Did Not Understanding The Leverage Cycle Kill The Economy?

from the something-worth-exploring dept

David Warsh's latest economics column delves into the renewed interest being given to economist John Geanakoplos' paper explaining how the real issue that brought down the economy was a misunderstanding of "the leverage cycle." Basically, the argument is that everyone (mainly, the Fed) gets so focused on the interest rates, that they stop focusing on the leverage/collateral involved. It's sort of the central banker equivalent of when the mortgage broker tries to get you to ignore all the real terms in your mortgage and just gets you to focus on how much you'll be paying each month. The argument, then, is that the government could have done much more to prevent the crisis if it had simply paid more attention to the leverage situation, which had obviously grown totally out-of-hand. Basically, the argument says that in a competitive market for credit, leverage will always rise, as some parties take bigger and bigger risks, forcing others to do the same. But then everyone's way overleveraged, and when the music stops, basically everyone's left without a seat. It's an interesting theory -- one that sounds good, though on a first read I'm not entirely convinced. While the issue of how much leverage was out there is obviously a part of the problem, I'm not entirely sure that the government would realistically be able to totally control the issue. While it could put in place certain regulations, it seems like there would always be loopholes that allowed leverage to occur elsewhere. Either way, I'm going to do some more reading on the subject, but wanted to pass it along here to see what others thought of it in the meantime.
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Filed Under: economy, financial crisis, leverage, leverage cycle

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  • identicon
    yogi, 15 Apr 2009 @ 1:14am

    It's not that complicated

    Stupidity and greed killed the economy.

    Maybe we should outlaw both traits. That would make how many people criminals?

    reply to this | link to this | view in chronology ]

    • identicon
      Man from Atlanta, 15 Apr 2009 @ 4:36am

      Re: It's not that complicated

      Dead on, it's not that complicated and we don't need a theory to explain what happened. People saw the "bubble" coming years before it burst. Those who lost out were blind to (or simply ignored) the increasing risk.

      Now our gov't. rewards not those who acted reasonably, but those who gambled and lost.

      reply to this | link to this | view in chronology ]

  • identicon
    Rob, 15 Apr 2009 @ 1:40am

    To fix the problem, we have to look at the source

    While I'm sure that many people will rush to suggest regulation as a solution for over-leveraged loans, as is suggested in the linked article, regulation of financial markets isn't a solution - it's the problem.

    Investing of any kind - whether it be buying stocks, bonds, making loans, or even just having a savings account - has inherent risks - and it should have risks. Some investments are high risk and therefore have a high potential payback, some are low risk, and therefore have lower returns. There's a natural balance that occurs, purely based on this very basic, easily understood risk/return model. Part of that model is collateral. Loans with valuable collateral are less risky than those with no collateral or collateral of questionable value.

    When the government comes in, however, and decides to offer a guarantee (implied or otherwise) on some investments, as they did with Fannie/Freddie and all of the bailouts, the risk/return model gets thrown completely out of balance. Investments that have higher risk suddenly become more attractive due to their "government guaranteed" status, and it therefore makes more traditional, less risky investments less attractive due to their lower payback. The quality of collateral becomes far less important because the government is going to "guarantee" the investment anyway. When there is no perceived risk and collateral becomes a secondary consideration, the next thing to go is lending standards and borrower creditworthiness - again, why do those things matter when the government will pick up the tab if the loan goes south? Once those first few dominoes fall, it's tough to stop the trend.

    What the author of the article suggests would be like the engineer on a train pulling the brake after the train has already crashed. He expects to watch a trailing indicator - i.e. over-leveraging - and make accurate adjustments using monetary policy to correct course. This is completely the wrong answer. The only way to fix the problem is to go back to it's source and cure the moral hazards inherent in government guarantees and bailouts - and that means doing away with government programs, laws, and regulations that exist for the purpose of attempting to manipulate the markets, such as Fannie/Freddie, TALF/TARP, etc. Anything less is simply a band-aid that our economy will eventually bleed through.

    reply to this | link to this | view in chronology ]

    • identicon
      DCX2, 15 Apr 2009 @ 5:03am

      Re: To fix the problem, we have to look at the source

      While you are correct about the problems associated with the warped risk incentives created with government assistance, you should consider that Fannie and Freddie had strict requirements for the mortgages that they would underwrite (20% down payment, $417,000 limit). Those 0% down payment mortgages did not go through Fannie and Freddie. The loans for a McMansion in Vegas were not Fannie and Freddie loans. Wall Street started cutting Fannie and Freddie out of the securitization process because Fannie and Freddie couldn't launder the dirtiest loans as easily.

      Further, what does any of this have to do with regulation? And how is it a "trailing indicator"? The net capital rule (i.e. regulation) fully prevented this kind of problem until the SEC fell asleep at the wheel in 2004.

      reply to this | link to this | view in chronology ]

    • identicon
      Monopoly, 15 Apr 2009 @ 1:00pm

      Re: To fix the problem, we have to look at the source

      I suggest you sit down and play a game of Monopoly and allow everyone in the game to make up their own rules. Would you win or lose?

      There are risks and rewards in driving, what rules and regulations do you ignore when driving? Do you stop at stop lights?

      Regulations need to be put in place like rules in a hockey game, without them, you don't have a game, you have free-for-all and no one wins.

      reply to this | link to this | view in chronology ]

  • identicon
    Chris Coles, 15 Apr 2009 @ 2:57am

    Leverage is printing money

    Rob, you have missed the point completely. If you have a government printing money, you always understand that there are consequences, particularly inflation and a debased currency. What no one understood was that the major investment banks were printing money. No, not as bank notes, (which would have been immediately recognised and as quickly stopped), but as bonds.

    What they were doing was increasing the money supply. In an old fashioned economy were most consumer transactions were always in cash and bonds were always internal to the traditional trading industrial economy, the matter would have been containable. But in the modern economy, where almost all transactions are through credit mechanisms, the overflow of the new money into bonds automatically flows into the consumer.

    What happened was truly disastrous. For every mortgage sold, some of these banks were issuing another 30, yes thirty, bonds for the same value. So every time they issued a loan, they were increasing the money in circulation by another thirty times the original loan...... as bonds.

    Then it got worse again as another company, mainly AIG decided to sell insurance on those original loans and called them Credit Default Swops. Again, they did not sell one contract for a possible default for one loan, but in fact, so many that today NO ONE knows how many have been sold. Estimates vary from several trillion (at minimum), to several hundred trillion dollars.

    This will bring you all into the picture much better than anything I can say here.


    reply to this | link to this | view in chronology ]

  • identicon
    DCX2, 15 Apr 2009 @ 4:48am

    Chris Cox and the SEC screwed us in 2004

    Before 2004, there were rules that said regulated the amount of leverage you take on. It's called the Net Capital Rule. Among other things, it said that the big five investment banks that are no more could only be leveraged 12:1 or so. Worse, if they even approach 12:1 they have to issue a warning, and if they hit 12:1 they have to stop immediately!

    After 2004, the SEC loosened their regulation of leverage, allowing Bear Stearns to hit 33:1 - nearly three times the limit they couldn't even cross before!


    reply to this | link to this | view in chronology ]

    • identicon
      Anonymous Coward, 15 Apr 2009 @ 1:08pm

      Re: Chris Cox and the SEC screwed us in 2004

      Goldman Sacs CEO, Hank Paulson led the charge to extent the leverage from 12:1 to 40:1 so they could “compete with the European companies”.

      Frontline recently produced a show called “Black Money” about European companies bribing for business, so I can see where Hank got the idea.

      reply to this | link to this | view in chronology ]

  • identicon
    Comboman, 15 Apr 2009 @ 4:57am

    While the issue of how much leverage was out there is obviously a part of the problem, I'm not entirely sure that the government would realistically be able to totally control the issue.

    I don't think they would attempt to directly control leveraging, but rather that if the market seemed over-leveraged, the Fed would raise the interest rate (making leveraging less attractive). The downside of this approach is the potential for inflation, but perhaps a little inflation is good thing to slow down an over-heated economy.

    reply to this | link to this | view in chronology ]

  • identicon
    Larry, 15 Apr 2009 @ 5:40am

    Explain to me why this market can be trusted with my money

    This bubble, bust, punish the crooks cycle is getting old. It's bad enough that my real estate-driven mutual fund is worth 10% of what I paid for it, but since the market is so interdependent, everything else goes down too. The argument that 401(k) investors should ride out the market cycles simply doesn't hold water any more. I need to find a nice mattress to stuff my retirement money into.

    reply to this | link to this | view in chronology ]

    • identicon
      Jake, 15 Apr 2009 @ 6:08am

      Re: Explain to me why this market can be trusted with my money

      Try investing in something tangible, maybe, like precious metals; their value might fluctuate pretty wildly, but they'll still exist.
      As for myself, when I come into my grandma's trust money, I'm putting two thirds of it into a patch of woodland somewhere and building a house on it. The rest I'll cash in various major currencies -dollars, euros, whatever the Chinese use- and put in a fire-safe in my basement.

      reply to this | link to this | view in chronology ]

  • identicon
    Anonymous Coward, 15 Apr 2009 @ 5:59am

    Mike, look at the Canadian banking system. They do tightly regulate leverage and reserves and now they have the most stable banking system in the world. They didn't take part in the boom, and now they can largely avoid the bust.

    reply to this | link to this | view in chronology ]

  • identicon
    Anonymous Coward, 15 Apr 2009 @ 6:27am


    Stop saying “basically!”

    reply to this | link to this | view in chronology ]

  • icon
    dataGuy (profile), 15 Apr 2009 @ 9:13am

    Problem is a lack of honesty

    Id you want to place the blame on one thing, I tend to agree with Mark Anderson that the the Board of Directors were the group in the best position to keep the market from getting out of hand:

    http://www.tapsns.com/blog/index.php/2009/04/%c2%bb-an-open-letter-to-the-board-of-director s/

    reply to this | link to this | view in chronology ]

  • identicon
    Freedom, 15 Apr 2009 @ 11:27am


    It seems like we had all the government regulation needed but 'they' wouldn't pull the trigger. If the Fed Reserve would have raised the interest rates, it would have cut the legs out of the housing market before it got too bad, unfortunately, no one was willing to take the short term hit/pain and instead they let the bubble grow until it burst.

    One has to wonder if/when interest rates increase which has to happen at some point what this will do to an already poor housing market. If interest rates go from 5 to 10%, the average consumer will only be able to afford ~half as much home. While the price of the homes may hold or even rise due to inflation, I worry that the real value will decline rapidly when the interest rates go back to more historic levels and the # of real buyers decreases even further causing a 'reverse bubble'.

    If you take the demand part out of the equation, my house that I bought in 1993 is still 10 to 15% over priced (inflation dollar adjusted) if you assume a house just holds it core value. Add in coming increases in mortgage interest rates and I don't think we are anywhere near the bottom yet.


    reply to this | link to this | view in chronology ]

  • identicon
    Anonymous Coward, 15 Apr 2009 @ 2:01pm

    Another problem...

    Also, getting into weird commodity markets may have played a role too.

    Lehman never ceases to amaze me.


    reply to this | link to this | view in chronology ]

  • identicon
    Paul Fraser, 15 Apr 2009 @ 3:13pm

    Royal Bank of Canada (RBC Bank) : Corporate Bully

    RBC Bank President Gordon Nixon - Salary $11.73 Million


    I'm a commercial fisherman fighting the Royal Bank of Canada (RBC Bank) over a $100,000 loan mistake. I lost my home, fishing vessel and equipment. Help me fight this corporate bully by closing your RBC Bank account.

    There was no monthly interest payment date or amount of interest payable per month on my loan agreement. Date of first installment payment (Principal + interest) is approximately 1 year from the signing of my contract.
    Demand loan agreements signed by other fishermen around the same time disclosed monthly interest payment dates and interest amounts payable per month.The lending policy for fishermen did change at RBC from one payment (principal + interest) per year for fishing loans to principal paid yearly with interest paid monthly. This lending practice was in place when I approached RBC.
    Only problem is the loans officer was a replacement who wasn't familiar with these type of loans. She never informed me verbally or in writing about this new criteria.

    Phone or e-mail:
    RBC President, Gordon Nixon, Toronto (416)974-6415
    RBC Vice President, Sales, Anne Lockie, Toronto (416)974-6821
    RBC President, Atlantic Provinces, Greg Grice (902)421-8112 mail to:greg.grice@rbc.com
    RBC Manager, Cape Breton/Eastern Nova Scotia, Jerry Rankin (902)567-8600
    RBC Vice President, Atlantic Provinces, Brian Conway (902)491-4302 mail to:brian.conway@rbc.com
    RBC Vice President, Halifax Region, Tammy Holland (902)421-8112 mail to:tammy.holland@rbc.com
    RBC Senior Manager, Media & Public Relations, Beja Rodeck (416)974-5506 mail to:beja.rodeck@rbc.com
    RBC Ombudsman, Wendy Knight, Toronto, Ontario 1-800-769-2542 mail to:ombudsman@rbc.com
    Ombudsman for Banking Services & Investments, JoAnne Olafson, Toronto, 1-888-451-4519 mail to:ombudsman@obsi.ca



    http://ww w.youtube.com/CORPORATEBULLY


    "Fighting the Royal Bank of Canada (RBC Bank) one customer at a time"

    reply to this | link to this | view in chronology ]

  • identicon
    Bill, 15 Apr 2009 @ 5:58pm

    I think you've all missed what happened.
    Back in 1977, the Community Reinvestment Act was signed into effect. (I know, a lot say this wasn't a problem, but follow me...)
    This "encouraged" banks to lend money (mortgages in particular) to those who, prior to the Act, were "Redlined" out of the housing market. The Act provided for the Federal Gov'nt to regulate lending banks in such a way that if they didn't follow the 'spirit' (not just the letter) of the law, the banks wouldn't be able to expand, either by merging nor by building new branches in emerging markets.
    (BTW, this is regulation, which we are told there wasn't enough of.)
    As time went on, more and more pressure (see ACORN) waqs put on both the lenders and the government to lend more and more to people who couldn't afford a mortgage. More regulation (again) waqs applied, and more subprime mortgages were made.
    Under Clinton, two things happened; the AG threatened lawsuits of the lenders didn't include unemployment benefits and welfare payments(!) as regular income, and the barrier between lending banks and investments was drastically lowered. The last enabled lending banks with too many subprime loans to package them up, and sell them to investment bakks, which gave the lending banks more money to lend out (which, remember, they were under a Federally held gun to to).
    From there, the housing bubble grew so fast, with so much money being made, that no one really wanted to look too closely at the underlying cause: far too many loans mad to far too many people who simply could not afford the mortgages.
    The lenders, of course, told these people, "No problem. WHen the ARM goes up, if you can't afford it, simply sell the house, and buy another." Greedy? Of course. But remember, they were under that gun. They HAD to lend money; the Government was, in effect, forcing them to do so.
    SO, who was to blame?

    1. The Federal Government, first and foremost. It forced banks to lend money to people who couldn't afford it. Regulations; the idea that the banking system needed more regulation is absurd: regulations forced them to make these loans.

    2. The Banking Industry. There were people here making million$ a year, precisely because they were smart enough to know what was wrong. And they did, but they were making so much money they didn't want to rock the boat.

    3. Stupid, greedy people. Just because someone tells you you can afford something doesn't mean you can.

    This is a big sh!t sandwich, and there's enough for all to take a bite. We, as a society, have gotten far too much in debt. We need to get back to a life based more on living than on accumulating baubles. There's no reason a car won't go far more than 150,000 miles and 10 years these days. Few of us need a 3,000 sq/ft house. Large TVs are nice, but not if you can't pay for them. Gaming consoles weren't around 20 years ago, and somehow kids survived. multi-hundred $ sneakers are absurd.
    Let's do a little research, and find out what really caused this problem, and recognioze that the vast majority of us are at fault.
    Recognize that a politician wants power, whichever side of the aisle he's on. Call them to account, and let them know their jobs are on the line. They MUST own up to the fact that regulation got us into this mess, and it's up to them to figure that out. The banks, once onerous regs are removed, will sort them selves out. Stupid people will be with us forever, but the gov't shouldn't be encouraging them.

    reply to this | link to this | view in chronology ]

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