Banks Increasing Leverage Again

You know that excess leverage that helped cause the collapse of Bear Sterns, Lehman Brothers and nearly every other investment bank? It's back. Bloomberg reports that big banks are quickly increasing their use of debt to make new investments. We haven't seen as high an increase in leverage since before the recession. I find this trend troubling, though unsurprising.

Here's some detail, via Bloomberg:

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

Bloomberg notes that this is the biggest increase since April 2007. And here's what it says that means:

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn't available.

Is this reason for concern? Yes and no.

First, I would say that this is absolutely unsurprising. Leverage runs like blood through investment bankers' veins. They love it because it allows them to make such huge profits. The less actual capital you need to use to make more investments, the higher your return on that capital invested.

Of course, the problem is that, when the music stops, and there isn't enough capital, bad things happen. Just ask Lehman. That's why the Treasury and Fed were forced to pour so much capital into the banks over the past year. If they had not been overleveraged, then things would not have gotten nearly as scary.

One Bloomberg source says:

"I am surprised by how quickly the market has become receptive to leverage again," said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Me too. I'm shocked the market has already begun allowing banks to resort to their old ways. As mentioned, I would have expected them to ultimately. But I was hoping the market's memory wasn't quite so short. The economy might be slowly improving, but it's hardly the good old days again.

Yet, with all of that said, I'm not sure it's time to panic quite yet. For starters, we're talking about a percentage increase. Their article also says:

Banks arranged $61.8 billion of leveraged, or high-yield, loans this year, a 74 percent decline from the same period in 2008, and 91 percent lower than two years ago, Bloomberg data show.

In other words, the raw numbers are still much, much lower.

Moreover, it's a little unclear to me just how "risky" the corporate and asset-backed securities used for collateral were. Not all of those kinds of bonds are particularly risky. For example, senior tranches of pristine AAA-rated auto loan-backed securities are probably virtually as safe as Treasuries. The latest CDO that an investment bank convinced the agencies to give a AAA-rating, however, may not be as safe as a Treasury -- though it still is likely much safer than CDOs that passed for AAA two years ago.

So while the trend, overall, might be worrying, the current situation is probably not as dire as this Bloomberg piece suggests. My final observation, however, is that I'm surprised we've seen leverage mentioned so little by Washington as a goal for regulation. While leverage did not exactly cause the financial crisis, it certainly contributed to it. As a result, I don't really know why we've heard it mentioned so little by Washington as it tries to determine how to regulate Wall Street. But maybe that will change once it is finally done talking about healthcare and able to move on to financial regulation.