IT'S THE LEVERAGE, STUPID

The huge financial freeze-up that has everybody spinning, politicians wind-bagging, and Treasury Secretary Paulson going sleepless essentially amounts to ONE THING: ABUSE OF LEVERAGE. Yes. It really IS the leverage, stupid. Address the leverage issue and for the most part you correct the problem.

Hence The Mass Mouth's solution:

let the Federal Reserve Bank -- which regulates the use of money in the financial system -- apply its MARGIN RULES, which now govern what percentage of the purchase price of stocks and bonds a buyer can borrow from broker accounts, to the purchase of mortgages and mortgage-derived securities.

Please allow me to explain. And first of all, a little history: the Fed's margin rules were first adopted back in 1913 when the Federal Reserve system was established by law. At first the rules were very liberal. Buyers of stocks were required only to post 10 % of the purchase price of a stock and as little as 1 % of the price of a bond. The remainder of the purchase price could be borrowed. Buyers of stock thus took on a leverage ratio of 9 to 1 -- 10 % the buyer's money, 90 % borrowed from a lender (most often, the broker holding the buyer's stock account). Then came the great stock market crash of 1929. Stock prices quickly declined much more than 10 %, leaving the buyer with a "margin call" -- a demand that he post additional cash. If he could not post it, stock was sold sufficient to "meet the call." Those stock sales then depressed the market yet further, leading to more "margin calls," and so on to the bitter end, by which time the US stock markets had declined about 90 % from their highs and practically every buyer of stock -- and his brokerage house, and a great many banks too -- were totally wiped out.

As a result of this financial disaster, many new regulations were put in place; as significant as any was that the "Fed" set much more conservative margin guidelines. Well into the 1970s the Fed's margin rule was 50 % -- a buyer had to post 50 % of the buy price of a stock -- and 10 % for purchases of bonds. Then came the "dot-com" craze, and as bad as its wipe out was of stock buyers, it had limited impact on financial institutions because early on in the craze's bull phase the Fed set margin requirements for 'net stocks at 70 %, evedn 100 %.

Now I'm suggesting that the Fed do the same for purchases of mortgages and mortgage-backed securities, including insurance contracts tied to those mortgage-backed securities.

I suggest that the Fed require buyers of such instruments to post at least 20 % of their buy price and, in the case of instruments evidencing significant risk, as much as 40 % , 50 %, even 70 % of the purchase price.

Granted, that such restrictive margin requirements severely limit the buyer's profit potential; granted, that if a buyer who understands risk and has significant net worth (I'm referring here to the "suitable investor:" standards as defined in the Securities Acts of 1933, 1934, and 1940) wants to risk all of his money he should be allowed to do so. The problem, however, is that the securities in question are almost all of them bought by institutions, who are using money that belongs to shareholders, many of whicfh are institutions investing depositors' money. It is not simply John Q. Capitalist investing his own stash ! And so my first point is made.

Applying the margin / leverage rules to mortgage investments also reflects the already changed reality of the mortgage world. Today, 20 % down is the general rule. In addition, income to mortgage expense qualifying ratios have retreated back to the fairly conservative standard -- 33 % to 40 % of gross income -- as set by FNMA and Freddie Mac and adhered to until about 1995.
It makes sense to apply to mortgage purchases the same level of leverage limitation that thge mortgage industry itself is now insisting on.

The new realism about leverage in the transacting of real estate reflects acceptance that real estate prices come down as well as go up. Real estate is a market. It is NOT a stairway to heaven. Unrealistic real estate prices are...unrealistic no matter how many thousands of brokers, appraisers, loan offricers, and lending company executives insist on thinking otherwise. It is time now to close the mortgage market to people who think that mortgage lending and mortgage investing are an oportunity to get high on financial LSD.

NEXT: Secretary Paulson's proposal evaluated "THE MASS MOUTH WAY."