Booms, Busts, and the Leverage Cycle

Over the Wall Street Journal, Mark Whitehouse has a nice piece on John Geanakoplos, a finance guru in the worlds of both academia and Wall Street. Over the past ten years, he’s been exploring how leverage and the value of collateral can drive booms and busts in financial markets.

His research was sparked by the challenges his investment fund faced after the demise of Long-Term Capital Management in 1998:

A lender to the fund where Mr. Geanakoplos was a partner abruptly demanded more margin on a loan. The event, which nearly toppled the fund as the partners scrambled to raise cash by selling securities, drove home to Mr. Geanakoplos how margins could work two ways — stimulating asset buying as they go lower, but forcing fire sales as they rise.

In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them “natural buyers.”

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

“It was evident to me that there was a cycle going on, not just in my little market, but all over the world,” says Mr. Geanakoplos, who is still a partner at Ellington Capital. The “leverage cycle,” he called it.

Well worth a read.