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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.

Filed Under: economy, financial crisis, leverage, leverage cycle

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  1. 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.

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