There's leverage everywhere!

Tyler Cowen:

"[A] central lesson of this depression will be how many different ways there are to leverage."

Megan argued yesterday in favor of banks returning to their roots as privately held partnerships:

Pretty much everyone agrees that two of our biggest problems are, first, excess risk-taking by banks, and second, the existance of institutions that are too big to fail.  So why not force banks to operate the way they used to:  as partnerships?  I don't think that anyone believed they were creating the kind of massive systemic exposure we ended up with, and in fact the heads of the banks tended to have their personal fortunes tied up in the bank's operations.  But the lower level employees, the ones who actually knew what was going on in their trading books, didn't.  If the banks had been partnerships, I'm willing to bet that a lot fewer of them would have been tempted to lever up quite so far.

They also wouldn't have been able to get too big to fail; the rationale behind going public, other than sheer greed, was the ability to raise more capital.  We'd have a lot of little banks, no one of them big enough to take the whole system down with it.

I'm not saying that this would have been a panacea; it would have costs, of course, and some banks would probably still have failed.  But things might not have gotten so bad so fast if everyone hadn't had such huge incentives to make highly leveraged bets. 

My first post for this blog argued that this thesis is not very convincing, based on the examples of (a) hedge funds (most notably the infamous Long-Term Capital Management) not being notably adverse to leverage, and (b) even public firms such as Bear and Lehman were heavily owned by their employees and managers, who thus should have had plenty of incentive not to destroy the franchise.  In a comment to Megan's post, our co-blogger Mindles H. Dreck reminds those who would draw analogies from LTCM of the difference between "a limited partnership using other people's money and a general partnership using your own...". This is surely right, even though LTCM is probably the least relevant example of the distinction - by the time LTCM blew itself up, John Meriwether & company were taking the risks with their own money, having handed back most of their outside capital the previous year. (This is not unheard of even in major hedge funds - for example, James Simons' flagship Medallion Fund, which famously charges fees of "5 and 44," returned the capital of its outside investors and now consists wholly of money invested by Simons and his employees.) And in any event, one would think that the substantial amount of money hedge fund principals typically have in their own funds would provide sufficient incentive not to go too risk-crazy.

But let's work the argument a little further.  It surely is true that unlike their current incarnations, the old Wall Street partnerships did not destroy the world with excessive leverage.  But in the pre-credit-boom era, no one else was incurring much leverage either. It might be worth considering whether there are entities that are structurally similar to the old Wall Street firms (i.e., partnerships in which a substantial portion of the partners' net worth was tied up in their employer, and could not easily be removed from same) and see whether they have taken on significant leverage in the modern age of easy credit. 

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Dr. Manhattan

Dr. Manhattan is the pseudonym of a lawyer in New York City who represents, among others, clients in the investment management industry. He started blogging in early 2002, when the entire NYC-based blogosphere could gather in one room (which they often did). In between his frequent retirements, he blogged about politics, baseball, Israel and autism (especially vaccine-related matters) at With the regulatory system up for grabs, for this project he has decided to try the novel approach of blogging about matters which bear some relationship to the topics that come up in his day job (within the strict limits of professional obligations, of course). In case anyone was wondering, none of his opinions expressed on this blog are necessarily those of his clients, employer or colleagues.

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