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Yesterday I wrote about  ( ) the obvious truth behind the current financial meltdown:

Depressions are caused by excessive leverage and asset inflation.

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:

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 ( ) 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.

Originally posted to arendt on Fri Feb 20, 2009 at 03:54 PM PST.

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Comment Preferences

  •  I am a regular person and I didn't understand a (2+ / 0-)
    Recommended by:
    crystal eyes, Earth Ling

    word Dr. Geanakopolos said. I'd love a translation. I take it that it meant banks shouldn't be allowed to borrow too much money. Or something like that.

    "Big boss ain't so big, just tall, that's all."

    by TheFatLadySings on Fri Feb 20, 2009 at 04:02:39 PM PST

    •  OK. Let me try. (8+ / 0-)

      When you get a loan, you negotiate not only the interest rate, but also the collateral rate (e.g., the downpayment on a mortgage).

      But, the collateral rate is not carefully monitored - it is not regulated very well.

      When times are easy, competition forces the collateral rate down (i.e., raises the leverage). This, in turn, causes house prices to go up, because with more leverage, more buyers have a downpayment to enter the market.

      This causes a positive feedback loop, driving asset values up and collateral rates down. In the last few years, we had NINJA loans (0% down) and the price of houses almost doubled.

      Eventually, such a bubble must pop.

      Dr. Geanakopolos, among others, says that the market does not correctly manage collateral rates. He proposes that the government either do that or force the markets to do that.



    •  FLS as I read it (3+ / 0-)
      Recommended by:
      truong son traveler, DBunn, ZAP210

      It mans that you need to actually put equity into the asset sufficient to allow you to carry it on income if values fall. For a homeowner this means that you take your income and limit your debt to an amount you can pay even if the market goes south on you and place enough equity that you still have some reasonable ownership of the asset. No interest only, no zero money down, no balloons. The critical part here is understanding that markets can go south and that you can get screwed. The effect of this would be to lower asset prices, since if people weren't able to leverage to the limit they wouldn't buy the house unless the price came into their target range. Slackening demand would then cut asset prices. Liberal interest and low equity terms raise asset prices (or get capitalized into pricing).

      When you offer no money down and interest only, people buy at inflated prices that are not based on the underlying utility of the asset and their resources to pay for the full value,  but are rather buying based on their desire to buy as much asset as possible based on limited resources. Since markets respond to prevailing sales prices, when so many are making decisions based upon hopes of appreciation, prices rise beyond the point that a prudent buyer can afford, and then you are in a bubble.

      The banks are a somewhat different problem. Banking used to be regulated to limit this sort of leveraging, but when we deregulated, all sorts of fun instruments for laying off the risk of leverage got invented that sounded really good. The problem is that the underlying assets still have the same economic utility, and therefore in the long run, the same value in relation to the actual economic ability for people to pay (local wages and wealth produced by the economy), no matter what the bubble is proposing as the current market value. I think.

      Yes we did, yes we will. President Obama

      by marketgeek on Fri Feb 20, 2009 at 04:37:45 PM PST

      [ Parent ]

    •  Link to diarist's tip jar (0+ / 0-)


  •   Santelli says- it's all Obama's fault... (0+ / 0-)

    Failure of regulation, lack of transparency,  and the market's unchecked greed have nothing to do with this mess.

  •  Wow! An intelligent diary!! (7+ / 0-)

    I knew it was possible, although the patience of Job was required to locate it.

    The financial panics of 1819, 1837, 1857, 1873, 1893, and 1929 were preceded by excessive leverage and asset inflation.

    You have written the truth on DailyKos!

  •  Stiglitz interview on the Financial Crisis (2+ / 0-)
    Recommended by:
    wbr, DBunn

    Inside Look - Conference on Financial Crisis

    From Columbia University in New York, NY: Interview with Nobel Laureate Joseph Stiglitz (Bloomberg News)

    "Chance has put in our way a most singular and whimsical problem, and its solution is its own reward." -Sherlock Holmes

    by The Anomaly on Fri Feb 20, 2009 at 04:19:38 PM PST

  •  Awesome (3+ / 0-)
    Recommended by:
    truong son traveler, wbr, oscarsmom

    the education of me continues.

    Thank you.

  •  As soon as I see "equilibrium" I zone out... (2+ / 0-)
    Recommended by:
    soros, Earth Ling

    it's a stupid usage of the word. The fact that economists use "equilibrium" under conditions that are clearly not equilibrium makes me think they are insane.

    Then, it's impossible to solve a two-variable equation. It requires at least two equations -- the fact that Geanakopolos said that he could, instead of saying that there is a secondary equation that forms the additional constraint shows how sloppy economists are.

    We should send economists to reeducation camps to learn how to farm potatoes; do something useful.

    •  I feel your mental pain... (4+ / 0-)

      Conventional economics is aping classical physics with all this "equilibrium" stuff.

      An economy is a living thing - a far from equilibrium system. The correct model for economics is biology.

      As Herman Daly said (paraphrase). The classical economics model is a body that only has a circulatory system, but no digestive system.

      I agree with you about the claim by Dr. G. concerning two equations. I think he merely said it for effect. I think there is some eye-glazing (and conventionally economical) mathematics behind his "common sense" solution.

      Have you ever read "More Heat than Light", by Mirowski (sp?)? It is a blistering, but heavily mathematical, dissection of what a crock classical economics is.

      Also, some Brit named Omerod has written several books demolishing the mathematics.


      •  Biology Crossed With Sociology and Anthropology n (2+ / 0-)
        Recommended by:
        wbr, DBunn

        We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy.... --ML King "Beyond Vietnam"

        by Gooserock on Fri Feb 20, 2009 at 04:33:23 PM PST

        [ Parent ]

        •  Even further from equilibrium... (3+ / 0-)

          and most certainly not rational.

          I love the market-droids going on about rational prices when there are people betting based on their horoscope or on theories like "Eliot Long Wave" or Kondratieff Wave.

          I'm not saying the wave theories are irrational. But I am saying that there can be massive disagreements about what is rational.

          Then, throw in political boycotts and disinvestment movements.

          Now tell me the market is "rational".

          Ha ha ha ha ha


          •  But you see what they do -- (2+ / 0-)
            Recommended by:
            truong son traveler, DBunn

            they define "rational" as what the market does, then define "all information" as what the market integrates, then use that as arguments for whatever the market does.

            It'd be funny if it wasn't so plainly dishonest.

            The simple test -- biology courses should be much harder than physics courses, and economics course should be much harder than biology courses, particularly mathematically. The inverse is true. The conclusion is obvious.

            •  These days, biology is way tougher... (2+ / 0-)
              Recommended by:
              truong son traveler, DBunn

              Have you seen "Molecular Biology of the Cell"? Its had its fourth edition come out five years ago - 6 editors, hundreds of authors, 2,500 pages. The book weighs ten pounds.

              Since then, we have had RNA interference, the histone code, 30,000 new proteins X-ray structure determined.

              Biology these days is unbelievably complicated. One nuclear pore complex is assembled by close to 1,000 proteins.

              Physics is complex. A few equations that fewer and fewer people (with IQs over 200, like Ed Witten) can comprehend.

              Classical economics is bullshit. It is people trolling data for 2 sigma correlations to publish as "just so" stories. Utter intellectual rubbish.

              The only honest economists are the ecological ones.


              •  Have it on my shelf! (2+ / 0-)
                Recommended by:
                truong son traveler, arendt

                It's "complicated", but not hard. It's a collection of data. What I meant was that the math should be hard -- that any unifying principles should far outstrip in difficulty the equations that bind physics together.

                MBC is often a graduate level book! I find the mathematics in physics 101 more challenging -- and that's just Newtonian mechanics, taught to freshmen. Economic textbooks are ridiculous -- they expect one to believe that the simultaneous solution of two simple equations decides price. The equations of force are more sophisticated than that. It's atrocious, they show no evidence even of internal consistency randomly throwing parameters...

                It does make me at least feel better about biology. For all the hell I give them, they are vastly superior to economists. They at least reduce their problems to try to make them tractable, rather than just wave their arms and pretend that you can attack at a large scale immediately.

                •  I agree with all you said; and... (1+ / 0-)
                  Recommended by:
                  truong son traveler

                  the physicists have gotten their hooks into biology.

                  Heard of "systems biology"? People writing systems of differential equations to describe as many enzyme systems as the computers can crunch.

                  They are trying to work up to modeling a single cell at the level of individual proteins. There is a mathematical/theoretical group in the field.

                  If you try to understand all the feedback loops in any "pathway", you get a headache. This enzyme inhibits that which turns on this which makes a product that turns itself off...

                  In general, I agree that bio is complicated if you just treat it as something to be memorized. Mathematically, enzyme systems are really hard.


                  •  Yes --- unfortunately! (1+ / 0-)
                    Recommended by:
                    truong son traveler

                    I got into biology specifically because I was interested in that. Unfortunately, most biologists make a mess of it, and some physicists and engineers use it just as a grant-creating side gig. I've seen some really bad papers come out of that combo.

                    There should be some really cool stuff there --- but I'm not located with some good physicists doing that work, so I went to the physical chemistry side.

                    There is a lot of interest from physicists, because some biological problems of that sort are becoming tractable. But it's slow going with the cultural/disciplinary rift. I hope that in 20 years some really good work will be going on as graduate students trained at the juncture come on line.

                    •  I've seen the disconnect... (1+ / 0-)
                      Recommended by:
                      truong son traveler

                      I'm a biophysicist. Most biologists aren't mathematical -  the aforementioned complication keeps them real busy. The physicists are jumping in with both feet (unemployment in physics is a very good incentive).

                      Physical chemistry is very difficult stuff. Separating enthalpy from entropy in a reaction has always baffled me. Did some calorimetry last year. Very confusing how to interpret the data.

                      I think that all the multi-disciplinary academic programs are up against how much info must be acquired before one can be a productive scientist. Four or five years of undergrad barely fill in the basics.


                      •  We're in the same field. (0+ / 0-)

                        I think the problem is one of training. Compare the training of engineers and biologists. Biological undergrads, most of the folks pulled into graduate programs, were being trained as pre-med -- not as scientists. Medicine is about collating a large database of facts -- not about "debugging" or doing "projects", but of learning a large set of algorithms and quickly following them.

                        Engineers get trained to solve problems. They do projects as undergrads and learn some unifying principles. They are actually trainable as problem solvers. They have personality and cultural quirks -- but that's more a problem of the overwhelmingly white-male population that is attracted to it.

                        I think biology graduate programs should not take biology undergrads. For example, MBC should not be a graduate level book, but an undergraduate level textbook for sophomore or juniors; instead of taking endless little lab courses, one big whallop and then some actual advanced material in a tiny little area.

                        •  At my company, I've mentored some... (0+ / 0-)

                          folks in a five-year undergrad engineering program in biochemistry. This program demands that all undergrads take a year off (in two separate semesters, not necessarily contiguous) and intern at a real company.

                          They really got thrown in the deep end of the pool at my startup. Asked to do real world stuff - i.e., stuff where the answer is not in the textbook - not even guaranteed to exist.

                          Those are the only biologists I've had direct contact with.

                          MBOC is something you can read as soon as you have had O-chem. Let people play with it. They can act on what they've learned later, after they have the basics.

                          What undergrads desperately need is contact with the real world, where things don't always work.


        •  Insulting everyone! (0+ / 0-)

          No actually anthropology in general is much more honest about what it does and what it's limitations are. If economics started from anthropology and worked it's way out, everything would be right.

          But it's not. It doesn't include those fields.

        •  And then there's Theology (0+ / 0-)

          There's a reason we call them "market fundamentalists".

      •  No, I haven't... (1+ / 0-)
        Recommended by:

        but I've already added it to my wish list.

        I see this kind of innumeracy and simple cheating in biology all the time -- but you expect it with biologists. But what else do economist have but math?

        That's what I see -- is mathematical cheating, the application of early 19th century physics, which within physics were always known to apply to a very small variety of phenomena. Even mid-nineteenth century economists knew that it was a poor metaphor, yet we get the same crap as if thermodynamics had never been invented.

        Yeah, I blow a gasket when I see other fields committing even worse scientific crimes than my compatriots. I just read "The Black Swan" by Nassim Taleb -- he's cranky, but it looks like justifiably so.

        •  The Black Swan is on my list... (2+ / 0-)
          Recommended by:
          truong son traveler, DBunn

          Right now, I'm reading "Bad Samaritans - The Myth of Free Trade and the Secret History of Capitalism" by Ha-Joon Chang.

          There is a major industry that keeps pumping out all the lies and dodges of the economics "profession". They are nothing but apologists for discrimination, cronyism, looting, and colonialism.


          •  Nassim Taleb is interesting, (1+ / 0-)
            Recommended by:
            truong son traveler

            since he's highly influenced by Libertarianism -- he was a trader, which was where he made his money.

            But he doesn't subscribe to the "magic market" concept, but generally to decentralization --- with the idea that throwing money around randomly is actually the way that markets succeed.

            I had to hold my nose with his references to Hayek, but that's my problem -- even an evil bastard has his good ideas.

            It's low math for a general readership, but he does seem to have some mastery of the underpinning math.

            •  IMHO, traders are gangsters in suits... (1+ / 0-)
              Recommended by:
              truong son traveler

              look at their whole act...swaggering, in your face thugs, like that bozo Santelli.

              Hayek - spare me from the whole Austrian school!


              •  His point is that they are stupid gangsters... (2+ / 0-)
                Recommended by:
                truong son traveler, DBunn

                that you're traditional gangster "Fat Tony" is a more competent mathematician and economist than the traders. It's pretty funny.

                On Hayek, all I know is that he went to Chile and declared Pinochet a great defender of freedom. Within two years of his policies being implemented, the banking sector (back on thread!) collapsed in the same manner as ours. Both morally and intellectually bankrupt. But of course, even the fascists weren't total imbeciles -- the Austrians are right that economists' mathematics are idiotic. It's just that the Austrians don't know that physics and physical chemistry have actually developed some new techniques since 1807.

        •  Its on Google books, so you can peruse... (0+ / 0-)
  •  Still, Nothing On the Scale of Now Happened for (1+ / 0-)
    Recommended by:

    70 years. For most of it we had steep top-end taxation which suppresses all kinds of gambling behavior at the top of the economy, plus other financial regulation that was repealed 8-9 years ago and earlier.

    I don't doubt the leverage cycle but it seems to me that we must have achieved [much better than today's] regulation of it in other ways without it being discussed specifically before now.

    I'm guessing that might apply to CDS's as well but maybe there were tighter regulations on them some years ago.

    We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy.... --ML King "Beyond Vietnam"

    by Gooserock on Fri Feb 20, 2009 at 04:32:09 PM PST

    •  Just follow the career of Phil Gramm (4+ / 0-)
      Recommended by:
      truong son traveler, wbr, DBunn, oscarsmom

      that crook demolished the government oversight of finance from the inside.

      He wrecked IRS enforcement, got Glass-Steagel repealed, worst of all, he engineered that the CDOs were NOT regulated. They are gambled on some exchange in London, beyond the reach of the CFTC (Commodity Futures Trading Commission).

      We had ten years of no regulation. The SEC asleep under Chris Cox (who's Madoff? who's Stanford? Enron?). All the toxic waste being traded offshore with no oversight.

      They were just a gang of looters. That is what Bush did.


  •  Great diary--thank you! (2+ / 0-)

    Save the parrots: Drink shade-grown coffee!

    by oscarsmom on Fri Feb 20, 2009 at 05:16:55 PM PST

  •  WOW, I suddenly feel like I know something & it (1+ / 0-)
    Recommended by:
    truong son traveler

    actually makes sense. Thanks for the economic clarity!!!

  •  My wife sez: Wall Street has no new paradigm (3+ / 0-)

    to turn to right now, hence the ridiculous ranting from CNBC's Santelli yesterday.  The entire Wall Street infrastructure knows only one thing: laissez-faire economic good, regulation bad.

    Now that their very way of life is upended they are frightened, confused and very, very lost.  Until some new paradigm emerges we can expect Wall Street to be unable to fix its current problems or move forward without direct governmental direction.  

    The people imbued in the old paradigm will need to be moved over and around because they will not be a part of the future of the markets.  Part of the reason the Depression took time to end was the need to retrain a new generation of investment bankers.

  •  that's it, that's how you explain it (0+ / 0-)

    to everyday people: keep the crooks on Wall Street from creating and inflating bubbles with these tricks.

    Well, you convinced this regular person.

    Thanks for the very informative diary!

    McCain does not support the troops

    by erin r on Fri Feb 20, 2009 at 06:25:02 PM PST

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