What's Really Needed: Leverage Scorecard

By SCOTT PATTERSON Regulators crafting new rules for the financial system also will need to develop tools to track one cause of the recent turmoil: leverage. In 2006, the height of the boom, a bank purchasing a triple-A mortgage security valued at $100 needed to put up just $1.60 in cash -- the rest could be borrowed. Home buyers could get a mortgage with a 5% deposit, sometimes even less. Insurers such as American International Group sold bets known as derivatives to book fees for promises they ultimately couldn't keep, a hidden form of leverage. Trouble is, there isn't a mechanism that monitors and publishes leverage in detail and systemwide. The Federal Reserve, closely focused on interest rates, tracks banks' fund flows but not daily leverage ratios at banks or hedge funds. Leverage is as important as interest rates in fueling economic cycles, says Yale University economist John Geanakoplos, who has spent 15 years studying "leverage cycles" in the economy. His solution: Regulators need to gather detailed, daily data directly from market participants such as banks and hedge funds -- and, more important, publish it in the aggregate. For instance, what is the average amount of collateral firms need to post to purchase a subprime-mortgage bond? With such information readily available, investors and regulators could know whether the system is getting tipsy on leverage, he maintains. "If everyone knows how leveraged everyone else is, it can make them nervous," causing investors to curb risk, said Mr. Geanakoplos, who also works for a hedge fund, Ellington Management Group. The Obama administration's white paper on financial-market reforms is peppered with comments on leverage, so clearly officials are focused on the issue. One hurdle to greater transparency into systemic leverage could be getting banks and hedge funds to divulge highly guarded data. Richard Bookstaber, a risk manager who has worked at these firms and who recently testified before Congress on how to monitor systemic risk, estimates that targeting the largest financial firms will cover roughly 80% of the risk. "If you get 80% of the risk, you're going to be able to detect what's systemic," he said. Email: tape@wsj.com