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The Leverage Cycle

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The Leverage Cycle by John Geanakoplos (Yale University)

In this very important article from 2009, John Geanakoplos describes his theory of the leverage cycle that explains the booms and busts caused by time-varying leverage.

According to the author

"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 sophisticated and know better how to hedge their exposure to the assets, 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."

Read more...
 

My Life in Finance

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Professor Eugene Fama has written a very interesting autobiography. It covers the first 50 years of modern financial economics (he has been at the University of Chicago since 1960!). His research has been really impressive and covers market efficiency, asset pricing and corporate finance. After 50 years of research, there still seems to be many unanswered questions in asset pricing (what are the Fama and French factors?) and the recent financial crisis of 2008 has put some doubts on the theory of market efficiency. You can read his paper here.
 

Fed Chairman Bernanke College Lecture Series

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Fed Chairman Bernanke is giving a four-part lecture series, "The Federal Reserve and the Financial Crisis," airing March 20, 22, 27 & 29.

On March 27 Chairman Bernanke will discuss "The Federal Reserve’s Response to the Financial Crisis and the Great Recession," live at 12:45 p.m. ET.

 More information, presentation materials, and on-demand video: www.federalreserve.gov/lectures

You can follow his lecture part I here. You can access live streaming of the lecture here.

 

 

Merton and Scholes on Dodd Frank

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An interesting interview of Robert Merton and Myron Scholes on Dodd Frank.

"Scholes says it is obviously important to understand institutions, but that such understanding is a very “tactical” piece of knowledge. “What you really want to think about is what’s driving it,” he says. Those drivers included government coordination that forced “all the different players to line up together in the same direction.” The government also created a “feedback loop” of guarantees, in which guarantors are guaranteeing some entity that is in turn guaranteeing the guarantor."

" Merton says other problems – such as the need to fix the accounting regime or the forces driving correlation of assets – are more important than the problems with proprietary trading."

Read the interview there.

 


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