverage may be obtained without debt, for example, through derivatives. Ms. Williams-Brown identified several sources of leverage expansion before the crisis emerged, including excessive reliance by financial institutions on short-term funding, transferring debt off balance sheets using SPEs, and growth in popularity of CDOs and credit default swaps. She added that deleveraging could have exacerbated the crisis by adding momentum to declining prices, fueling a downward spiral that became self-sustaining. Another theory noted in the report suggested that the sharp decline in asset values represented a reversion of overvalued assets to more reasonable values.
Mr. Geanakoplos presented an economic theory that leverage is a primary determinant of value, rejecting the economic theory that an asset has a “fundamental value” and instead asserting that the value of an asset can vary among potential buyers, who may assign different values to an asset based on, for example, their risk tolerance and optimism regarding potential for appreciation. When leverage is abundant, the most optimistic potential buyers with the highest risk tolerance will obtain the leverage necessary to outbid other buyers, thereby increasing the price of the asset. Thus, increases in leverage cause increases in prices, and vice versa. Mr. Geanakoplos suggested that, in an ideal financial system, asset prices would be determined by a “marginal buyer,” or a buyer with “middle-of-the-road” optimism and risk tolerance. Regulating leverage reduces the likelihood that prices will be determined by overly optimistic and risky buyers. Instead of monitoring leverage of only the largest institutions, however, Mr. Geanakoplos recommends regulating leverage of securities themselves, for example, by capping margins on residential mortgages (or minimum down payment percentages). He asserts that such an approach is preferable because, among other reasons, the data could be easily collected and objectively analyzed.
Professor Acharya added to the testimony of the other witnesses by providing three potential methods of regulating leverage of financial institutions. First, leverage could be regulated through taxes by eliminating the tax deductibility of interest payments on excessive leverage. According to Professor Acharya, the second, more prudent, approach would be to impose a leverage cap, and he suggested a cap of 15:1. He noted that Canada has adopted such an approach and that financial institutions with the lowest leverage ratios, such as JPMorgan Chase, fared comparatively well through the crisis. Third, the Federal Reserve could conduct stress tests going forward to ensure adequate capital among financial institutions with systemic risk. Echoing the views of Mr. Walker of the first panel, Professor Acharya cautioned that, while there is hope that regulation can restrict individual and corporate leverage, there is less hope that government leverage can be restricted.
The last witness, Mr. David A. Walker, first addressed consumer protection and advocated against the creation of a new agency for consumer protection: “Another government bureaucracy is not what consumers need.” Instead, he suggested that it would be more effective and less costly to assign additional responsibilities to the FDIC, which already has a consumer affairs department and maintains consumer protection systems. He argued that regulatory attention should focus on mismanaged firms (the firms that take unreasonable risks) and that no institution should be allowed to expand to the size that it is too big to fail.