Leverage cycle

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Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.

In finance, leverage is any technique involving the use of debt rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples⁠ ⁠— hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. For example, for a residential property the finance provider may lend up to, say, 80% of the property's market value, for a commercial property it may be 70%, while on shares it may lend up to, say, 60% or none at all on certain volatile shares.

The business cycle, also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic product (GDP) around its long-term growth trend. The length of a business cycle is the period of time containing a single boom and contraction in sequence. These fluctuations typically involve shifts over time between periods of relatively rapid economic growth and periods of relative stagnation or decline.

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Why is leverage significant?

Conventional economic theory suggests that interest rates determine the demand and supply of loans. This convention does not take into account the concept of default and hence ignores the need for collateral. When an investor buys an asset, they may use the asset as a collateral and borrow against it, however the investor will not be able to borrow the entire amount. The investor has to finance with their own capital the difference between the value of the collateral and the asset price, known as the margin. Thus the asset becomes leveraged. The need to partially finance the transaction with the investor's own capital implies that their ability to buy assets is limited by their capital at any given time.

Default (finance) failure to meet the conditions of a loan

In finance, default is failure to meet the legal obligations of a loan, for example when a home buyer fails to make a mortgage payment, or when a corporation or government fails to pay a bond which has reached maturity. A national or sovereign default is the failure or refusal of a government to repay its national debt.

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as a lender's protection against a borrower's default and so can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.

In finance, margin is collateral that the holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:

Impatient borrowers drive the interest rate higher while nervous lenders demand more collateral, a borrower's willingness to pay a higher interest to ease the concerns of the nervous lender may not necessarily satisfy the lender. Before the financial crisis of 2008 hit, lenders were less nervous. As a result, they were willing to make subprime mortgage loans. Consider an individual who took out a subprime mortgage loan paying a high interest relative to a prime mortgage loan and putting up only 5% collateral, a leverage of 20. During the crisis, lenders become more nervous. As a result, they demand 20% as collateral, even though there is sufficient liquidity in the system. The individual who took out a subprime loan is probably not in a position to buy a house now, regardless of how low the interest rates are. Therefore, in addition to interest rates, collateral requirements should also be taken into consideration in determining the demand and supply of loans.

In finance, subprime lending means making loans to people who may have difficulty maintaining the repayment schedule, sometimes reflecting setbacks, such as unemployment, divorce, medical emergencies, etc. Historically, subprime borrowers were defined as having FICO scores below 600, although "this has varied over time and circumstances."

Market liquidity markets feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the assets price

In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for. In a liquid market, the trade-off is mild: selling quickly will not reduce the price much. In a relatively illiquid market, selling it quickly will require cutting its price by some amount.

How does leverage affect the financial markets?

Consider a simple world where there are two types of investors – Individuals and Arbitrageurs. Individual investors have limited investment opportunities in terms of relatively limited access to capital and limited information while sophisticated “arbitrageurs “ (e.g.: dealers, hedge funds, investment banks) have access to better investment opportunities over individual investors due to greater access to capital and better information. Arbitrage opportunities are created when there are differences in asset prices. Individual investors are not able to take advantage of these arbitrage opportunities but arbitrageurs can, due to better information and greater access to capital. Leverage allows arbitrageurs to take on significantly more positions. However, due to margin requirements, even arbitrageurs may potentially face financial constraints and may not be able to completely eliminate the arbitrage opportunities. [1]

In financial services, a broker-dealer is a natural person, company or other organization that engages in the business of trading securities for its own account or on behalf of its customers. Broker-dealers are at the heart of the securities and derivatives trading process.

A hedge fund is an investment fund that pools capital from accredited investors or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk management techniques. It is administered by a professional investment management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds and regarded as alternative investments, as their use of leverage is not capped by regulators, and distinct from private equity funds, as the majority of hedge funds invest in relatively liquid assets. However, funds which operate similarly to hedge funds but are regulated similarly to mutual funds are available and known as liquid alternative investments.

An investment bank is a financial services company or corporate division that engages in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities, and FICC services. Most investment banks maintain prime brokerage and asset management departments in conjunction with their investment research businesses. As an industry, it is broken up into the Bulge Bracket, Middle Market, and boutique market.

It is important to note that the arbitrageur's access to external capital is not only limited but also depends on their wealth. An arbitrageur who is financially constrained, in other words, has exhausted his ability to borrow externally, becomes vulnerable in an economic downturn. In the event of a bad news, the value of the asset falls along with the wealth of the arbitrageur. The leveraged arbitrageurs then face margin calls and are forced to sell assets to meet their respective margin requirements. The flood of asset sales further leads to a loss in asset value and wealth of the arbitrageurs. The increased volatility and uncertainty can then lead to tightening margin requirements causing further forced sales of assets. The resulting change in margins mean that leverage falls. Hence, price falls more than they otherwise would due to the existence of leverage. Therefore, due to the leverage cycle (over-leveraging in good times and de-leveraging in bad times) there exists a situation that can lead to a crash before or even when there is no crash in the fundamentals. [2] This was true in the quant hedge fund crisis in August 2007, where hedge funds hit their capital constraints and had to reduce their positions, at which point prices were driven more by liquidity considerations rather than movement in the fundamentals. [3]

Wealth abundance of value

Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating old English word weal, which is from an Indo-European word stem. A community, region or country that possesses an abundance of such possessions or resources to the benefit of the common good is known as wealthy.

In the financial crisis of 1998, many hedge funds that were engaged in arbitrage strategies experienced heavy losses and had to scale down their positions. The resulting price movements accentuated the losses and triggered further liquidations. Moreover, there was contagion, in that price movements in some markets induced price movements in others. These events raised concerns about market disruption and systemic risk, and prompted the Federal Reserve to coordinate the rescue of Long Term Capital Management. [1]

Financial contagion

Financial contagion refers to "the spread of market disturbances – mostly on the downside – from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows". Financial contagion can be a potential risk for countries who are trying to integrate their financial system with international financial markets and institutions. It helps explain an economic crisis extending across neighboring countries, or even regions.

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk".

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage. The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998, among 16 financial institutions—which included Bankers Trust, Barclays, Bear Stearns, Chase Manhattan Bank, Crédit Agricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, Société Générale, and UBS—for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.

Consequences of the leverage cycle [2]

A very highly leveraged economy means that a few investors have borrowed a lot of cash from all the lenders in the economy. A higher leverage implies fewer investors and more lenders. Therefore, asset prices in such an economy will be set by only a small group of investors.

According to Tobin's Q, [4] asset prices can affect economic activity. When prices of assets are high, new productive activity can be stimulated that can lead to over production. Alternatively, when asset prices crash, production may come to a standstill. Therefore, the leverage cycle has the potential to amplify real economic activity.

When financially constrained arbitrageurs receive a bad shock, they are forced to shift to low volatility – low margin assets from high volatility - high margin assets, thereby increasing the liquidity risk of already illiquid (risky) assets. This can be categorized as a “flight to quality”. [3]

Broadly speaking market-making arbitrageurs can hold net long positions and as a result capital constraints are more likely to be hit during market downturns. This is likely to result in a sell-off making the markets more illiquid. [3]

Large fluctuations in asset prices in the leverage cycle lead to a huge redistribution of wealth and change in inequality. During a good shock, all optimists become extremely rich relative to lenders thanks to their highly leveraged position while during a bad shock, the optimists are wiped out and the relatively optimistic lenders become rich in the subsequent good shocks.

Highly leveraged agents can potentially become indispensable to the economy if the failure of an extremely leveraged agent increases the likelihood that other leveraged agents will have to follow suit. In other words, high levels of leverage can potentially lead to the “too big to fail” problem.

Leverage cycle (2007-2009)

The leverage cycle crisis of 2007-2009 was particularly significant for a number of reasons. The first and most obvious being that leverage got higher than ever before, and then margins got tighter than ever before. [2]

The subprime losses in 2007-2008 were in the order of several hundred billion dollars, corresponding to only about 5% of overall stock market capitalization. However, since they were primarily borne by levered financial institutions, spiral effects amplified the crisis so the stock market losses amounted to more than 8 trillion dollars. [5]

Credit default swaps (CDS) also played a significant role in the run up to the crisis. The buyer of a CDS is entitled to the principal of the bond in the case of default. A key characteristic of a CDS is that the buyer does not have to hold a bond in order to purchase a CDS. As a result, this financial instrument allowed pessimists to drive asset prices very low. Standardization of CDS facilitated large quantities of trades.

Also during this crisis, a number of real estate properties went “under water”, in other words, the promise to repay exceeded the value of the collateral. [2]

Welfare implication [1]

The highly leveraged arbitrageurs are only concerned about maximizing their own objectives (e.g.: profits) and do not take into consideration the effect their decisions have on asset prices. However, asset prices determine other arbitrageurs’ wealth, and through the financial constraints, arbitrageurs’ ability to invest. As a result, the arbitrageurs’ decisions involve externalities and may not be socially optimal. When arbitrageurs are not financially constrained (their borrowing needs do not exceed the maximum amount they can borrow given their wealth) then they are able to eliminate all arbitrage opportunities. As a result, they perform a socially useful task of reallocating risk by buying risky assets from investors whose valuation is low and selling them to those whose valuation is high. Thus the roles of arbitrageurs are socially optimal when there are no financial constraints. When there are financial constraints, arbitrageurs may not able to make the socially optimal trades and hence social optimality fails.

Policy implication

A financially constrained firm may need to sell assets substantially below fundamental value due to margin requirements in an industry downturn. This is because the buyers with the highest valuation for the assets are other firms in the same industry who are also likely to be financially constrained and in need of selling assets. [6] During a liquidity crisis, central banks should pursue monetary expansions by increasing liquidity. The results will be most effective when investors are near their financial constraint. [3] If the central bank is better than the market at distinguishing liquidity shocks from fundamental shocks, then the central bank should convey this information to lenders and urge them to relax their funding requirements. [3] Therefore, In order to reduce business cycles the Federal Reserve should manage system wide leverage, limiting leverage in good times and encouraging higher levels of leverage during times of uncertainty, by extending lending facilities. [2] [7]

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

Mortgage-backed security security

A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. The mortgages of a MBS may be residential or commercial, depending on whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by structures set up by investment banks. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations and collateralized debt obligations (CDOs).

Collateralized debt obligation financial product

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.

Syndicated loan

A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as lead arrangers.

Secondary mortgage market

The secondary mortgage market is the market for the sale of securities or bonds collateralized by the value of mortgage loans. A mortgage lender, commercial banks, or specialized firm will group together many loans and sell grouped loans known as collateralized mortgage obligations (CMOs) or mortgage-backed securities (MBS) to investors such as pension funds, insurance companies and hedge funds. Mortgage-backed securities were often combined into collateralized debt obligations (CDOs), which may include other types of debt obligations such as corporate loans.

A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations (CDOs) in that they are permanently capitalized and have an active management team.

The United States subprime mortgage crisis was a nationwide financial crisis, occurring between 2007 and 2010, that contributed to the U.S. recession of December 2007 – June 2009. It was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies and foreclosures and the devaluation of housing-related securities. Declines in residential investment preceded the recession and were followed by reductions in household spending and then business investment. Spending reductions were more significant in areas with a combination of high household debt and larger housing price declines.

Initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities.

Minsky moment


A Minsky moment is a sudden, major collapse of asset values which generates a credit cycle or business cycle. The rapid instability occurs because long periods of steady prosperity and investment gains encourage a diminished perception of overall market risk, which promotes the leveraged risk of investing borrowed money instead of cash. The debt-leveraged financing of speculative investments exposes investors to a potential cash flow crisis, which may begin with a short period of modestly declining asset prices. In the event of a decline, the cash generated by assets is no longer sufficient to pay off the debt used to acquire the assets. Losses on such speculative assets prompt lenders to call in their loans. This rapidly amplifies a small decline into a frank collapse of asset values, related to the degree of leverage in the market. Leveraged investors are also forced to sell less-speculative positions to cover their loans. In severe situations, no buyers bid at prices recently quoted, fearing further declines. This starts a major sell-off, leading to a sudden and precipitous collapse in market-clearing asset prices, a sharp drop in market liquidity, and a severe demand for cash.

A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments, such as US treasuries or gold. This is considered a sign of fear in the marketplace, as investors seek less risk in exchange for lower profits.

The financial accelerator in macroeconomics is the process by which adverse shocks to the economy may be amplified by worsening financial market conditions. More broadly, adverse conditions in the real economy and in financial markets propagate the financial and macroeconomic downturn.

In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but outside normal banking regulations. The phrase "shadow banking" contains the pejorative connotation of back alley loan sharks. Many in the financial services industry find this phrase offensive and prefer the euphemism "market-based finance".

Collateralized loan obligation

Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.

A credit crunch is a sudden reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability. Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal, and thus one profits by the amount of convergence.

Many factors directly and indirectly caused the Great Recession, with experts and economists placing different weights on particular causes.

Financial crisis of 2007–2008 Global financial crisis

The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s.

References

  1. 1 2 3 Gromb, D., and D. Vayanos. 2002. Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs. Journal of Financial Economics 14:71-100
  2. 1 2 3 4 5 Geanakoplos, J. (2010). The Leverage Cycle. Cowles Foundation
  3. 1 2 3 4 5 Brunnermeier, M. Pedersen, L 2009. Market Liquidity and Funding Liquidity. The Review of Financial Studies v 22 n 6 2009
  4. ↑ Tobin, J. and Golub, S. (1998). Money, Credit, and Capital. Irwin/McGraw-Hill
  5. ↑ Brunnermeier, M.K. 2009. Deciphering the Liquidity and Credit Crunch 2007-08. Journal of Economic Perpspectives. 2009, Issue 1
  6. ↑ Shleifer, A. and Vishny, R. (1992). Liquidation Values and Debt Capacity: A Market Equilibrium Approach. The Journal of Finance, Vol XLVII, No. 4
  7. ↑ Ashcraft, A., Garleanu, N. and Pedersen, L. (2010). Two Monetary Tools: Interest Rate and Haircuts. NBER Working Papers. RePEc:nbr:nberwo:16337
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