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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."

The key ingredient of his theory is to introduce heterogeneous investors who differ by their optimisms about the asset value and (of course) the possibility of leverage. Geanakoplos then describes his anatomy of a crisis:

"i) Assets go down in value on scary bad news.
ii) This causes a big drop in the wealth of the natural buyers (optimists) who were
leveraged. Leveraged buyers are forced to sell to meet their margin requirements.
iii) This leads to further loss in asset value, and in wealth for the natural buyers.
iv) Then just as the crisis seems to be coming under control, margin requirements
are tightened because of increased uncertainty and disagreement.
v) This causes huge losses in asset values via forced sales.
vi) Many optimists will lose all their wealth and go out of business
vii) There may be spillovers if optimists in one asset hit by bad news are led to
sell other assets for which they are also optimists.
viii) Investors who survive have a great opportunity."

At each stage of the cycle, the marginal investor differs, he is the leveraged optimistic buyer at the peak of the cycle, he is the conservative pessimist at the bottom of the cycle. This amplifies the cycle and shows the importance of quantity (leverage) vs. the price (interest rate) to regulate the cycle.

His theory also puts a dent on the efficient market hypothesis. Indeed, he writes "The efficient markets hypothesis essentially says that prices are priced fairly by the market, and that even an uninformed agent should not be afraid to trade, because the prices already incorporate the information acquired by more sophisticated agents. That is true in collateral equilibrium for the contracts, but it is not true of the assets that can be used as collateral. An unsophisticated buyer who did not know how to use leverage would find that he grossly overpaid for housing."

You can read his paper here.



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