Leverage and Asset Bubbles: Averting Armageddon with Chapter 11?

Abstract

An iconic model with high leverage and overvalued collateral assets is used to illustrate the amplification mechanism driving asset prices to ‘overshoot’ equilibrium when an asset bubble bursts – threatening widespread insolvency and what Richard Koo calls a ‘balance sheet recession’. Besides interest rates cuts, asset purchases and capital restructuring are key to crisis resolution. The usual bankruptcy procedures for doing this fail to internalise the price effects of asset ‘fire‐sales’ to pay down debts, however. We discuss how official intervention in the form of ‘super’ Chapter 11 actions can help prevent asset price correction causing widespread economic disruption.

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