Solving the Present Crisis and Managing the Leverage Cycle

Abstract

1. INTRODUCTION The present crisis is bottom of a leverage cycle. Understanding that tells us what to do, in what order, and with what sense of urgency. Public authorities have acted aggressively, but because their actions were not rooted in (or explained with reference to) a solid understanding of causes of our present distress, we have started in wrong place and paid insufficient attention and devoted insufficient resources to matters--most notably, still-growing tidal wave of foreclosures and sudden deleveraging of financial system--that should have been first on agenda. In short and simple terms, by leverage cycle I mean this. There are times when leverage is so high that people and institutions can buy many assets with very little money down and times when leverage is so low that buyers must have all or nearly all of money in hand to purchase those very same assets. When leverage is loose, asset prices go up because buyers can get easy credit and spend more. Similarly, when leverage is highly constrained, that is, when credit is very difficult to obtain, prices plummet. This is what happened in real estate and what happened in financial markets. Governments have long monitored and adjusted interest rates in an attempt to ensure that credit did not freeze up and thereby threaten economic stability of a nation. However, leverage (equivalently, collateral rates) must also be monitored and adjusted if we are to avoid destruction that tail end of an outsized leverage cycle can bring. Economists and public have often spoken of tight credit markets, meaning something more than high interest rates, but without precisely specifying or quantifying exactly what they meant. A decade ago, I showed that collateral rate, or leverage, is an equilibrium variable distinct from interest rate. (1) The collateral rate is value of collateral that must be pledged to guarantee one dollar of loan. Today, many businesses and ordinary people are willing to agree to pay bank interest rates, but they cannot get loans because they do not have collateral to put down to convince banks their loan will be safe. Huge moves in collateral rates, which I have called the leverage cycle, are a recurring phenomenon in American financial history. (2) The steps we must take at end of current cycle emerge from understanding what makes a leverage cycle swing up, sometimes to dizzying extremes, and then come crashing down, often with devastating consequences. All leverage cycles end with: 1) bad news that creates uncertainty and disagreement, 2) sharply increasing collateral rates, and 3) losses and bankruptcies among leveraged optimists. These three factors reinforce and feed back on each other. In particular, what begins as uncertainty about exogenous events creates uncertainty about endogenous events, like how far prices will fall or who will go bankrupt, which leads to further tightening of collateral, and thus further price declines and so on. In aftermath of crisis, we always see depressed asset prices, reduced economic activity, and a collection of agents that are not yet bankrupt but hovering near insolvency. How long aftermath persists depends on how deep crisis was and how effective government intervention is. Once crisis has started, thematic solution is to reverse three symptoms of crisis: contain bad news, intervene to bring down margins, and carefully inject optimistic equity back into system. As with most difficult problems, a multi-pronged approach is generally most successful. To be successful, any government plan must respect all three remedial prongs, and their order. The unusual government interventions in this cycle have in many respects been quite successful in averting a disaster--precisely, I would argue, because they embodied some of novel leverage cycle principles I describe here. …