In a previous post I discussed a paper by John Geanakoplos on the Leverage Cycle (due to appear in the NBER Macroeconomics Annual later this year). I presented this paper in the Columbia finance reading group last Thursday, and have posted my slides in case anyone is interested in taking a look.
The paper is considerably more accessible to the general reader than most of the recent theoretical literature on the financial crisis. It avoids the standard theorem-and-proof format, and consists instead of a sequence of elaborate numerical examples that fit together like a jigsaw puzzle. It also contains a number of very interesting ideas and insights, many more than I was able to discuss in my earlier post.
One of the key features of the Geanakoplos model is that the same set of physical assets can serve as collateral multiple times for loans of different maturities. For example, housing serves as collateral for long-term loans in the mortgage market, while the loans themselves (after securitization and tranching) can serve as collateral for short-term borrowing in the repo market. Geanakoplos shows that the extent of leverage in the long-term market will endogenously be such as to allow for a positive probability of default, and is interested in the effects of bad news in this market (interpreted as an increased likelihood of eventual default) on the market for short-term loans backed by financial rather than physical assets.
Among the main insights in the paper is the following: a decline in the expected terminal value of the physical assets will result in a far greater decline in the prices of the financial assets that they back. This happens for three reasons. Most obviously, there is a decline in fundamentals. But the effects of this are amplified because the initial prices (before bad news arrives) reflect the beliefs of the most optimistic market participants, who borrow from the pessimists in order to buy their asset holdings. In other words, the marginal buyer is (endogenously) very optimistic and this is reflected in the market price. The decline in fundamentals not only wipes out these highly leveraged optimists, but also substantially reduces equilibrium leverage in the market. As a result, the decline in the financial asset price is far greater than any market participant's expectations concerning the terminal value of the physical asset.
The careful reader will note that incomplete markets and maturity mismatch play a critical role in this argument. One of the most interesting aspects of the model is that both market incompleteness and maturity transformation arise endogenously, and the asset prices at various points in the tree of uncertainty are all correctly anticipated. The results are driven not by irrational exuberance or systematic biases, but by heterogeneous preferences and beliefs, and changes over time in equilibrium leverage. It's a precise, rigorous and carefully constructed interpretation of recent events, based on work that was done well before this crisis erupted.
In response to my earlier post on this paper, David at Deus Ex Macchiato agreed that the work is important, but added:
What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?This is a good question. A lot of the less formal work in this area never made it into the canonical models taught to successive cohorts of graduate students in economics. Geanakoplos doesn't mention Galbraith explicitly, but he does mention Minsky and Tobin, who themselves were surely familiar with Galbraith's work on the crash. Implicit in David's question is the accusation that the training of professional economists has become too narrow, and on this point I believe that he is absolutely correct.