Leverage Cycles and the Financial Crisis

A John Geanakoplos-style breakdown of leverage cycles, the role they played in the financial crisis, and how government should regulate.

(Yale Open Courses)

Introduction:

If today, one were to look at the Wall Street Journal or Financial Times, one would believe that the interest rate is a preternatural determining factor in the economy. All one will hear about is Janet Yellen’s next big decision on whether to hike the interest rate. Collateral, on the other hand, seemingly does not have the same effect.We often do not even think about how much lenders depend on collateral, or how much they require changes with economic times.

John Geanakopolos, professor of Economics at Yale, suggests that leverage, and their inherent cycles, are arguably just as important a macroeconomic variable as the interest rate. Additionally, he states that the supply and demand equilibrium for loans will determine leverage as much as they do the interest rate.

Leverage cycles undeniably play a pivotal role in the global economy, having a material impact on asset prices.

The Basics:

When a bank requires a home-buyer to put up $20 for a $100 dollar house, lending the difference, the loan-to-value is 80% or the leverage ratio is 5 to 1. The theory of leverage cycles is defined as the change in leverage over time — rising in happy times, and falling in uncertain ones.

For instance, perhaps the economy is in great shape. The home-buyer would not need $20, but only $10 for that same $100 home with the identical financial ability to pay back the money. The home-buyer will be excited because he or she now owns a home, and the lender does not feel any uncertainty in the market, therefore believing that he cannot lose any money on the loan. This is how leverage can change due to a general feeling of exuberance. It also works vice-versa.

The ‘cycle’ goes as follows:

  1. Prices rise as more enthusiastic buyers utilize leverage to buy more assets
  2. More leverage = higher asset prices
  3. Scary news causes uncertainty, and lenders quickly restrict capital
  4. Asset prices fall and cause large losses to enthusiastic buyers

Once both sides of leverage extremes come into play, there can be major consequences. For instance, when even financially capable buyers cannot receive the capital they need in uncertain periods, then a recession can be propagated further.

Also crucial to this theory is the notion that not all buyers perceive the assets in the exact same way. Whether it is because they may be able to utilize the asset more efficiently, or maybe they just like the asset more, some people will be able to justify as higher buy price than all the others. This enthusiasm causes them to pay a higher price for the asset and utilize leverage to do so.

Leverage Cycles and the Financial Crisis:

So what did leverage cycles do for the financial crisis? A good way to picture the effects are to see them as accelerating the underlying economic environment. When the economy is booming and people are confident, then the increase of leverage will thrust the economy forward. When the economy is a recession, then capital is very hard to procure and will stagnate growth. This is precisely what happened. The graph below illustrates an interesting point:

(Geanakoplos, 2009)

Above, the full cycle can be seen. The green line represents an index of housing prices, while the purple line shows the down payment needed as a percentage of houses. The correlation really demonstrates how connected housing prices are to leverage. This is not simply just correlation either, but a causal relationship, and these bubble like housing prices can be somewhat determined by an increase in systematic leverage.

Does Government Have a Role in Managing Systemic Leverage?

In the future, does it make sense to have the market responding to how the government pushes and pulls the levers of lending markets? Perhaps. Professor Geanakoplos speaks about how the government could curtail collateral in exuberant times, and enhance the ability for buyers to receive capital in times of uncertainty. While in a theoretical sense this could work, it may give the market another variable to have to work with, creating uncertainty. Ultimately, it is impossible to say whether the marginal benefit of attempting to control the economy would out way the price to pay for a radical shift in both the role of government and the free markets.

Thank you for reading this article. I write other articles about topics in finance, accounting, math, and technology you may find interesting.

Blockchain: https://medium.com/@nicholastomic13/two-minute-topic-blockchain-3dc5b6e53a0f

Special Purpose Entities: https://medium.com/@nicholastomic13/two-minute-topic-special-purpose-entities-2f81ae2eff51

Work Cited:

Geanakoplos, John. The Leverage Cycle. Thesis. Cowles Foundation, 2009. N.p.: Cowles Foundation, n.d. Print.

John Geanakoplos. N.d. Yale Open Courses, New Haven.

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