Home > Predictions > Leverage brings disaster

Leverage brings disaster

This should happen in Oz eventually (from the same article):

Today leverage has been drastically curtailed by nervous lenders wanting more collateral for every dollar loaned. Those toxic mortgage securities are now leveraged on average only about 1.2 to 1. Home buyers can now only leverage themselves 5 to 1 if they can get a government loan, and less if they need a private loan. De-leveraging is the main reason the prices of both securities and homes are still falling.

Now suppose that the initial news is indeed bad. Geanakoplos shows that the asset price will fall dramatically, much more than changing expectations about its eventual value could possibly warrant. This happens for two reasons. First, the most optimistic individuals have been wiped out and can no longer afford to purchase the asset at any price. And second, the amount of equilibrium leverage itself falls sharply. There is less borrowing by less optimistic individuals resulting in a much lower price than would arise if those who had borrowed in the initial period had not lost their collateral.

Categories: Predictions
  1. No comments yet.
  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: