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Leverage cycle
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Leverage cycle
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.
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.
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 2008 financial crisis, 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.
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.
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. 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.
During the 1998 Russian financial crisis, 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 financial 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.
Source:
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.
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Leverage cycle
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.
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.
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 2008 financial crisis, 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.
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.
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. 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.
During the 1998 Russian financial crisis, 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 financial 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.
Source:
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.