The Leverage Cycle

Abstract

Previous articleNext article FreeThe Leverage CycleJohn GeanakoplosJohn GeanakoplosYale University Search for more articles by this author Yale UniversityPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. Introduction to the Leverage CycleAt least since the time of Irving Fisher, economists, as well as the general public, have regarded the interest rate as the most important variable in the economy. But in times of crisis, collateral rates (equivalently margins or leverage) are far more important. Despite the cries of newspapers to lower the interest rates, the Federal Reserve (Fed) would sometimes do much better to attend to the economy-wide leverage and leave the interest rate alone.When a homeowner (or hedge fund or a big investment bank) takes out a loan using, say, a house as collateral, he must negotiate not just the interest rate but how much he can borrow. If the house costs $100, and he borrows $80 and pays $20 in cash, we say that the margin or haircut is 20%, the loan to value (LTV) is $$\$ 80/ \$ 100=80\% $$, and the collateral rate is $$\$ 100/ \$ 80=125\% $$. The leverage is the reciprocal of the margin, namely, the ratio of the asset value to the cash needed to purchase it, or $$\$ 100/ \$ 20=5$$. These ratios are all synonymous.In standard economic theory, the equilibrium of supply and demand determines the interest rate on loans. It would seem impossible that one equation could determine two variables, the interest rate and the margin. But in my theory, supply and demand do determine both the equilibrium leverage (or margin) and the interest rate.It is apparent from everyday life that the laws of supply and demand can determine both the interest rate and leverage of a loan: the more impatient borrowers are, the higher the interest rate; the more nervous the lenders become, or the higher volatility becomes, the higher the collateral they demand. But standard economic theory fails to properly capture these effects, struggling to see how a single supply-equals-demand equation for a loan could determine two variables: the interest rate and the leverage. The theory typically ignores the possibility of default (and thus the need for collateral) or else fixes the leverage as a constant, allowing the equation to predict the interest rate.Yet, variation in leverage has a huge impact on the price of assets, contributing to economic bubbles and busts. This is because, for many assets, there is a class of buyer for whom the asset is more valuable than it is for the rest of the public (standard economic theory, in contrast, assumes that asset prices reflect some fundamental value). These buyers are willing to pay more, perhaps because they are more optimistic, or they are more risk tolerant, or they simply like the assets more. If they can get their hands on more money through more highly leveraged borrowing (that is, getting a loan with less collateral), they will spend it on the assets and drive those prices up. If they lose wealth, or lose the ability to borrow, they will buy less, so the asset will fall into more pessimistic hands and be valued less.In the absence of intervention, leverage becomes too high in boom times and too low in bad times. As a result, in boom times asset prices are too high, and in crisis times they are too low. This is the leverage cycle.Leverage dramatically increased in the United States and globally from 1999 to 2006. A bank that in 2006 wanted to buy a AAA-rated mortgage security could borrow 98.4% of the purchase price, using the security as collateral, and pay only 1.6% in cash. The leverage was thus 100 to 1.6, or about 60 to 1. The average leverage in 2006 across all of the US$2.5 trillion of so-called toxic mortgage securities was about 16 to 1, meaning that the buyers paid down only $150 billion and borrowed the other $2.35 trillion. Home buyers could get a mortgage leveraged 35 to 1, with less than a 3% down payment. Security and house prices soared.Today leverage has been drastically curtailed by nervous lenders wanting more collateral for every dollar loaned. Those toxic mortgage securities are now (in 2009:Q2) leveraged on average only about 1.2 to 1. A homeowner who bought his house in 2006 by taking out a subprime mortgage with only 3% down cannot take out a similar loan today without putting down 30% (unless he qualifies for one of the government rescue programs). The odds are great that he would not have the cash to do it, and reducing the interest rate by 1% or 2% would not change his ability to act. Deleveraging is the main reason the prices of both securities and homes are still falling.The leverage cycle is a recurring phenomenon. The financial derivatives crisis in 1994 that bankrupted Orange County in California was the tail end of a leverage cycle. So was the emerging markets mortgage crisis of 1998, which brought the Connecticut-based hedge fund Long-Term Capital Management to its knees, prompting an emergency rescue by other financial institutions. The crash of 1987 also seems to be at the tail end of a leverage cycle. In figure 1, the average margin offered by dealers for all securities purchased at the hedge fund Ellington Capital is plotted against time. (The leverage Ellington actually used was generally far less than what was offered.) One sees that the margin was around 20%, then spiked dramatically in 1998 to 40% for a few months, and then fell back to 20% again. In late 2005 through 2007, the margins fell to around 10%, but then in the crisis of late 2007 they jumped to over 40% again and kept rising for over a year. In 2009:Q2, they reached 70% or more.Fig. 1. View Large ImageDownload PowerPointThe theory of equilibrium leverage and asset pricing developed here implies that a central bank can smooth economic activity by curtailing leverage in normal or ebullient times and propping up leverage in anxious times. It challenges the “fundamental value” theory of asset pricing and the efficient markets hypothesis. It suggests that central banks might consider monitoring and regulating leverage as well as interest rates.If agents extrapolate blindly, assuming from past rising prices that they can safely set very small margin requirements, or that falling prices means that it is necessary to demand absurd collateral levels, then the cycle will get much worse. But a crucial part of my leverage cycle story is that every agent is acting perfectly rationally from his own individual point of view. People are not deceived into following illusory trends. They do not ignore danger signs. They do not panic. They look forward, not backward. But under certain circumstances, the cycle spirals into a crash anyway. The lesson is that even if people remember this leverage cycle, there will be more leverage cycles in the future, unless the Fed acts to stop them.The crash always involves the same three elements. First is scary bad news that increases uncertainty and so volatility of asset returns. This leads to tighter margins as lenders get more nervous. This, in turn, leads to falling prices and huge losses by the most optimistic, leveraged buyers. All three elements feed back on each other; the redistribution of wealth from optimists to pessimists further erodes prices, causing more losses for optimists, and steeper price declines, which rational lenders anticipate, leading then to demand more collateral, and so on.The best way to stop a crash is to act long before it occurs. Restricting leverage in ebullient times is one policy that can achieve this end.To reverse the crash once it has happened requires reversing the three causes. In today’s environment, reducing uncertainty means, first of all, stopping foreclosures and the free-fall of housing prices. The only reliable way to do that is to write down principal. Second, leverage must be restored to reasonable levels. One way to accomplish this is for the central bank to lend directly to investors at more generous collateral levels than the private markets are willing to provide. Third, the lost buying power of the bankrupt leveraged optimists must be replaced. This might entail bailing out crucial players or injecting optimistic capital into the financial system.My theory is not, of course, completely original. Over 400 years ago, in The Merchant of Venice, Shakespeare explained that to take out a loan one had to negotiate both the interest rate and the collateral level. It is clear which of the two Shakespeare thought was the more important. Who can remember the interest rate Shylock charged Antonio? (It was 0%.) But everybody remembers the pound of flesh that Shylock and Antonio agreed on as collateral. The upshot of the play, moreover, is that the regulatory authority (the court) decides that the collateral Shylock and Antonio freely agreed upon was socially suboptimal, and the court decrees a different collateral: a pound of flesh but not a drop of blood. In some cases, the optimal policy for the central bank involves decreeing different collateral rates.In more recent times there has been pioneering work on collateral by Shleifer and Vishny (1992), Bernanke, Gertler, and Gilchrist (1996, 1999), and Holmstrom and Tirole (1997). This work emphasized the asymmetric information between borrower and lender, leading to a principal agent problem. For example, in Shleifer and Vishny (1992), the debt structure of short versus long loans must be arranged to discourage the firm management from undertaking negative present value investments with personal perks in the good state. But in the bad state this forces the firm to liquidate, just when other similar firms are liquidating, causing a price crash. In Holmstrom and Tirole (1997) the managers of a firm are not able to borrow all the inputs necessary to build a project, because lenders would like to see them bear risk, by putting down their own money, to guarantee that they exert maximal effort. The Bernanke et al. (1999) model, adapted from their earlier work, is cast in an environment with costly state verification. It is closely related to the second example I give below, with utility from housing and foreclosure costs, taken from Geanakoplos (1997). But an important difference is that I do not invoke any asymmetric information. I believe that it is important to note that endogenous leverage need not be based on asymmetric information. Of course, the asymmetric information revolution in economics was a tremendous advance, and asymmetric information plays a critical role in many lender-borrower relationships; sometimes, however, the profession becomes obsessed with it. In the crisis of 2007–9, it does not appear to me that asymmetric information played a critical role in determining margins. Certainly the buyers of mortgage securities did not control their payoffs. In my model, the only thing backing the loan is the physical collateral. Because the loans are no-recourse loans, there is no need to learn anything about the borrower. All that matters is the collateral. Repo loans, and mortgages in many states, are literally no-recourse loans. In the rest of the states, lenders rarely come after borrowers for more money beyond taking the house. And for subprime borrowers, the hit to the credit rating is becoming less and less tangible. In looking for determinants of (changes in) leverage, one should start with the distribution of collateral payoffs and not the level of asymmetric information.Another important paper on collateral is Kiyotaki and Moore (1997). Like Bernanke et al. (1996), this paper emphasized the feedback from the fall in collateral prices to a fall in borrowing capacity, assuming a constant loan to value ratio. By contrast, my work defining collateral equilibrium focused on what determines the ratios (LTV, margin, or leverage) and why they change. In practice, I believe the change in ratios has been far bigger and more important for borrowing than the change in price levels. The possibility of changing ratios is latent in the Bernanke et al. models but not emphasized by them. In my 1997 paper I showed how one supply-equals-demand equation can determine leverage as well as interest even when the future is uncertain. In my 2003 paper on the anatomy of crashes and margins (it was an invited address at the 2000 World Econometric Society meetings), I argued that in normal times leverage and asset prices get too high, and in bad times, when the future is worse and more uncertain, leverage and asset prices get too low. In the certainty model of Kiyotaki and Moore (1997), to the extent leverage changes at all, it goes in the opposite direction, getting looser after bad news. In Fostel and Geanakoplos (2008b), on leverage cycles and the anxious economy, we noted that margins do not move in lockstep across asset classes and that a leverage cycle in one asset class might spread to other unrelated asset classes. In Geanakoplos and Zame (2009), we describe the general properties of collateral equilibrium. In Geanakoplos and Kubler (2005), we show that managing collateral levels can lead to Pareto improvements.1The recent crisis has stimulated a new generation of important papers on leverage and the economy. Notable among these are Brunnermeier and Pedersen (2009), anticipated partly by Gromb and Vayanos (2002), and Adrian and Shin (2009). Adrian and Shin have developed a remarkable series of empirical studies of leverage.It is very important to note that leverage in my paper is defined by a ratio of collateral values to the down payment that must be made to buy them. Those securities leverage numbers are hard to get historically. I provided an aggregate of them from the database of one hedge fund, but, as far as I know, securities leverage numbers have not been systematically kept. It would be very helpful if the Fed were to gather these numbers and periodically report leverage numbers across different asset classes. It is much easier to get “investor leverage” (debt + equity)/equity values for firms. But these investor leverage numbers can be very misleading. When the economy goes bad and the true securities leverage is sharply declining, many firms will find their equity wiped out, and it will appear as though their leverage has gone up instead of down. This reversal may explain why some macroeconomists have underestimated the role leverage plays in the economy.Perhaps the most important lesson from this work (and the current crisis) is that the macro economy is strongly influenced by financial variables beyond prices. This, of course, was the theme of much of the work of Minsky (1986), who called attention to the dangers of leverage, and of James Tobin (who in Tobin and Golub [1998] explicitly defined leverage and stated that it should be determined in equilibrium, alongside interest rates) and also of Bernanke, Gertler, and Gilchrist.1For Pareto-improving interventions in credit markets, see also Gromb and Vayanos (2002) and Lorenzoni (2008).A. Why Was This Leverage Cycle Worse than Previous Cycles?There are a number of elements that played into the leverage cycle crisis of 2007–9 that had not appeared before, which explains why it has been so bad. I will gradually incorporate them into the model. The first I have already mentioned, namely, that leverage got higher than ever before, and then margins got tighter than ever before.The second element is the invention of the credit default swap. The buyer of “CDS insurance” gets a dollar for every dollar of defaulted principal on some bond. But he is not limited to buying as much insurance as he owns bonds. In fact, he very likely is buying the credit default swaps (CDS) nowadays because he thinks the bonds are bad and does not want to own them at all. These CDS are, despite their names, not insurance but a vehicle for optimists and pessimists to leverage their views. Conventional leverage allows optimists to push the price of assets up; CDS allows pessimists to push asset prices down. The standardization of CDS for mortgages in late 2005 led to their trades in large quantities in 2006 at the very peak of the cycle. This, I believe, was one of the precipitators of the this leverage cycle was a of two leverage in mortgage securities and in The two each The margins in securities led to lower security prices, which made it to new which made it for to which made them more likely to which down on which made housing prices which made securities which made their margins get and so when collateral as when housing is or there are typically large losses in over the collateral, partly because of and so subprime only of the loan back when they on a A huge number of homes are to be say In this model we will see that even if borrowers and lenders that the loan is so large that there will be in which the collateral is under and this will they will not be able to from on the leverage cycle has a impact on for two like and that find under even if they have not no have the same to (or This is called the debt Second, high asset prices for and a to The fall in asset prices has a on new This is the of And it is the reason why the crisis of the leverage cycle is so and I present the model of the leverage cycle, on my 2003 in which a of investors in their In the model of I show that the price of an asset when it can be leveraged more. The reason is that then optimists are needed to all of the asset the determines the asset price, is more One is that pricing even the of one price If two assets are that the one can be leveraged and the one then the asset will for a higher I show that when news in any is good or then the equilibrium of supply and demand will down leverage so that the made on collateral is the that does not any of This is of the there is any It that if lenders and investors a worse for the collateral value when the loan there will be a equilibrium loan less I again on my 2003 paper to a of the model in The asset pays out only in the and in the information about the of the payoffs. important of the leverage in is that loan in the model will be very So much can with the collateral price over that only very leverage can default for on a long loan with a who want to leverage a will have to borrow short This one for the in which assets are with loans. In the model equilibrium, all investors take out loans. and leverage is each news in the the agents rationally their about payoffs. I between bad which and bad which and increases volatility This asset prices at least by reducing payoffs on of the bad news and by leverage on of the increased normal bad the asset price drop is by in bad news in the the asset price more than any agent in the economy thinks it The reason is that three In to the of bad news on leverage of the most optimistic buyers (who leveraged their in the first the buyer in the is a different and much less optimistic agent than in the first by of the leverage cycle that might a to smooth it all of these are in the model, but they could be with when leverage is high, the price is determined by very few buyers who the in be Second, when leverage is high, so are asset prices, and when leverage prices The upshot is that when there is high leverage, economic activity is when there is low leverage, the economy is If the prices are by absurd might be in the boom times that are costly to in the down times. Third, even if the are many people who cannot will be to tremendous risk that can be by the cycle. over the cycle can dramatically if the leveraged buyers getting and dramatically if the leveraged buyers lose it may be that the leveraged buyers do not the costs of their own as when a does not take into that his will not be able to find or when a further in a I move to a second model, from my 1997 in which are and among investors not from in but from in the utility of the collateral, as with leverage is but now default in eq