Leverage cycle
Encyclopedia
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.
and hence ignores the need for collateral
. When an investor buys an asset, he 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 his 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 his ability to buy assets is limited by his capital at any given time.
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 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.
, hedge fund
s, 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.
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 call
s 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. 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.
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
.
According to Tobin’s Q
, asset prices can have an impact on 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”.
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.
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.
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.
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.
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.
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. 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. 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.
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.
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 defaultDefault
Default may refer to:*Default , the failure to do something required by law**Default judgment*Default , failure to satisfy the terms of a loan obligation or to pay back a loan*Default , a preset setting or value...
and hence ignores the need for collateral
Collateral (finance)
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 protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. When an investor buys an asset, he 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 his own capital the difference between the value of the collateral and the asset price, known as the margin
Margin
Margin may refer to:*Margin *Margin , a type of financial collateral used to cover credit risk*Margin , the white space that surrounds the content of a page...
. Thus the asset becomes leveraged. The need to partially finance the transaction with the investor’s own capital implies that his ability to buy assets is limited by his capital at any given time.
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 hit, lenders were less nervous. As a result, they were willing to make subprime mortgage loans
Subprime lending
In finance, subprime lending means making loans to people who may have difficulty maintaining the repayment schedule...
. 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
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
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.
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 “ (eg: dealersBroker-dealer
A broker-dealer is a term used in United States financial services regulations. It is a natural person, a company or other organization that trades securities for its own account or on behalf of its customers....
, hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s, investment banks
Investment banking
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities...
) have access to better investment opportunities over individual investors due to greater access to capital and better information. Arbitrage
Arbitrage
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...
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.
It is important to note that the arbitrageur’s access to external capital is not only limited but also depends on their wealth
Wealth
Wealth is the abundance of valuable resources or material possessions. The word wealth is derived from the old English wela, which is from an Indo-European word stem...
. 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 call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
s 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. 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
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
considerations rather than movement in the fundamentals.
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
Financial contagion
Financial contagion refers to a scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy, in a manner similar to the transmission...
, in that price movements in some markets induced price movements in others. These events raised concerns about market disruption and systemic risk
Systemic risk
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. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
, and prompted the Federal Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
to coordinate the rescue of Long Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
.
Consequences of the Leverage Cycle
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
Tobin's q
Tobin's q was developed by James Tobin as the ratio between the market value and replacement value of the same physical asset:One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction...
, asset prices can have an impact on 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
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
of already illiquid (risky) assets. This can be categorized as a “flight to quality”.
Flight-to-quality
A flight-to-quality 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...
Broadly speaking market-making
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
arbitrageurs can hold net long positions
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
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.
Large fluctuations in asset prices in the leverage cycle lead to a huge redistribution of wealth and change in inequality
Economic inequality
Economic inequality comprises all disparities in the distribution of economic assets and income. The term typically refers to inequality among individuals and groups within a society, but can also refer to inequality among countries. The issue of economic inequality is related to the ideas of...
. 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”
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...
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.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.
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”
Negative equity
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".People...
, in other words, the promise to repay exceeded the value of the collateral.
Welfare Implication
The highly leveraged arbitrageurs are only concerned about maximizing their own objectives (eg: 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 externalitiesExternality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
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.During a liquidity crisis
Liquidity crisis
In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
, central banks should pursue monetary expansions
Expansionary monetary policy
In economics, expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth. In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply...
by increasing liquidity. The results will be most effective when investors are near their financial constraint. 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. Therefore, In order to reduce business cycles the Federal Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
should manage system wide leverage, limiting leverage in good times and encouraging higher levels of leverage during times of uncertainty, by extending lending facilities.