The Leverage Cycle

Abstract

Equilibrium determines leverage, not just interest rates. Variations in leverage cause fluctuations in asset prices. This leverage cycle can be damaging to the economy, and should be regulated.

Introduction

At least since the time of Irving Fisher, economists, as well as the general public, have regarded the interest rate as themost important variable in the economy. But in times of crisis, collateral rates (equivalently margins or leverage) are far more important. Despite the cries of newspapers to lower the interest rates, the Fed would sometimes do much better to attend to the economy-wide leverage and leave the interest rate alone.
When a homeowner (or hedge fund or a big investment bank) takes out a loan using say a house as collateral, he must negotiate not just the interest rate, but how much he can borrow. If the house costs $100 and he borrows $80 and pays $20 in cash, we say that the margin or haircut is 20%, the loan to value is $80/$100 = 80%, and the collateral rate is $100/$80 = 125%. The leverage is the reciprocal of the margin, namely the ratio of the asset value to the cash needed to purchase it, or $100/$20 = 5. These ratios are all synonomous.

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20. April 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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