Yesterday I wrote about ( http://www.dailykos.com/... ) the obvious truth behind the current financial meltdown:
I mentioned some Scandinavian economists who are pointing out that leverage is not something that the market can bring to equilibrium. After doing some more research, I found an American economist at Yale (Plantation Owner's Tech for you Vonnegut fans) who holds an endowed chair named after one of the few sane economists - James Tobin, of Tobin Tax fame. This economist, John Geanakoplos, has recently had a NY Times op-ed and a slot in a Nature ( the British science journal) series on the "recession".
Below the fold I will quote extensively on his ten year study of "the leverage cycle".
Dr. Geanakoplos's website: http://cowles.econ.yale.edu/...
If you click on "Dealing with the present crisis" and select "Solving the Present Crisis", you can read the paper from which the following excerpts have been taken.
Fact #1: classical economics has glossed over the issue of collateral rates
In standard economic theory, the equilibrium of supply and demand determines the interest rate on loans. But in real life, when somebody takes out a loan, he must negotiate two things: the interest rate, and the collateral rate. A proper theory of economic equilibrium must explain both. Standard economic theory has not really come to grips with this problem for the simple reason that it seems intractable: how can one supply equals demand equation for a loan determine two variables, the interest rate and the collateral rate? There is not enough space to explain the resolution of this puzzle here, but suffice it to say that the common sense conclusion that supply and demand does also determine collateral rates is true.
The collateral rate, or margin, is the percentage you must "put down" in order to get a loan. The reciprocal of the collateral rate is the "leverage". That is, if you put down 20% of the purchase price of your house and get a loan for the other 80%, your leverage is 5 to 1. There is a slang phrase in use in the bond community that refers to the collateral as "a haircut", because, apparently, when you cash out of a leveraged position, you "take a haircut" for the supposedly tiny fraction of collateral you put down to get your leverage.
Fact #2: there is something called "The Leverage Cycle"
It is well known that a reduction in interest rates will increase the prices of assets like houses. It is less appreciated, but more obviously true, that a reduction in margins will raise asset prices. Conversely, if margins go up, asset prices will fall...Economists and the Fed ask themselves every day whether the economy is picking the right interest rates. But one can also ask the question whether the economy is picking out the right equilibrium margins. At both ends of the leverage cycle, it does not. In ebullient times the equilibrium collateral rate is too loose, that is equilibrium leverage is too high. In bad times equilibrium leverage is too low. As a result, in normal times asset prices are too high, and in crisis times they plummet too low. This is the leverage cycle.
Fact #3: the leverage cycle is a collective failure mode of the market
...the rapid increase in margins always comes at the worst possible time. Buyers who were allowed to massively leverage their purchases with borrowed money are forced to sell. But when margins rise dramatically, more modestly leveraged buyers are also forced to sell. Tightening margins themselves force prices to fall...The leverage cycle is no accident, but a self-reinforcing dynamic. The cycle emerges even if - in fact precisely because - every agent is acting rationally. But this individual rationality leads to collective disaster. The government must intervene. And the intervention becomes all the more necessary if agents are also prone to short-sighted greed and panic.
Fact #4: the current crisis is the worst in a very long time
In the graph ( http://www.poly-ticker.org/... ) one can see the margins faced by one hedge fund over the last eleven years, including the crisis stage in 1998 of the previous cycle. Note that the spike in margins has lasted for nearly one year, whereas in 1998 it was all over in two months.
The most dramatic change in margins has come from assets that were rated AAA, and which now are downgraded, or are about to be downgraded. Previously one could borrow 90 or even 97 cents on a dollar’s worth of AAA assets, and now one cannot borrow anything at all using many of these assets as collateral. According to Moody’s, AAAs are supposed to have a 1 in 10,000 risk of default over a 10 year period. We are now seeing over 50% of all Alt-A and subprime AAAs partially defaulting, and we will see virtually 100% of all CDO AAAs partially default. Even when some assets have little or no chance of losing more than a few percent of their value, the market no longer trusts the AAA rating, and lenders will not lend even one percent of their current price.
Fact #5: simple regulation can fix this failure mode
What the Federal Reserve should do is to manage leverage, curtailing it in ebullient times and propping it up in anxious times...Instead it remains obsessed with managing the economy by lending money to banks at lower and lower interest rates, hoping, for no good reason, that the banks will turn around and lower the collateral requirements they impose on borrowers.
The first step is to monitor leverage. Every newspaper prints the interest rates every day, but none of them mentions what margins are. The Fed needs to settle on a menu of different haircuts, and monitor them daily, and make them public. The leverage of money managers should also be public. The mere transparency of these numbers should bring a great deal of discipline to the market, and warn investors of impending trouble...
Some investors will not curtail their leverage, no matter how much the public scrutiny, and how far out of line with recent practice they become. It is imperative that the Fed limit this behavior. Limits need to be put on leverage. There are two basic externalities. First the manager of the borrowing fund typically does not fully internalize the costs to society (especially to his own workers) that his bankruptcy will cause. Second, that manager almost surely does not internalize the fact that his recklessness makes it more likely that another firm will go bankrupt, because when he is forced to sell it will make for greater losses at other leveraged firms.
Many people have argued that setting margin limits is difficult, since the securities are so heterogeneous. But I believe this problem will be solved once the haircut data history becomes more public.
A third critical step is to reform the CDS markets. There needs to be a central clearing house, so that losses are netted. I have already observed the chaos that comes from not knowing whether your counterparty is defaulting or not. A more general point is that complexity always increases markedly in the crisis stage of the cycle. Securities that some people can understand and trade in the ebullient or normal phases of the cycle become incomprehensible in the crisis stage. These must be monitored and discouraged.
Even more important for the CDS market should be a limit on the size of the CDS positions people hold. In theory rational agents should be allowed to make bets of arbitrary size on exogenous events. But the CDS events are far from exogenous. Consider a credit default swap for a trillion dollars on a corporate bond promising a billion dollars. The writer of the insurance has every incentive to buy the whole failing corporation and pay off its bond holders for one billion dollars rather than pay the trillion dollars of default insurance. Thus the holders of insurance can never be sure they will get their money.
The Bottom Line
Just about any real economist (and, how much better credentials can you get than this guy?) understands leverage and leverage cycles. They all agree that they are something that must be regulated because the market is incapable of regulating itself.
So why does this important, rigorously proven information never get into the bullshit corporate media debate? Because it would stop the crooks on Wall St. the minute they tried their bubble-inflating tricks.
When I saw his dissection of collateral vs interest, it gave me hope that there is a way to explain this problem to everyday people, and cut through the screen of mathematical flak that economists throw up to keep everyone else from participating in their discussions.
Give your tips to Dr. Geanakoplos.