Blinders Villain 2 Leverage Misused
BlindersVillain 2: Leverage Misused
Inthe case of the financial crisis of the 2007, the villain that causeda lot of havoc was the misuse of leverage. In the situation for the“misused leverage” villain, government intervention to preventeconomic harm has a legitimate economic rationale. The leverage toolin the financial is used to allow individuals and companies to buystock or assets by putting down certain percentage of the costs.However, financial players overused this provision and borrowed morethan their balance sheets would accommodate. According to Blinders(10), some companies had leveraged up to 97.5% of the asset costs. Inthis case, the government intervention was legitimate and wasnecessary to prevent excessive leveraging. According to Blinders(11), the level of gearing ratio in the financial market was higherat the time, leading to financial challenges.
Appropriategovernment regulation and intervention would have saved the financialsystem from the effect of this villain. One of the main interventionpolicies would be a limitation of the percentage of gearing ratiothat a financial entity or a firm should have. In setting this ratio,the government should have placed the percentage to be based on thebalance sheet and not on the general ratio or value on the cost ofthe asset. Setting a ratio based on the balance sheet would mean thata company cannot take debt that is higher than a certain percentageof the balance sheet.
Atthe same time, the government would have placed a requirement thatcompanies should not freely accumulate a certain number ofoff-balance sheet financial instruments. However, there could bedifficult for the government to regulate the adherence to such aregulatory measure. Therefore, the government would empower themanagement boards and financial market authorities to enforce suchprudential measures. According to Blindersand Baumol(293), such government regulation would reduce the level of debt inthe financial institutions especially arising from mortgages. Thiswould have made possible if the government would have included suchmeasures in the financial obligations of a company.
Governmentintervention would be solely aimed at reducing the extent to which afirm can finance the acquisition of an asset. Limiting investmentfirms from over-borrowing in such a manner would have placed thegearing levels in the system at manageable levels and managed therisk of failure to service debts. Moreover, such regulation wouldalso extend to bar certain investments from being leveraged so as toregulate the level of risks that investment firms faced. According toBlindersand Baumol(268), investors had altered the definition of risk during the periodthat even mortgages and bonds were riskier than they were known tobe. The intervention would also limit the extent of application ofcall option on the risky and highly geared financial instruments.
Theeconomic consequences of these interventionist actions would beimpacted on the financial operations of the firms in the system. Oneof the consequences is reduced ability of companies to borrow theirway to the investment of their choice through the purchase of stocks.However, the limited ability would be beneficial to the financialinstitutions. In addition, the consequence would reduce theprofitability of investment firms and economic growth during theperiod (Blindersand Baumol,289). This would be an outcome of reduced uptake of some stocks andfinancial instruments due to the limitation of debt component. As aresult, the intervention could have created some mild marketfailures, but would be healthy enough to avoid any havoc on thefinancial system.
Blinders,Allan. The Crisis, 2007:Blinder’s 7 Villains. PowerPointPresentation
Blinders,Allan and Baumol, William. Macroeconomics:Principles and Policy.Stamford: Cengage Learning