I credit the reliable David Warsh of Economic Principals for first bringing this to my attention. The essential concept is simple: Every debtor/creditor transaction involves the negotiation of two critical terms, but economic literature has focused on only one: The interest rate.

That is to say, as far as macroeconomics is concerned, the Fed's key job in terms of maintaining relative equilibrium is to focus on interest rates. But the other key variable we've ignored is that of collateral. Or, stated differently, leverage. How much collateral is the debtor putting up? How much leverage are they relying upon?

For this insight, in turn, Warsh credits John Geanakoplos, a professor of economics at Yale since 1994. (Interestingly for our purposes, Geanakoplos also served 5 years in the early 1990's as Managing Director and Head of Fixed Income Research at Kidder, Peabody, which, until it flamed out in the wake of the Joseph Jett scandal was an innovative firm, particularly in the greenfield territory of CMO's.)

Here's the gist of the theory (emphasis mine):

For at least a century, economists have been accustomed to thinking of the interest rate as the most important variable in the economy - lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands - alternatively, margin requirements, loan-to-value ratios, leverage rates or "gearing" - become much more important.

Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down - say, the down payment on a house - prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.

Central banks, therefore, should rethink their priorities. The Fed should learn to manage system-wide leverage, reining in on it in ebullient times and propping it up in anxious times, in order to prevent the worst outcomes. Leverage cycles happen not because people are stupid, or because they ignore danger signs. It's in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects.

I find this fascinating on several levels.

For one thing, it partially explains why the dot-com bubble didn't bring the entire global financial system to its knees. Stock margin requirements have always been essentially 50%, not zero money down. As well, of course, that was limited to one industry in (largely) one geographic territory, not the national housing market.

Second, it has potential implications for our professional judgment and behavior when we act for debtors and for creditors. I will leave you to be the conscience and the brains of your own professional conduct, but just a thought.

The key point is that in certain circumstances, it's the collateral terms and not the interest terms that assume overwhelming importance. If you want a memorable "hook" to understand this, look no further than The Merchant of Venice. Geanakoplos writes:

"Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral -a pound of flesh but not a drop of blood."

What, you should be asking by now, are the implications of this for getting out of our current predicament?

As hard as it may be to stomach, if you believe (as do I) that getting "underwater" homeowners to have a real stake in continuing to pay their mortgages, so as to staunch the bleeding of foreclosures, bank writeoffs, deteriorating or unguessable values of "toxic" or "legacy" CMO's and CDO's, and all the follow-on destruction that causes, we may need to swallow deeply and simply absorb big writedowns on those underwater mortgages in order to give the homeowners an incentive to keep paying.

Again, Geanakoplos has written about this:

Despite all the job losses and economic uncertainty, almost all owners with real equity in their homes, are finding a way to pay off their loans. It is those "underwater" on their mortgages -- with homes worth less than their loans -- who are defaulting, but who, given equity in their homes, will find a way to pay. They are not evil or irresponsible; they are defaulting because -- for anyone with an already compromised credit rating -- it is the economically prudent thing to do.

Isn't it against the interest of bondholders to have "cramdown" writedowns of the value of the collateral in the form of homes with underwater mortgages? In a perfect world, it would be, but we've traveled a long way from that perfect world. Consider:

For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line. This is also best for taxpayers, who now effectively guarantee the securities linked to these mortgages because of the various deals we've made to support the banks.

For these non-prime mortgages, there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.

As usual, a graphic can illustrate succinctly what a multitude of words cannot.

What this shows is the default percentage rate by month on the horizontal axis (0-2-4-6-8-10-12-14%) and the amount owed on all mortgages on a home divided by the current value of the home on the vertical axis, from 0% at the top to 100% where the green shaded field begins through 300% at the bottom.

The four different right-downward descending lines represent, from left to right, prime loans, ALT-A loans, option ARM loans, and subprime loans.

What's notable to me in eyeballing this is:

• In the white area, where homeowners have positive equity, defaults are relatively low, even for the lowest-quality loans.
• At above 25% equity (75% loan to value), defaults are not material.
• But at about 150% loan to value (50% underwater), defaults go up dramatically, at all levels of loan quality.
• This suggests that if writedowns could occur, giving deeply underwater homeowners equity of at least 25%, much of the national and global problem could be resolved by hardworking people getting back to work to save their homes. Not too much further bailout needed. At least so it suggests.

And again, lessons for us in all of this?

First of all, I hope it's simply been informative and eye-opening. The worst thing about all those liar loans may not have been the teaser interest rates but the no-downpayment scourge.

As I said earlier, your professional obligations, as you interpret them in your mind and your soul, will dictate the extent to which you will participate in negotiating and drafting highly-leveraged transactions in future. As a capitalist at heart, I imagine--with rueful confidence--that you will, by and large, negotiate and draft transactions with every last ounce of leverage your clients can negotiate. It is advisedly the Fed's role, and not yours, to regulate the extension of credit in our economy. But you are not thereby exempted from telling your clients, in the immortal words, that "they're a damned fool and they oughtn't do it."

If you're in a position of leadership in your firm, this would be the most opportune of times to re-examine your firm's capital structure. What level of commitment are people in for? Are you over-leveraged, as a firm? What's the level of "equity" that your partners feel you have in your firm?

This is not only financial equity, of course. But you know that.

Update (15 April):

A reader preferring anonymity (but a regular correspondent) writes:

Great post today.  You made one assertion that is worth exploring.  You said that unlike the dot-com bubble (which was limited to one industry in (largely) one geographic territory), the housing crisis is national in scope.  I thought you might find the following map of interest.  According to these data, 32 counties account for more than half of all foreclosures.  Therefore, the current housing crisis really isn't national but instead is highly concentrated in a few discrete regions.

Therefore, not only is a mortgage bailout sub-optimal economically it is also a hidden income transfer from most of the country to a few counties (as well as an income transfer from responsible borrowers to less responsible borrowers).  

32 Counties Account for 50 Percent of Foreclosures

As someone who has all four feet planted squarely in the "responsible" camp—and whose primary residence is a Manhattan co-op, famously immune from speculative fever because of both the vigilance of co-op boards and the non-negotiable requirement of sizable down-payments and substantial post-closing liquidity—I am deeply sympathetic to our correspondent.  Reckless economic behavior is anathema to me even when I'm immune from collateral damage, and as a taxpayer, here I'm not immune.

But I'm also a pragmatist at heart; I think most Americans are.  So let me quote from the conclusion of Geanakoplos' original piece, which suggests very pragmatic reasons to throw expensive life-jackets at the underwater homeowners:

We know there are some who will be outraged at the idea that their neighbors might get a break, while they -- so much more responsible -- get nothing. To these outraged folks we say, you would benefit too. It is not just your home values and your neighborhoods that will deteriorate if you insist that your underwater neighbors not get relief; it is your tax dollars and that of your children that will be needed to make up for the plummeting value of those toxic assets held by banks, which we taxpayers now guarantee and may soon own outright. It is your job that will be at stake when your neighbors can no longer afford to buy goods and services, causing more companies to cut jobs. So you need to act responsibly again, for your own sake and for the welfare and future prosperity of the entire nation.

This type of cool, ratiocinated argument may come off as a bit too close for comfort to those who defended the AIG bonuses as a trivial amount of money in the larger scheme of things:  That is to say, probably true, but completely tone-deaf in terms of public outrage and more likely to inflame than to cool passions.  You have probably also heard the strained analogy that just because your neighbor smokes in bed doesn't mean you want to short-change the fire department. 

I honestly don't know how to respond to or rebut the "morally outrageous" argument since, as noted, I could easily be tempted to incline in that direction myself. 

The problem is that succumbing to that mildly vengeful instinct doesn't get us out of this.  And at the moment, I want out.  I want out bad. 

If anyone has a suggestion for what "out good" would look like, I'm all ears.  Barring that, I'll take out bad.

First of all, what can we learn from the past? Unfortunately, less than we think. As The American put it in "Our Epistemological Depression:"

History rarely repeats itself. There are some standard patterns in economic recessions, but major recessions are characterized by something novel. If only this were not the case: economists have devoted a great deal of attention to learning the lessons of the Great Depression that began in 1929, not least Ben Bernanke. As a result, we are unlikely to make the errors of monetary policy made by the Fed in that era (of tightening money when it should have been loosened); or the errors of fiscal policy made by the Treasury (such as raising taxes when they should have been lowered); or the errors of ideological tone made during the 1930s, when anticapitalist rhetoric frightened many potential investors from making new investments. In all of these respects, we have learned from the past.

Unfortunately, initial conditions are too different from case to case to simply apply some historical template that would permit us to fully understand what is currently happening, let alone how to deal with it. Instead of explaining why this recession (or depression) is just like the others, we should attend to what is new and especially problematic about the current downturn and why it may not respond to policies modeled on avoiding the errors of the past.

This is not a counsel of confidence. It suggests there's not so much we can learn from the past and that, by implication, we're flying relatively blind. That's not to say deny that by and large, this piece defends--as do I!--capitalism. Only consider its opening lines (emphasis original):

The history of socialism is the history of failure--and so is the history of capitalism, but in a different sense. For the history of socialism is one of fundamental failure, a failure to provide incentives and an inability to coordinate information about supply and effective demand. The history of capitalism, by contrast, is the history of dialectical failure: it is a history of the creation of new institutions and practices that may be successful, even transformative for a while, but which eventually prove dysfunctional, either because their intrinsic weaknesses become more evident over time or because of a change in external circumstances.

Opposing this counsel of faith in the long-run wisdom of capitalism is a piece written by a former chief economist of the International Monetary Fund, The Quiet Coup, from The Atlantic, which posits essentially that the US is "becoming a banana republic:"

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there's a deeper and more disturbing similarity: elite business interests--financiers, in the case of the U.S.--played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

This piece reaches its rhetorical apogee in "The great wealth that the financial sector created and concentrated gave bankers enormous political weight--a weight not seen in the U.S. since the era of J.P. Morgan (the man)." There are other counts to the indictment:

• Under "The Wall Street/Washington Corridor:" "Just as we have the world's most advanced economy, military, and technology, we also have its most advanced oligarchy. [...]
• The American financial industry gained political power by amassing a kind of cultural capital--a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors. [...]
• Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. [...]
• A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan's pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone.

You get the gist: The "oligarchs" of the financial services industry have thoroughly captured the mewling and subservient regulators, Cabinet officials, and Congressmen and Senators. If this is an accurate diagnosis, the solution follows inevitably:

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical--since we'll want to sell the banks quickly--they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

Fundamentally, this posits the economic meltdown as just desserts for the over-reaching of the priviliged few, who now need to be put brusquely in their place by force majeure.

Warrant you, I do not subscribe to this ideology or this explanatory device for a moment, but I have dwelt on it herein to bring attention to what a substantial stream of thought it is. The Atlantic, after all, is not exactly a fringe publication.

Having presented these two dueling explanations--the first that capitalism, the best of all possible worlds, is still subject to episodic paroxysms of dysfunction in the face of endogenous excesses or exogenous shocks, and the second that (democratic) capitalism, not necessarily the best of all worlds, is subject to capture by oligarchies to the supreme detriment of the commonweal--I'd like to present a third and, I believe, more informative, perspective: What if this recession is not the usual "income statement" recession but instead a "balance sheet" recession.

For suggesting this train of thought I'm indebted to Roger Altman, Chairman and CEO of Evercore Partners but perhaps better known as deputy Treasury secretary under President Clinton, who recently wrote in the FT that:

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out [...]

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. [...]

For households, net worth peaked in mid-2007 at $64,400bn but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big - especially when household debt reached 130 per cent of income in 2008..... Now that wealth effect has reversed with a vengeance. The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent.

Why do I emphasize this?

Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income.

The famous arithmetic tautologies still hold, alas: If your portfolio drops by 20%, it takes a 25% gain to recover; if by 33%, a 50% gain; and if by 50%, a doubling.

By contrast, replacing "lost" income isn't all that simple, especially if, blessings upon you, you're unemployed in this environment. But once you are re-hired, the bleeding instantly stops. Not so easy and not so fast in terms of regaining lost wealth.

Aside from having had a tour d'horizon of how we might have gotten here, where does this leave us?

Actually, with some perspective.

Law firms are not, permit me to suggest, the worst industry to be in right now. Would you rather work for a large retail chain? A resort or hotel or entertainment complex? A bank? An investment bank? A hedge fund or private equity house? A magazine or newspaper publisher? An auto company?

If this is a "balance sheet recession," be grateful at least that, while no firm you work for and no industry you work in can bulletproof your 401(k) or the "mark to market" value of your home, the long-term prospects for your income are, I maintain, as bright or brighter than ever.

Chin up.

Just as McKinsey's consulting practice centers on corporate America, certainly its core clientele and expertise, as opposed to law firms, where they have no domain expertise that anyone would notice, the McKinsey Quarterly surveys do not encompass law firm leaders, but global corporate executives. Nevertheless, these are widely traveled and well-informed people with their fingers on the pulse of the global economy, so it's worth reviewing what McKinsey learned in its most recent (March 10--March 16) series of interviews in its "Global Survey."

Here's what they found.

In summary, a "gloomy economic stasis has taken hold," and while the proportion of executives saying economic conditions have deteriorated has, at least, not increased this quarter, fewer than one-third expect an economic upturn this year.

As we've almost come to expect in these types of surveys, and amusingly, overall they remain confident about how their own companies are handling the crisis (still, over half expect profits to drop in the near term).

Some other interesting results of the study:

• There's no doubt whatsoever that trust in business has fallen: 85% have that view. And the culprit? The #1 response(56%) was: Financial firms' inability to comprehend risk and guard against its repercussions. For our purposes, what's more interesting is that after #2 (33%, "job losses," which is something of a non-response) was "executive compensation levels" (29%). Why do I mention this? Only because lawyers are seen as highly paid.
  
  
• Recovery will take time. 90% of these global executives say their own national economies "are in very poor shape" and "have declined since September 2008" but a similar number also agree conditions have not gotten worse since then.
  
  
• Some particularly revealing responses came in answer to questions about jobs and prices:
  • Compared to just three months ago, even more executives expect their workforces to shrink: 50% now vs. 42% in January, and only 38% expect them to stay the same size now vs. 45% in January.
  • The news on prices (can you say: Rates?) is equally telling: Projecting changes for the first half of 2009, only 12% see an increase, 25% see a decrease, and 54% see no change (9%, presumably in commodity businesses, don't know).
    
    
• There are very modest signs of a potential upturn in economic conditions. By and large, these executives are more hopeful than they were as recently as January:
  • When asked how they expect their country's economy to be in the first half of 2009, the results were:
    • January: 50% moderately worse, 7% moderately better
    • March: 41% moderately worse, 14% moderately better
      
      
• In terms of seeking new funds for new initiatives, while two-thirds of firms said they had sought no new funding, the change in the composition of what the other third that were seeking new funding planned to do with it was revealing:
  • Four months ago, 40% sought funding simply to increase available cash; now that's down to 30%
  • Four months ago, 32% sought it to pay for new initiatives; now that's up to 37%.
    
    
• A final, and suggestive, set of responses concerns differences between executives and managers who consider their firms to be "weathering the crisis well" (i.e., well-managed firms) and those at firms who say they have been hurt by the crisis because of poor management. What are firms deemed to be well-managed (by those who should know) doing differently than those poorly managed?
  • "Reducing operating costs:" Over three-quarters of well-managed firms but just more than half of poorly managed firms are doing this.
  • "Introducing new products/services to gain market share from weakened competitors:" Over one-third of good firms but just over one-quarter of bad firms.
  • "Increasing productivity:" Nearly 2 in 5 good firms, just over 1 in 4 bad firms.
  • "Leaving certain markets:" Only 8% of good firms, nearly one-quarter (23%) of bad firms.

What does this tell us, back here in LawFirm Land and out of McKinsey Land?

If trust in business at large has fallen, it perhaps cannot help but have spilled over into our world. Or, if as I do, you would prefer not to believe that, it nevertheless signals an opportunity to get closer than ever to your clients. Don't permit even a whiff of questioned trust to enter your relationships with your clients. Do you think (do they think?) that if there's nothing going on, there's nothing to talk about? Wrong, wrong, wrong. Reach out to them.

Second, if businesses are shedding jobs and prices are under pressure, surely we have known since at least September 2008 that the same is true of us. This is, at this point, very old news.

Third and most important, what is your firm actually doing in response to the crisis?

Here the McKinsey survey actually provides a bit of guidance, even if you're tempted to more realistically categorize it as confirmation of common sense. But the guidance would be:

• "Cut operating costs:" Engage in the dreadful substance, process, and experience of laying off lawyers and staff. And yes, associates today and partners tomorrow.
• "Increase productivity:" Partly by engaging in (a), above, but more creatively and more importantly by reallocating people to practice areas in greater relative demand. You object that it's hard to retrain people? I retort that it's only hard if those individuals who are about to be among the retrained find it hard themselves. And then you know who is onboard the train and who is not.
• "Leaving certain markets:" Here the message may be, if any of these are, more positive. Do not retrench. At least not if you're in markets you entered after due consideration, and not in a pell-mell rush to emulate a competitor or to plant a flag for ego's sake. If you are in a particular city for a fundamentally sound reason, aligned with your own internal firm strategy and your clients' long-term demands, do not retreat. We last saw this, may I remind you, in 2000 when everyone seemed to plunge into Northern California just about at the peak of the dot-com boom. Those who subsequently retreated were not there for the long haul, and should not have been there for the short.

Summing this up, I choose to put at least a skin-deep positive gloss on it.

We clearly don't know nearly as much as we'd like about what we're experiencing, but that doesn't mean we know nothing. We can take some obvious steps (costs, productivity, markets).

We can, also and imperatively, engage our partners, associates, and staff in the new firm-wide enterprise of shifting from a mindset of do-no-harm and steady-as-she-goes to one of:

• creativity,
• agility,
• flexibility,
• and suppleness.

Think different.