Partially true. However, leverage is not the issue here. Irresponsible lending is the root cause. How do you propose to legislate risk? Would you be willing to bail out hedge funds next?
Leverage is one of the central issues in what caused the melt-down in i-banks. The SEC allowed them to go from 12:1 to 40:1 leverage, and this guarantees a bank’s failure when they’re using this leverage to buy illiquid instruments.
History shows us that leverage, coupled with securities that you cannot sell easily, is a deadly combination. Unless you have large quantities of liquid investments that you can sell quickly at a profit or low loss, you’re screwed.
So, translating this into the current issue:
Irresponsible lending (to mortgage borrowers who cannot afford the home), which is then turned into an illiquid “mortgage backed security” (like a CDO), which is then bought with leverage... is like pouring a can of gasoline out all over the floor, and now you’re standing in the middle with a lit match. If you don’t drop the match, you’re A-OK. If there is sufficient ventilation in the room, you’re OK.
As soon as someone closes the doors and windows.... you’re living on borrowed time.
I propose to legislate risk by limiting how much leverage can be used to buy illiquid instruments. If you have to use “mark to model” accounting on an instrument, it should not be allowed to be bought on margin, AND it should not be counted against capital reserve requirements. If the banks want to call it a “level 3” asset, then that sword should cut both ways - it isn’t considered a liability because there isn’t sufficient market liquidity to get a fair bid for it. By the same standard, it shouldn’t be considered an asset, because we cannot value it appropriately.
Forcing this type of accounting down on banks would make them cease playing these games with illiquid instruments that they hide off in the basement of their balance sheets like a crazy old aunt...