There's leverage everywhere!

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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. 

As it turns out, there are such entities. We call them "big law firms."  And their example is instructive.

Over the last few decades - concurrent with the growth of leverage in the financial system - the business model of most large law firms has developed into one built on leverage as well.  It is just a leverage which utilizes people rather than borrowed money.  Specifically, since law firms generally bill by the hour (a system whose demise has been predicted for the near future and, in my opinion, always will be), firms increase their profitability by increasing the amount billed in respect of each equity partner. Since there is only so much time in the day, firms have tended to increase the ratio of attorneys per equity partner.  Without irony, this ratio is known as..."leverage," and this tendency is how you can read now-horrifying articles like this one, which begins:

Law firm leaders throughout California identify increasing leverage as a key strategy in their business model.

 (To be sure - as the article linked above points out - leverage ratios are not themselves the sole determination of law firm profitability, and there are even Wall Street firms which operate on a different model entirely. But the general trends remain.)

Now, in times where there is an easy supply of credit work, this system of leverage works very well for all involved.  But when the flow dries up, the firms are left with high fixed costs to be serviced - and the more leveraged the firm is, the harder it is to service those costs with reduced revenue.  Sound familiar? It should be no surprise that large law firms have been laying off attorneys in far greater numbers than in previous downturns, with some doomsayers (whom I hope are less accurate than their counterparts with respect to the economy generally) predicting additional firm collapses and permanent changes to the firms' business models. (The one saving grace to the law firm model of leverage is that they can "deleverage" far more easily than banks, as banks can't merely fire their "troubled assets.")

But all this strongly suggests that a private partnership model, in which the partners' wealth is largely bound, does not provide immunity to the siren song of leverage and the resulting risks.  True, law firms's leverage issues haven't destroyed the financial system (we're working on it), and Megan's point about how keeping banks private may limit their size enough to prevent systemic risk may be accurate (there are also other reasons why it may be a good idea to limit banks' ability to go public).  As such, I suspect that even if the banks had remained privately held, they would have nonetheless gotten themselves into trouble as memories of the Depression were replaced by those of the "Great Moderation" and credit boomed.

Addendum 1: Law firms are typically organized as limited liability entities (the exact form depends on the jurisdiction). It is possible that the real brake on risk-taking stems from not the private-public distinction, but  - per Mindles' comment - the distinction between the unlimited liability of general partnerships and any other form of limited liability organization, whether public or private.  Should we limit financial institutions to unlimited-liability vehicles?

Addendum 2: Full disclosure: I have a professional obligation not to provide full disclosure. Very Partial Disclosure: I work at one of these big law firms.

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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 blissfulknowledge.com. 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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