Bloat, leverage, meltdown

An old saw asserts that you can predict next year’s economic performance by knowing the number of Harvard Business School graduates opting for careers in finance — the more students entering finance, the worse the economy will be.

Like many jokes, this one reveals a kernel of truth — that America’s finance sector is too large.

And that is one of two aspects of President Obama’s recently announced financial regulations that require even greater focus.

I admit it straight off — I am out of my depth here. Obama’s policy team has more economic knowledge in each of their pinkies than I do in my whole body.

Nevertheless, I’m convinced the size of the financial sector, along with the dangers of overleveraging, cry out for even more attention.

Financial markets are simply an allocation mechanism; they’re designed to allocate capital across competing uses. In the 1940s, the financial sector accounted for about 4 percent of the gross domestic product; in 1975, about 15 percent and in 2005 over 20 percent.

Looked at differently, in 1959, financial firms accounted for 15 percent of America’s corporate profits, but in 2005, financial companies raked in 30 percent of the country’s profits.

Just how big should the financial sector be? I don’t know. But consider other resource-allocation mechanisms. Triage nurses allocate scarce emergency-room resources to patients. I’m told they represent about 1 percent of hospital budgets, not 20 or 30 percent.

At colleges, admissions departments allocate scarce places in the freshman class. If the admissions office were spending 20 or 30 percent of the university’s budget, people would be howling.

So while determining the optimal size of the finance sector may be impossible, it is clear that this country is spending too much on allocating its capital.

In the aftermath of the Wall Street meltdown, politicians inveighed against greed. Greed has a concrete manifestation in the market — overleveraging — a second arena of concern, and one requiring stringent regulation.

At root, leverage is benign and perfectly normal. Vastly oversimplifying, you buy a house for $100,000 (OK, not in Washington you don’t) and put down 20 percent, while the bank loans the remaining 80 percent. You are leveraged at a ratio of 4 to 1. For every dollar you put into the house, the bank is putting in four. If the house appreciates in value by 10 percent the next day, you have made $10,000 on your $20,000 investment — a 50 percent return. On the other hand, if your house declines in value by 10 percent, you have lost $10,000, but you are still in decent financial shape.

Banks may limit your leverage, but heading into the financial crisis, Lehman Brothers leveraged itself at 30 to 1 — borrowing $30 for every dollar of capital it held. So when they bought $100,000 worth of securities (or $100 million) they were only putting in $3,226 and were borrowing $96,774. A 10 percent increase in value of the securities yields a 310 percent profit. Woohoo! Toast to greed!

However, when the price declines by 10 percent, they have lost $10,000 — a sum three times greater than their equity. And since the value of the securities is now $6,774 less than the loan, the lender asks for that amount to cover the difference. But since all their investments have fallen in value, Lehman doesn’t have the nearly seven grand — and defaults cascade throughout the economy.

A recent computer simulation found that when leverage stayed below 5 to 1 — in the range most people leverage their homes — the economy steamed ahead normally. However, when leverage exceeded 5 to 1, markets and firms became unstable and crashed. High leverage is a root cause of the meltdown we suffered.

Preventing another crash requires tighter limits on leverage, which will have the added benefit of reducing the size of our bloated financial sector.

Mellman is president of The Mellman Group and has worked for Democratic candidates and causes since 1982. Current clients include the majority leaders of both the House and Senate.