Solving The Present Crisis and Managing The Leverage Cycle: John Geanakoplos

John Geanakoplos
Solving the Present

Crisis and Managing
the Leverage Cycle
1. Introduction (equivalently, collateral rates) must also be monitored and
adjusted if we are to avoid the destruction that the tail end of an
T he present crisis is the bottom of a leverage cycle.

Understanding that tells us what to do, in what order,
and with what sense of urgency. Public authorities have acted
outsized leverage cycle can bring.
Economists and the public have often spoken of tight credit
markets, meaning something more than high interest rates, but
aggressively, but because their actions were not rooted in (or without precisely specifying or quantifying exactly what they
explained with reference to) a solid understanding of the causes meant. A decade ago, I showed that the collateral rate, or
of our present distress, we have started in the wrong place and leverage, is an equilibrium variable distinct from the interest
paid insufficient attention and devoted insufficient resources rate.1 The collateral rate is the value of collateral that must be
to matters—most notably, the still-growing tidal wave of pledged to guarantee one dollar of loan. Today, many
foreclosures and the sudden deleveraging of the financial businesses and ordinary people are willing to agree to pay bank
system—that should have been first on the agenda. interest rates, but they cannot get loans because they do not
In short and simple terms, by leverage cycle I mean this. have the collateral to put down to convince the banks their loan
There are times when leverage is so high that people and will be safe.
institutions can buy many assets with very little money down Huge moves in collateral rates, which I have called “the
and times when leverage is so low that buyers must have all or leverage cycle,” are a recurring phenomenon in American
nearly all of the money in hand to purchase those very same financial history.2 The steps we must take at the end of the
assets. When leverage is loose, asset prices go up because buyers current cycle emerge from understanding what makes a
can get easy credit and spend more. Similarly, when leverage is leverage cycle swing up, sometimes to dizzying extremes,
highly constrained, that is, when credit is very difficult to and then come crashing down, often with devastating
obtain, prices plummet. This is what happened in real estate consequences.
and what happened in the financial markets. Governments 1
Geanakoplos (1997, 2003).
have long monitored and adjusted interest rates in an attempt 2
The history of leverage is still being written, because until recently it was
to ensure that credit did not freeze up and thereby threaten not a variable that was explicitly monitored. But work by Adrian and Shin
the economic stability of a nation. However, leverage (forthcoming) and others is helping to restore the historical record.
John Geanakoplos is the James Tobin Professor of Economics at Yale On October 3, 2008, the author presented to Ben Bernanke and the Federal
University, an external professor at the Santa Fe Institute, and a partner in Reserve Board of Governors the substance of this paper’s proposal. The author
Ellington Capital Management, which trades primarily in mortgage securities. is grateful to Susan Koniak for very helpful and detailed comments and advice,
[email protected] as well as for allowing him to use material from their two New York Times
editorials. He is also appreciative of the very fine comments received from
Asani Sarkar and two referees, and is deeply indebted to Joseph Tracy for
editorial advice far beyond the call of duty, encompassing tone, style, and
content. Needless to say, neither he nor anyone else is responsible for, or even
necessarily in agreement with, the views expressed here. The views expressed
are those of the author and do not necessarily reflect the position of the
Federal Reserve Bank of New York or the Federal Reserve System.
FRBNY Economic Policy Review / August 2010 101

All leverage cycles end with: 1) bad news that creates 2. Margins, the Leverage Cycle,
uncertainty and disagreement, 2) sharply increasing collateral and Asset Prices
rates, and 3) losses and bankruptcies among the leveraged
optimists. These three factors reinforce and feed back on each Traditionally, governments, economists, as well as the general
other. In particular, what begins as uncertainty about public and the press, have regarded the interest rate as the most
exogenous events creates uncertainty about endogenous important policy variable in the economy. Whenever the
events, like how far prices will fall or who will go bankrupt, economy slows, the press clamors for lower interest rates from
which leads to further tightening of collateral, and thus further the Federal Reserve, and the Fed often obliges. But sometimes,
price declines and so on. In the aftermath of the crisis, we especially in times of crisis, collateral rates (equivalently,
always see depressed asset prices, reduced economic activity, margins or leverage) are far more important than interest rates.
and a collection of agents that are not yet bankrupt but The Fed could be managing collateral rates all through the
hovering near insolvency. How long the aftermath persists leverage cycle, but especially in the ebullient and the crisis
depends on how deep the crisis was and how effective stages.
government intervention is. The use of collateral and leverage is widespread. A home-
Once the crisis has started, the thematic solution is to owner (or a big investment bank or hedge fund) can often
reverse the three symptoms of the crisis: contain the bad news, spend $20 of his own cash to buy an asset like a house for $100
intervene to bring down margins, and carefully inject by taking out a loan for the remaining $80 using the house as
“optimistic” equity back into the system. As with most difficult collateral. In that case, we say that the margin or haircut or
problems, a multi-pronged approach is generally the most down payment is 20 percent, the loan to value is $80/$100 =
successful. To be successful, any government plan must respect 80 percent, and the collateral rate is $100/$80 or 125 percent.
all three remedial prongs, and their order. The unusual The leverage is the reciprocal of the margin, namely, the
government interventions in this cycle have in many respects ratio of the asset value to the cash needed to purchase it, or
been quite successful in averting a disaster—precisely, I would $100/$20 = 5. All of these ratios are different ways of saying
the same thing.
argue, because they embodied some of the novel leverage cycle
In standard economic theory, the equilibrium of supply and
principles I describe here. The effectiveness of the interventions
demand determines the interest rate on loans. But in real life,
could be increased even further by respecting the priorities of
when somebody takes out a secured loan, he must negotiate
the problem.
two things: the interest rate and the collateral rate. A proper
In what follows, I explain what happens in the leverage cycle
theory of economic equilibrium must explain both. Standard
and why it is so bad for the economy that it must be monitored
economic theory has not really come to grips with this problem
and controlled by the government. I show how this last cycle
for the simple reason that it seems intractable: how can one
fits the pattern and I further explain why this leverage cycle is
supply-equals-demand equation for a loan determine two
worse than all the others since the Depression. I point out that
variables—the interest rate and the collateral rate? There is not
the now-famous counterparty risk problem, which has
enough space to explain the resolution of this puzzle here, but
received so much attention of late, is also a matter of collateral.
suffice it to say that ten years ago I showed that supply and
Next, I present details on how to intervene to pull out of a
demand do indeed determine both. Moreover, the two
leverage cycle crisis like the one we are passing through now;
variables are influenced in the equilibration of supply and
this discussion is divided into three sections, corresponding to
demand mainly by two different factors: the interest rate
the three symptoms of every leverage cycle crisis. I advocate a
reflects the underlying impatience of borrowers, and the
permanent lending facility that will stand ready, should
collateral rate reflects the perceived volatility of asset prices and
another crisis arise, to give loans with less collateral than the
the resulting uncertainty of lenders.3 Another factor
market demands. In another section, I suggest that principal
influencing leverage in the long run is the degree of financial
reduction (partial debt forgiveness) by private lenders is a key
innovation. Since scarce collateral is often an important
tool in dealing with the many agents, like homeowners today,
limiting factor, the economy will gradually devise ways of
that fall underwater at the bottom of a deep leverage crisis. In
stretching the collateral, by tranching (so the same collateral
the third section, I assemble the many pitfalls the government
backs several loans) and pyramiding loans (so the same
must be watchful of if it feels obliged to rescue drowning firms
or it is tempted to buy assets at “fire-sale” prices in the darkest 3
In Geanakoplos (1997), I show how supply and demand can indeed
days of the crisis. I conclude with a list of recommendations simultaneously determine the interest rate and the collateral rate. In
Geanakoplos (2003), I show how intertemporal changes in volatility lead to
for managing the leverage cycle in its ebullient period that
changes in the equilibrium leverage over time as part of what I call a leverage
might prevent the next cycle from reaching such a devastating cycle. In Geanakoplos (1997) and Geanakoplos and Zame (2009), I emphasize
crisis stage. the scarcity of collateral and the role of tranching and pyramiding.
102 Solving the Present Crisis and Managing the Leverage Cycle
collateral can be used over and over to back loans backed by Natural Buyers Theory of Price
loans).
Practitioners, if not economists, have long recognized the
importance of collateral and leverage. For a Wall Street trader, Natural buyers
leverage is important for two reasons. The first is that if he is
leveraged λ times, then a 1 percent change in the value of the Marginal buyer
collateral means a λ percent change in the value of his capital.
(If the house in our example goes from $100 to $101, then after
selling the house at $101 and repaying the $80 loan, the investor Public
is left with $21 of cash on his $20 investment, a 5 percent return.)
Leverage thus makes returns riskier, either for better or for
worse. Second, a borrower knows that if there is no-recourse
collateral, so that he can walk away from his loan after giving up
the collateral without further penalty, then his downside is
limited. The most the borrower can lose on the house loan is his marginal buyer is the agent at the threshold on the cusp of
$20 of cash, even if the house falls in value all the way to $0 and selling or buying and it is his opinion that determines the price.
the lender loses $80. No-recourse collateral thus effectively gives The higher the leverage, the smaller the number of buyers at the
the borrower a put option (to “sell” the house for the loan top required to purchase all the available assets. As a result, the
amount). Recently, several commentators have linked leverage marginal buyer will be higher in the continuum and therefore
to the crisis, arguing that if banks were not so leveraged in their the price will be higher.
borrowing they would not have lost so much money when prices It is well known that a reduction in interest rates will
went down, and that if homeowners were not so leveraged, they increase the prices of assets such as houses. It is less
would not be so far underwater now and so tempted to exercise appreciated, but more obviously true, that a reduction in
their put option by walking away from their house. Of course, margins will raise asset prices. Conversely, if margins go up,
these two points are central to my own leverage cycle theory; I asset prices will fall. A potential homeowner who in 2006 could
discuss them in more detail later. But there is another, deeper buy a house by putting 3 percent cash down might find it
point to my theory that has so far not received as much attention, unaffordable to buy now that he has to put 30 percent cash
which I think is the real story of leverage. down, even if the Fed managed to reduce mortgage interest
The main implication of my leverage cycle theory is that rates by 1 percent or 2 percent. This has diminished the
when leverage goes up, asset prices go up, and when leverage demand for housing, and therefore housing prices. What
goes down, asset prices go down.4 For many assets, there is a applies to housing applies much more to the esoteric assets
class of natural buyers or optimists who are willing to pay much traded on Wall Street (such as mortgage-backed investments),
more for the asset than the rest of the public. They may be more where the margins (that is, leverage) can vary much more
risk-tolerant. Or they may simply be more optimistic. Or they radically. In 2006, the $2.5 trillion of so-called toxic mortgage
may like the collateral (for example, housing) more.5 If they securities could be bought by putting $150 billion down and
can get their hands on more money through borrowing, they borrowing the other $2.35 trillion.6 In early 2009, those same
will spend it on the assets and drive those asset prices up. If they securities might collectively have been worth half as much, yet
lose wealth, or lose the ability to borrow, they will be able to buy a buyer might have had to put nearly the whole amount down
less of the asset, and the asset will fall into more pessimistic in cash. In Section 3.1, I illustrate the connection between
hands and be valued less. leverage and asset prices over the current cycle.
Economists and the Federal Reserve ask themselves every
It is useful to think of the potential investors arrayed on a
vertical continuum, in descending order according to their day whether the economy is picking the right interest rates. But
willingness to buy, with the most enthusiastic buyers at the top one can also ask the question whether the economy is picking
(see exhibit). Whatever the price, those at the top of the the right equilibrium margins. At both ends of the leverage
continuum above a threshold will value the asset more and cycle, it does not. In ebullient times, the equilibrium collateral
become buyers, while those below will value it less and sell. The rate is too loose; that is, equilibrium leverage is too high. In bad
times, equilibrium leverage is too low. As a result, in ebullient
4
Leverage is like more money in making prices go up, but, unlike money, it times asset prices are too high, and in crisis times they plummet
affects only prices of goods that can serve as collateral; printing more money
too low. This is the leverage cycle.
tends to increase all prices, including those of food and other perishables.
5 6
Two additional sources of heterogeneity are that some investors are more This number is calculated by applying the bank regulatory capital
expert at hedging assets, and that some investors can more easily obtain the requirement (based on bond credit rating) to each security in 2006 at its
information (like loan-level data) and expertise needed to evaluate the assets. 2006 credit rating.

The policy implication of the leverage cycle is that the Fed The upshot of increased uncertainty and disagreement is
could manage systemwide leverage, seeking to maintain it that margins go up drastically. Lenders are typically more
within reasonable limits in normal times, stepping in to curtail pessimistic than buyers. Otherwise, they too would be buying,
it in times of ebullience, and propping it up as market actors instead of lending. Even if the optimists are not worried much
become anxious, and especially in a crisis. To carry out this about more losses, the lenders are, and they will demand high
task, of course, the Fed must first monitor leverage. The Fed margins. When the lenders are worried about 80 percent losses
must collect data from a broad spectrum of investors, including from current levels, they will lend only if margins are at least
hitherto secretive hedge funds, on how much leverage is being 90 percent, or not lend at all.
used to buy various classes of assets. Moreover, the amount of As we have just witnessed, the rapid increase in margins
leverage being employed must be transparent. The accounting always comes at the worst possible time. Buyers who were
and legal rules that govern devices, such as structured allowed to massively leverage their purchases with borrowed
investment vehicles, that were used to mask leverage levels money are forced to sell when bad news drives asset prices
must be reformed to ensure that leverage levels can be more lower. But when margins rise dramatically, more modestly
readily and reliably discerned by the market and regulators leveraged buyers are also forced to sell. Tightening margins
alike. As we shall see, the best way to monitor leverage is to do turn willing buyers into forced sellers, driving prices further
it at the security level by keeping track of haircuts on all the down. We enter the crisis stage I discuss below.
different kinds of assets used as collateral, including in the repo The dynamic of the leverage cycle cannot be stopped by
market and in the housing market. Also very useful, but less a tongue lashing of greedy Wall Street investors or overly
important, is monitoring the investor leverage (or the debt-
ambitious homeowners in the ebullient stage of the cycle, nor
equity ratio) of big firms.
by exhortations not to panic in the crisis stage. The cycle
The leverage cycle is no accident, but a self-reinforcing
emerges even if (in fact, precisely because) every agent is acting
dynamic. Declining margins, or, equivalently, increasing
rationally from his individual point of view. It is analogous to
leverage, are a consequence of the happy coincidence of
a prisoner’s dilemma, where individual rationality leads to
universal good news and the absence of danger on the horizon.
collective disaster. The government must intervene.
With markets stable and the horizon looking clear, lenders are
The intervention becomes all the more necessary if agents
happy to reduce margins and provide more cash. Good, safe
are irrationally exuberant and then irrationally panicked, or are
news events by themselves tend to make asset prices rise. But
prone to short-sighted greed, or to the “keeping up with the
they also encourage declining margins, which in turn cause the
Jones” syndrome. If greedy investors want higher expected
massive borrowing that inflates asset prices still more.
returns, no matter what the risk, competition will force even
Similarly, when the news is bad, asset prices tend to fall on the
news alone. But the prices often fall further if the margins are conservative fund managers to leverage more. For example, an
tightened. Sudden and dramatic increases in margins are relatively investor comes to a hedge fund and says, “the fund down the
rare. They seem to happen once or twice a decade. Bad news block is getting higher returns.” The fund manager counters
arrives much more often than that, so it is not bad or even very bad that the competitor is just using more leverage. The investor
news alone that drastically raises margins. Bad news lowers responds, “well whatever he’s doing, he’s getting higher
expectations, and, like all news, usually clarifies the situation. returns.” Pretty soon, both funds are leveraging more. Housing
Every now and then, bad news, instead of clarifying matters, prices can rise in the same way. When some families borrow a
increases uncertainty and disagreement about the future. It is lot of money to buy their houses, housing prices rise and even
this particular kind of “scary bad” news that increases margins. conservative homeowners are forced to borrow and leverage so
For example, when an airline announces the plane will be ten they too can live in comparable houses, if keeping up with their
minutes late, the passengers start to worry the delay might be peers is important to them. At the bottom end, nervous
an hour. When a bank announces a $5 billion loss, investors investors might withdraw their money, forcing hedge fund
worry that more losses might be on the way. In 2006, people managers to sell just when they think the opportunities are
disagreed about whether losses from defaults on prime greatest. However, of all the irrationalities that exacerbated this
mortgages would be 1/4 percent or 1/2 percent, and whether leverage cycle, I would not point to these or to homeowners
losses on subprime mortgages would be 1 percent or 5 percent. who took out loans they could not really afford, but rather to
By contrast, after the scary news of 2007, people disagreed lenders who underestimated the put option and failed to ask
about whether some subprime losses would be 30 percent or for enough collateral.
80 percent. Even from their low, many lenders were afraid The observation that collateral rates are even more
many assets could lose even more value, maybe all their value. important outcomes of supply and demand than interest rates,
The present became worse, and the future more uncertain. and even more in need of regulation, was made over 400 years
ago. In The Merchant of Venice, Shakespeare depicted 2.1 Investor Heterogeneity, Equilibrium
accurately how lending works: one has to negotiate not just an Leverage, Default, and Maturity
interest rate but the collateral level too. And it is clear which of
the two Shakespeare thought was the more important. Who Without heterogeneity among investors, there would be no
can remember the interest rate Shylock charged Antonio? But borrowers and lenders, and asset prices would not depend on
everybody remembers the “pound of flesh” that Shylock and the amount of leverage in the economy. It is interesting to
Antonio agreed on as collateral. The upshot of the play, observe that the kind of heterogeneity influences the amount of
moreover, is that the regulatory authority (the court) equilibrium leverage, and hence equilibrium asset prices, and
intervenes and decrees a new collateral level—very different equilibrium default.
from what Shylock and Antonio had freely contracted— When investors differ only in their optimism about future
“a pound of flesh, but not a drop of blood.” The Fed, too, could events in a one-dimensional manner, then the equilibrium
sometimes decree different collateral levels (before the fact, not leverage will consist of the maximum promise that does not
after, as in Shakespeare). permit default.8 For example, suppose an asset will be worth
The modern study of collateral seems to have begun with either 1 or .2 next period. Suppose further that risk-neutral
Kiyotaki and Moore (1997), Bernanke, Gertler, and Gilchrist investors differ only in the probability h that they assign to the
(1996, 1999), Holmstrom and Tirole (1997), Geanakoplos outcome being 1. The most optimistic investor h = 1 is sure that
(1997, 2003), and Geanakoplos and Zame (2009).7 Bernanke, the asset will be worth 1, and the most pessimistic investor h = 0
Gertler, and Gilchrist and Holmstrom and Tirole emphasize is sure the asset will be worth .2. At any asset price p, the
the asymmetric information between borrowers and lenders as investors with h big enough that h*1 + (1-h)*(.2) > p will want
the source of limits on borrowing. For example, Holmstrom to buy the asset, while the rest will want to sell the asset. The
and Tirole argue that the managers of a firm would not be able buyers with high h will want to borrow money in order to get
to borrow all the inputs necessary to build a project, because their hands on what they regard as cheap assets, while the
lenders would like to see them bear risk, by putting their own sellers with low h will not need the money and so will be willing
money down, to guarantee that they exert maximal effort. to lend. How much will the borrowers be able to promise using
Kiyotaki and Moore (1997) and Geanakoplos (1997) study the the asset as collateral, assuming the promise is not contingent
case where the collateral is an asset such as a mortgage security, on the state? The answer is .2, precisely the maximum promise
where the buyer/borrower using the asset as collateral has no that does not lead to default in either state.9
role in managing the asset, and asymmetric information is Thus, when the heterogeneity stems entirely from one-
therefore not important. The key difference between Kiyotaki dimensional differences in opinion, equilibrium leverage
and Moore and Geanakoplos (1997) is that in Kiyotaki and entails no default. A consequence of this is that the loans will be
Moore, there is no uncertainty, and so the issue of leverage as a very short term. The longer the maturity of the loan, the more
ratio of loan to value does not play a central role; to the extent that can go wrong in the meantime, and therefore the smaller
it does vary, leverage in Kiyotaki and Moore goes in the wrong the loan amount can be if it avoids any chance of default.
direction, getting higher after bad news, and dampening the Investors who want to borrow large amounts of money will be
cycle. In Geanakoplos (1997, 2003), I introduce uncertainty driven to borrow very short term. The repo market displays
and solve for equilibrium leverage and equilibrium default these characteristics of short, one-day loans, on which there is
rates; I show how leverage could be determined by supply and almost never any default, even in the worst of crises.
demand, and how under some conditions, volatility (or more Much the same analysis holds when investors differ only in
precisely, the tail of the asset return distribution) pins down their risk aversion. For the most risk-averse investors, an asset
leverage. In Geanakoplos (2003), I introduce the leverage cycle that pays 1 or .2 will be regarded as too dangerous, while
in which changes in the volatility of news lead to changes in
leverage, which in turn lead to changes in asset prices. This line 8
See Geanakoplos (2003).
9
of research has been pursued by Gromb and Vayanos (2002), At first glance, it would seem that the most optimistic buyers might be willing
Fostel and Geanakoplos (2008), Brunnermeier and Pedersen to promise, say, .3 in both states, in order to get more money today to invest in
a sure winner of an asset. But since this promise will deliver .3 in the good state
(2009), and Adrian and Shin (forthcoming), among others. but only .2 in the bad state (assuming no-recourse collateral), the lenders will
not want to pay much for this debt: this risky debt is very much like the asset
they do not want to hold, and so they will pay very little more for it than the
7
Minsky (1986) was a modern pioneer in calling attention to the dangers of (.2,.2) promise, where (g,b) denotes a payoff of g if the good state occurs and b
leverage. But to the best of my knowledge, he did not provide a model or formal if the bad state occurs. Since the borrowers would have to give up .3 > .2 in the
theory. Tobin and Golub (1998) devote a few pages to leverage and the state they think is likely to occur, they will choose to use their scarce collateral
beginnings of a model. to back the (.2,.2) promise instead of the (.3,.3) promise.

investors with greater risk tolerance will find it attractive at the scary kind that does not clarify but obscures the situation and
right price. These risk-tolerant investors will leverage their produces widespread uncertainty and disagreement about
purchases, by borrowing money to buy the asset, using it as what will happen next. Suddenly, lenders increase the margins
collateral for their loan. Once again, the equilibrium leverage and thus deliver the fatal blow. At that point, even modestly
will rise to the point that the promises made will be (.2,.2) but leveraged buyers are forced to sell. Prices plummet. The assets
no more (see footnote 9 for an explanation of notation). To be eventually make their way into hands that will take them only
more concrete, suppose contrary to the previous case, that all at rock-bottom prices.
the agents regard the outcomes 1 and .2 as equally likely. But During a crisis, margins can increase 50 percent overnight,
suppose that untraded endowments rise and fall together with and 100 percent or more over a few days or months. New
the asset payoffs. Then risk-averse agents on the margin will homeowners might be unable to buy, and old homeowners
regard an extra penny when the asset pays 1 as less valuable might similarly be unable to refinance even if the interest rates
than an extra penny when the asset pays .2; on the margin, they are lowered. But, holding long-term mortgages, at least they do
would prefer a penny when the asset pays .2. Hence, they will not have to put up more cash. For Wall Street firms, the
behave as if they regarded the payoff of 1 as less likely, exactly situation is more dire. They often borrow for one day at a time
the same way the pessimists behaved, despite having the same in the repo market. If the margins double the next day, then
beliefs as the risk-tolerant agents. Equilibrium leverage with they immediately have to double the amount of cash they hold
heterogeneous risk aversion becomes the same as with for the same assets. If they do not have all that cash on hand,
heterogeneous beliefs. they will have to sell the assets. This is called deleveraging.
The situation changes when some investors simply like All this would happen even if traders were completely
owning the asset for its own sake in the period they buy it, such rational, processing information dispassionately. When we add
as when a homeowner likes living in the house. A similar the possibility of panic and the turmoil created by more and
situation arises if a producer can get more output from the more bankruptcies, it is not surprising to see lending
asset than can be recovered if the lender takes it over. completely dry up.
Somewhat surprisingly, in these cases the equilibrium leverage
might be to promise (1,1) even when the asset will only deliver
(1,.2) with probabilities everyone agrees on. If there are
multiple states, and a cost of seizing the collateral, then the 2.3 The Aftermath of the Crisis
equilibrium promise will be somewhere between the
maximum and minimum delivery. Contrary to the previous After the crisis ends, many businesses and individuals will be
two cases, equilibrium leverage will involve a distinctly positive broke and unemployed. Parts of the economy will be disrupted,
probability of default. Furthermore, in order to avoid the and some markets may be on the verge of shutting down. The
default costs of seizing the collateral, the equilibrium loans will government will then face the choice of who to assist, and at
be longer term, as in the mortgage market, where we see what cost. This assistance will typically be very inefficient,
defaults and long-maturity loans. causing further losses to economic productivity. Doubts about
which firms will survive will create more uncertainty,
contributing to a difficult lending environment.
2.2 The Crisis Stage
The crisis stage of the leverage cycle always seems to unfold in 2.4 What Is So Bad about the Leverage Cycle?
the same way. First there is bad news. That news causes asset
prices to fall based on worse fundamentals. Those price The crisis stage is obviously bad for the economy. But the
declines create losses for the most optimistic buyers, precisely leverage that brings it on stimulates the economy in good
because they are typically the most leveraged. They are forced times. Why should we think the bad outweighs the good? After
to sell off assets to meet their margin restrictions, even when all, we are taught in conventional complete-markets economics
the margins stay the same. Those forced sales cause asset prices that the market decides best on these types of trade-offs. In
to fall further, which makes leveraged buyers lose more. Some Geanakoplos (2010), I discuss eight reasons why the leverage
of them go bankrupt. And then typically things shift: the loss cycle may nevertheless be bad for the economy. The first three
spiral seems to stabilize—a moment of calm in the hurricane’s are caused by the large debts and numerous bankruptcies that
eye. But that calm typically gives way when the bad news is the occur in big leverage cycles.
First, optimistic investors can impose an externality on the complete-markets price, because of the expectation by the
economy if they internalize only their private loss from a leveraged few that good times are coming, a huge wave of
bankruptcy in calculating how much leverage to take on. For overbuilding usually results. In the bad state, this overbuilding
example, managers of a firm calculate their own loss in profits needs to be dismantled at great cost and, more importantly, new
in the down states, but sometimes neglect to take into their building nearly stops. To make the point a bit more dramatically,
calculations the disruption to the lives of their workers when very high leverage means that the asset prices are set by a small
they are laid off in bankruptcy. If, in addition, the bankruptcy group of investors. If agent beliefs are heterogeneous, why
of one optimist makes it more likely in the short run that other should the prices be determined entirely by the highest outliers?
optimists (who are also ignoring externalities) will go In the current crisis, as I observed earlier, the $2.5 trillion of toxic
bankrupt, perhaps starting a chain of defaults, then the mortgage securities were purchased with about $150 billion in
externality can become so big that simply curtailing leverage cash and $2.35 trillion in loans. As of 2006, just two men, Warren
can make everybody better off. Buffet and Bill Gates, between them had almost enough money
Second, debt overhang destroys productivity, even before to purchase every single toxic mortgage security in the whole
bankruptcy, and even in cases when bankruptcy is ultimately country. Leverage allows the few to wield great influence on
avoided. Banks and homeowners and others who are prices and therefore on what is produced.12
underwater often forgo socially efficient and profitable Sixth, a large group of small businesspeople who cannot buy
activities. A homeowner who is underwater loses much of the insurance against downturns in the leverage cycle can easily sell
incentive to repair a house, even if the cost of the repairs is less loans to run their businesses or pay for their consumption in
than the gain in value to the house, since increases in the value good times at the height of the leverage cycle, but have a hard
of the house will not help him if he thinks he will likely be time at the bottom. Government policy may well have the goal of
foreclosed eventually anyway.10 protecting these people by smoothing out the leverage cycle.13
Third, seizing collateral often destroys a significant part of Seventh, the large fluctuations in asset prices over the
its value in the process. The average foreclosure of a subprime leverage cycle lead to massive redistributions of wealth and
loan leads to recovery of only 25 percent of the loan, after all changes in inequality. When leverage λ = 30, there can be wild
expenses and the destruction of the house are taken into swings in returns and losses. In the ebullient stage, the
account, as I discuss later. Auction sales of foreclosed houses optimists become rich as their bets pay off, while in the down
usually bring 30 percent less than comparable houses sold by states, they might go broke. Inequality becomes extreme in
their owners. both kinds of states.14
The next four reasons stem from the swings in asset prices The eighth problem with the leverage cycle is caused by the
that characterize leverage cycles. A key externality that inevitable government responses to the crisis stage. In an effort
borrowers and lenders in both the mortgage and repo markets to mitigate the crisis, the government often intervenes in
do not recognize is that if leverage were curtailed at the high inefficient ways. In the current crisis, the government is
end of the leverage cycle, prices would fall much less in the supporting the financial sector by holding the federal funds rate
crisis. Foreclosure losses would then be less, as would near zero. The government’s foreclosure prevention efforts
inefficiencies caused by agents being so far underwater. One have created financial subsidies for households that opt not to
might argue that foreclosure losses and underwater move, which can create inefficiencies in labor market
inefficiencies should be taken into account by a rational adjustment.15 Government bailouts, even if they were all for
borrower and lender and be internalized: it may be so the public good, cause resentment from those who are not
important to get the borrower the money, and the crisis might bailed out. The agents in the economy do not take into account
ex ante be so unlikely, that it is “second best” to go ahead with that by leveraging more and putting the economy at greater
the big leverage and bear the cost of the unlikely foreclosure.
11
But that overlooks the pecuniary externality: by going into See Tobin and Golub (1998).
12
foreclosure, a borrower lowers housing prices and makes it Standard economics does not really pay any attention to the case where
agents have different beliefs, and median beliefs are closer to the truth than
more likely that his neighbor will do the same. extreme outliers.
Fifth, asset prices can have a profound effect on economic 13
Here I rely on Tobin’s Q and the absence of insurance markets. The small
activity. As James Tobin argues with his concept of Q, when the businessmen cannot insure themselves against the crisis stage of the leverage
prices of old assets are high, new productive activity, which often cycle. In conventional complete-markets economics, they would be able to
buy insurance for any such event. Geanakoplos and Polemarchakis (1986)
involves issuing financial assets that are close substitutes for the offer a proof that when insurance markets are missing, there is almost always
old assets, is stimulated. When asset prices are low, new activity a government intervention in the existing markets that will make everyone
might grind to a halt.11 When asset prices are well above the better off.
14
This is a purely paternalistic reason for curtailing leverage.
10 15
See Myers (1977) and Gyourko and Saiz (2004). See Ferreira et al. (forthcoming).

risk, they create more inefficient government interventions. Chart 1
And of course, the expectation of being assisted by the Housing Leverage Cycle
Margins Offered (Down Payments Required) and Home Prices
government, should things go wrong, causes many agents to
be more reckless in the first place.16 Down payment Case-Shiller
for mortgage (percent) national HPI
0 200
Average down payment
for 50 percent lowest 180
5 down payment, subprime/
3. The Leverage Cycle of 2000-09 alt-A borrowers
(Left scale)
160
Fits the Pattern 10
140
Case-Shiller national
15 home price index (HPI) 120
3.1 Leverage and Prices (Right scale)
100
20
By now, it is obvious to everybody that asset prices soared from 2000 02 04 06 08 09
1999 (or at least after the disaster period that began September 11, Sources: First American CoreLogic LoanPerformance Data Base;
2001) to 2006, and then collapsed from 2007 to 2009. My thesis Ellington Capital Management.
is that this rise in prices was accompanied by drastic changes in Notes: The down payment axis has been reversed, because lower down
leverage, and was therefore just part of the 1999-2006 upswing payment requirements are correlated with higher home prices. For every
alt-A or subprime first-lien loan origination from 2000:1 to 2008:1, the
in the leverage cycle after the crisis stage in 1997-98 at the end down payment percentage was calculated as appraised value (or sale price,
of the last leverage cycle. I do not dispute that irrational if available) minus total mortgage debt, divided by appraised value. For
each quarter, the down payment percentages were ranked from highest
exuberance and then panic played a role in the evolution of to lowest, and the average of the bottom half is shown. This number is
prices over this period, but I suggest that they may not be as an indicator of the down payment required; clearly, many homeowners
important as leverage; certainly, it is harder to regulate animal put down more than they had to, which is why the top half is dropped
from the average. A 13 percent down payment in 2000:1 corresponds
spirits than it is leverage. to leverage of about 7.7, and a 2.7 percent down payment in 2006:2
Let us begin with the housing bubble, famously documented corresponds to leverage of about 37. Subprime/alt-A issuance ended
by Robert Shiller. In Chart 1, I display the Case-Shiller national in 2008:1.
housing index for 2000-09. It begins at 100 in 2000:1, reaches

190 in 2006:2, and falls to 130 by 2009:1, as measured on the It is striking how correlated prices and leverage are, rising
right vertical axis. But I superimpose on that graph a graph of and then falling together. Especially noteworthy is that leverage
leverage available to homeowners each month. This is peaks in 2006:2, with 2.7 percent down, exactly when housing
measured on the left vertical axis and labeled “Down payment prices peak, and heads down much faster than housing prices.
for mortgage,” which is 100 percent minus the loan-to-value In Chart 2, I present the history of the J.P. Morgan AAA
(LTV) ratio. To compute this, I begin by looking house by prime floater mortgage index from about 2000 to 2009. The
house each month from 2000-09 at the ratio of all the index is measured on the right vertical axis. The prime
outstanding mortgage loans (usually a first and sometimes a mortgages underlying the bonds in the index were taken out by
second lien) to the appraised value of the house at the moment investors with pristine credit ratings, and the bonds are also
a first mortgage was issued for every subprime and alt-A house protected by some equity in their deals. For most of its history,
available in the First American CoreLogic LoanPerformance this index stays near 100, but starting in early 2008, it falls
Data Base. I then average over the 50 percent houses with the rapidly, plummeting to 60 in early 2009. The cumulative losses
highest LTV levels.17 In this way, I obtain a robust estimate of on these prime loans even today are still in the single digits; it is
leverage offered to homeowners. By leaving out the bottom hard to imagine them ever reaching 40 percent (which would
50 percent, I ignore homeowners who clearly chose to leverage mean something like 80 percent foreclosures with only
less than they could have, and by including all homes in the top 50 percent recoveries). It is of course impossible to know what
50 percent, I ensure that the leverage measure was really people were thinking about potential future losses when the
available and not just a special deal for a few outliers. If index fell to 60 in late 2008 and early 2009. My hypothesis is
anything, my numbers underestimate the offered leverage.18 that leverage played a big role in the price collapse.
16
This mechanism has been formalized in Farhi and Tirole (2009). 18
At the peak of nonprime lending in mid-2005, these loans represented
17
These data were compiled and analyzed by the research team at the hedge 45 percent of the flow of new mortgage borrowing (correspondence with
fund Ellington Capital Management. editors).
Chart 2 Chart 3
Securities Leverage Cycle VIX Index
Margins Offered and AAA-Rated Securities Prices
Margin down payment required 90

to purchase securities (percent) Price 80
0
100 70
10
60
20 90
Average margin on portfolio of collateralized 50
30 mortgage obligations rated AAA at issuance
(Left scale) 80 40
40 30
Estimated
50 average margin 70
(Left scale)
20
60 10
Prime fixed prices 60
70 (Right scale) 0
1990 92 94 96 98 00 02 04 06 08 10
80 50
1998 99 00 01 02 03 04 05 06 07 08 09
Sources: Ellington Capital Management; J.P. Morgan.

Chart 3 displays the history of implied volatility for the S&P
Notes: The chart represents the average margin required by dealers
on a hypothetical portfolio of bonds subject to certain adjustments 500, called the VIX index. Volatility in equities is by no means
described below. The margin axis has been reversed, because lower a perfect proxy for volatility in the mortgage market, but it is
margins are correlated with higher prices. The portfolio evolved over
striking that the VIX reached its peak in 2008 at the crisis stage
time, and changes in average margin reflect changes in composition
as well as changes in margins of particular securities. In the period of the current leverage cycle, and reached a local peak in 1998
following August 2008, a substantial part of the increase in margins at the bottom of the last leverage cycle in fixed-income
is attributable to bonds that could no longer be used as collateral
after being downgraded, or for other reasons, and hence count as
securities. The VIX also shot up in 2002, but there is no
100 percent margin. indication of a corresponding drop in leverage in the Ellington
mortgage data.
On the left vertical axis, I give the loan-to-value, or,

equivalently, the down payment or margin, offered by Wall 3.2 What Triggered the Crisis?
Street banks to the hedge fund Ellington Capital Management
on a changing portfolio of AAA mortgage bonds.19 As I noted The subprime mortgage security price index collapsed in
earlier, it is astonishing that the Fed itself does not have such January 2007. The stock market kept rising until October 2007,
historical data. Fortunately, the hedge fund Ellington, which I when it too started to fall, losing eventually around 57 percent
have worked with for the past fifteen years, does keep its own of its value by March 2009 before rebounding to within
data. The data set is partly limited in value by the fact that the 27 percent or so of its October peak in January 2010. What, you
data were only kept for bonds Ellington actually followed, and might wonder, was the cataclysmic event that set prices and
these changed over time. Some of the variation in average leverage on their downward spiral?
margin is due to the changing portfolio of bonds, and not to The point of my theory is that the fall in prices from scary
changes in leverage. But the numbers, while not perfect, bad news is naturally going to be out of proportion to the
provide substantial evidence for my hypothesis and tell a significance of the news, because the scary bad news
fascinating story. In the 1997-98 emerging markets/mortgage precipitates and feeds a plunge in leverage. A change in
crisis, margins shot up, but quickly returned to their previous volatility, or even in the volatility of volatility, is enough to
levels. Just as housing leverage picked up over the period after prompt lenders to raise their margin requirements. The data
1999, so did security level leverage. Then in 2007, leverage show that that is precisely what happened: margins were raised.
dramatically fell, falling further in 2008, and leading the drop But that still begs the question, what was the news that
in security prices. Very recently, leverage has started to increase indicated volatility was on the way up?
again, and so have prices. One obvious answer is that housing prices peaked in mid-
2006, and their decline was showing signs of accelerating in the
beginning of 2007. But I do not wish to leave the story there.
19
These are the offered margins and do not reflect the leverage chosen by Housing prices are not exogenous; they are central to the
Ellington, which since 1998 has been drastically smaller than what was offered. leverage cycle. So why did they turn in 2006?

3.3 Why Did Housing Prices Start to Fall? Chart 4
Cumulative Loss of Original Balance
Many commentators have traced the beginning of the Cumulative loss (percent)
subprime mortgage crisis to falling housing prices. But they 1.0
0.9 Beginning of subprime crisis
have not asked why housing prices started to fall. Instead, they
0.8 2004
have assumed that housing prices themselves, fueled on the
0.7
way up by irrational exuberance and on the way down by a 0.6
belated recognition of reality, were the driving force behind the 0.5
economic collapse. 0.4
I see the causality going in the other direction, starting with 0.3 2003
the turnaround in the leverage cycle. The leverage cycle was of 0.2 2005 2006
course greatly exacerbated by the terrible consequences of 0.1 2007

0
falling housing prices, which then fed back to cause further 2003 04 05 06 07
housing declines.
Source: Ellington Capital Management.
As I hope I have made clear, in my view housing prices
soared because of the expansion of leverage. Greater leverage
enabled traditional buyers to put less money down on a bigger
house, and therefore pushed up housing prices. It also enabled Chart 5
people to buy houses who previously did not have enough cash Delinquencies on Original Balance
to enter the market, pushing housing prices up even further.
OTS delinquent 90+ (percent)
There is, however, a limit on how much leverage can 16
increase, and on how many new people can enter the market. Beginning of subprime crisis
14
Though negative amortizing loans pushed the envelope, no 12
2007
money down is a natural threshold beyond which it is hard to
10
move. And as more and more households entered the market
8 2006
with less and less money down, lenders began to become
6
apprehensive that these people were less reliable and more 2005
inclined to exercise their put option to walk away from the 4 2003
house if housing prices fell. The rapidly expanding supply of 2 2004
new housing demand, fueled by access to easy mortgages, 0
2003 04 05 06 07
began to slow for completely rational reasons, not because of a
sudden pricking of irrational exuberance. This naturally led to Source: Ellington Capital Management.
a peak in housing prices by 2006:2. But this does not explain
why housing prices should steeply decline. Indeed, over the
next two quarters, prices and leverage waffled, both moving happen next. With that new information, how much
slightly in a negative direction: During the last half of 2006, extrapolation should a buyer from 2006 have made in his
housing down payment requirements rose slightly, from expectations of losses and delinquencies going forward?
2.7 percent to 3.2 percent, and prices fell slightly, by The ABX index for 2006 vintage subprime bonds began to
1.8 percent. fall in November 2006 with the smallest trickle of bad news
At that point, bad news appeared in the securities market in about homeowner delinquencies, then spiked downward in
the form of rising delinquencies. Charts 4 and 5 show losses January 2007 after the year-end delinquency report (Chart 6).
and delinquencies of Countrywide deals by vintage.20 (These This price drop of 2006 BBB bonds to below 80 implied that the
deals are fairly representative of the whole subprime market.) market was suddenly anticipating huge losses on subprime
One can see in Chart 4 that by January 2007, losses for the deals on the order of 10 percent. Recall that for a pool of
2005 vintage were just 0.2 percent and losses for the 2006 mortgages to lose 9 percent or 10 percent of its value, the
vintage were nonexistent. But the 2005 and 2006 delinquencies market must anticipate that something like 30 percent of the
displayed in Chart 5 were already approaching 5 percent, more homeowners will be thrown out of their houses, with 30 per-
than double those of previous vintages. More disturbing, they cent losses on the mortgage on each home sold (30 percent x
showed no signs of leveling off. This is precisely the kind of 30 percent = 10 percent). This expectation turned out to be not
scary news that creates wide uncertainty about what might pessimistic enough, but at that time it was a heroic
extrapolation from the observed delinquencies of less than
20
Data were provided by Ellington Capital Management. 5 percent.21
Chart 6
ABX Index
ABX-HE:
AAA 06-1 AA 06-1 A 06-1 BBB 06-1 BBB- 06-1
AAA 06-2 AA 06-2 A 06-2 BBB 06-2 BBB- 06-2
AAA 07-1 AA 07-1 A 07-1 BBB 07-1 BBB- 07-1
Percent AAA 07-2 AA 07-2 A 07-2 BBB 07-2 BBB- 07-2
120
100
80
60
40
20
0
2006 07 08 09 10
My contention is that this sudden drop in prices, and the the peak of the securities market, the collapse in securities
further price declines later, were not simply the result of a drop prices preceded the significant fall in housing prices. Thus, in
in expected payoffs (that is, in fundamentals) by the same old my view the trigger for the downturn in bonds was the bad
buyers, but also the result of a change in the marginal buyer. A news about delinquencies and the concurrent creation of the
critical new downward force entered the market for mortgage standardized CDS market in subprime mortgage indexes,
securities. Standardized credit default swaps (CDS) on which then spilled over into the housing market.
mortgage bonds were created for the first time in late 2005, at The downward pressure on bond prices from credit default
the very height of the market. The volume of CDS expanded swaps and worrisome delinquency numbers meant that new
rapidly throughout 2006 and especially in 2007 (Chart 7).22 securitizations became more difficult to underwrite.
A CDS is an insurance contract for a bond. By buying the Securitizers of new loans looked for better loans to package in
insurance, the pessimists for the first time could leverage their order to continue to back bonds worth more than the loan
negative views about bond prices and the houses that backed amounts they had to give homeowners. They asked for loans
them. Instead of sitting out of the subprime securities market, with more collateral. As Chart 7 shows, from 2006:4 to 2007:4,
pessimists could actively push bond prices down. Their
purchase of insurance is tantamount to the creation of more
(“synthetic”) bonds; naturally, the increase in supply pushed Chart 7
the marginal buyer down and thus the price down. Volume of Credit Default Swaps
In January 2007, after the dramatic fall in BBB subprime Trillions of dollars
mortgage prices, housing prices were still only 1.8 percent off 70
their peak. Though the peak of the housing market preceded 60
21
The collapse of the ABX index in January 2007 is a powerful illustration of 50
the potency of market prices to convey information. This first market crash 40
should have been enough to alert our government to the looming foreclosure
disaster, but three years later we still have not taken decisive action to mitigate 30
foreclosures.
22
20
Chart 7 is derived from data provided in “ISDA Market Survey: Historical
Data,” available at www.isda.org/statistics/historical/html. Unfortunately, it 10
includes all CDS, not just CDS on mortgages. The data on mortgage CDS seem 0
difficult to find, since these CDS were traded bilaterally and not on an 2000 01 02 03 04 05 06 07 08 09
exchange. It seems very likely to me that the mortgage CDS increased even
more dramatically from 2004-05 to 2006-07. Source: “ISDA Market Survey: Historical Data.”

the required down payment on houses rose dramatically from behind all of them is a failure to put up enough collateral to
3.2 percent to 15.9 percent (equivalently, LTV fell from 96.8 back promises.
percent to 84.1 percent). This meant that potential new
homeowners began to be closed out of the market, which of
course reduced home prices. In that same period, housing
prices began to fall rapidly, declining by 8.5 percent. 4.1 Securities Leverage Got Higher then
But more insidiously, the desire by lenders to have more Fell Farther than Ever Before
collateral for each dollar loaned kept homeowners from
refinancing because they simply did not have the cash: given In this cycle, leverage on traditional collateralizable assets
the drop in the permissible LTV ratio, and the fall in housing increased to more than the highs from the previous cycle. That
prices, they suddenly needed to put down 25 percent of their can be seen in the history of one mortgage hedge fund’s
original loan in cash to refinance. Refinancing virtually stopped margins (haircuts) over the last eleven years (Chart 2). Note in
overnight. Until 2007, subprime bondholders could count on the chart that before the crisis of 1997-98 that ended the last
70 percent or so of subprime borrowers refinancing by the end leverage cycle, leverage was about 10 to 1 (margins were about
of their third year.23 These homeowners began in pools that 10 percent). During the 1998 crisis, margins jumped to
paid a very high rate of interest because of their low credit 40 percent, staying there about two months, before returning
rating. But after two years of reliable mortgage payments, they to their previous levels of 10 percent. In the “great moderation”
would become eligible for new loans at better rates, which they in the nine years afterward, when volatility got very low,
traditionally took in vast numbers. Of course, a prepayment leverage increased from about 10 to 1 to about 20 to 1 (the
means a full payment to the bondholder. Once refinancing margins fell from 10 percent to 5 percent).
plummeted and this sure source of cash disappeared, the bonds Beginning in 2007 (after reaching its peak in 2006), leverage
became much more at risk and their prices fell more. Margins collapsed, with margins going from 5 percent to 70 percent on
on bonds began to tighten. average. Two years after the collapse, leverage was still low,
Mortgagees who had anticipated being able to refinance whereas in 1998 the crisis was all over in two months.
were trapped in their original loans at high rates; many The most dramatic change in margins has come from assets
subsequently became delinquent and entered foreclosure. that were rated AAA, and that have been, or are about to be,
Foreclosures obviously lead to forced sales and downward downgraded. Previously, one could borrow 90 or even 98.4 cents
pressure on housing prices. And falling home prices are a on a dollar’s worth of AAA assets, and now one cannot borrow
powerful force for further price reductions, because when anything at all with these assets as collateral. According to
house values fall below the loan amount, homeowners lose the Moody’s, AAAs are supposed to have a 1 in 100 risk of default
incentive to repay their loans, leading to more defaults, over a ten-year period.24 We are now seeing over 50 percent of all
foreclosures, and forced selling. All this leads back to falling alt-A and subprime AAA bonds partially defaulting, and we will
security prices and tighter margins on securities. see virtually 100 percent of all AAA collateralized debt
The feedback from falling security prices to higher margins obligations (CDOs) partially default. Even when some assets
on housing loans to lower house prices and then back to tougher
have little or no chance of losing more than a few percent of their
margins on securities and to lower security prices and then back
value, the market no longer trusts the AAA rating, and lenders
again to housing is what I call “the double leverage cycle.”
will not lend anything on them.
In the run-up to the present crisis, financial innovation
enabled many new kinds of assets to become usable as
collateral. Thus, even if margins had not declined on old
4. Why this Leverage Cycle Is the collateral, the leverage of the economy as a whole would have
Worst since the Great Depression increased because there was new borrowing backed by
previously unusable collateral, which brings us to pooling and
Every leverage cycle has the same broad features. The crisis
securitization.
stage of every leverage cycle is bad. But the current crisis is far
The process of pooling and securitization has been a crucial
worse than the crises we saw in the two previous leverage cycles.
source of new collateral and increased leverage. Imagine a
There are a number of reasons why this cycle is worse than all
single subprime mortgage loan. Even in the days when it was
previous cycles since the Depression, but the unifying theme
believed that the expected loss from such a mortgage was
23
Seventy-four percent of all subprime loans issued in or before 2004 had between 1 percent and 4 percent, people still recognized that
refinanced by the end of their third year, according to the First American
24
CoreLogic LoanPerformance Data Base. See Backman and O’Connor (1995).
there was a nontrivial chance of a much bigger loss on a single involved many financial institutions, it never involved such a
loan. Lenders, inherent pessimists, would not have considered large fraction of the general population. When housing prices
lending using a single subprime mortgage as collateral. But and securities prices fell, millions of homeowners as well as
now consider a pool of subprime mortgages from around the many of the most venerable financial institutions in America
country. If one believed that the loans were independent, so found themselves underwater, owing more money than the
that a housing price decline in Detroit did not imply a housing value of their assets.
price decline in California, then on a big enough pool of loans, Thus, the current cycle is really a double leverage cycle: not
the chance for more than 30 percent default might be only are the mortgage securities subject to the leverage cycle,
considered less than 1 in 10,000. Even a very pessimistic lender but their “fundamental” cash flows (namely, homeowner
who believed in a 4 percent expected loss per loan would be mortgage payments) are also subject to the leverage cycle.
willing to lend 70 percent of the value of the entire pool, These two cycles feed off each other. When margins are raised
provided that he got paid before anyone else. Thus, a buyer of on homeowners, it becomes more difficult to get a new
the pool of mortgages could imagine borrowing 70 percent of mortgage and home prices fall, jeopardizing mortgage
their collective value, when it would have been impossible to securities backed by houses. But more importantly, it becomes
borrow anything on the individual loans. more difficult for homeowners to refinance their old loans,
Securitization took this borrowing on pools one step further putting these loans and the securities they back in much more
by converting the loans into long-term loans. The underwriter jeopardy of defaulting. Similarly, when margins on securities
of the pool typically issued different bonds, whose payments are raised and their prices fall, then in order to sell the securities
depended on the homeowners’ payments on their loans. for higher prices, underwriters demand better underlying
Consider, for example, a bond structure with just two mortgages, that is, more money down from home buyers.
“tranches” of bonds. The senior tranche might pay interest
slightly above the riskless government rate on the best
70 percent of the loans. As long as losses on the pool are below
30 percent, the senior tranche holder continues to get paid his 4.3 Credit Default Swaps
interest and eventually his principal. The junior bondholder
receives what is left from the pool after the senior bondholder The current cycle has been more violent because of the
is paid. The whole securitized structure can be interpreted as if standardization/creation of the derivative credit default swap
the buyer of the junior piece actually bought the whole pool, market for mortgages in 2005, just at the top of the leverage
using a long-term loan from the buyer of the senior piece, cycle. One reason for the abruptness of the fall is that CDS
collateralized by the whole pool. Once one understands the allowed pessimists to leverage at just the worst time. Once CDS
juniors as effectively borrowing from the seniors, it becomes emerged, they were bound to put downward pressure on
clear how the rapid spread of securitization over the last thirty prices, because they allowed pessimists to express their views
years, but especially over the last ten years, dramatically for the first time and indeed leverage those views. Had the CDS
increased the leverage in the system. market for mortgages been around from the beginning, asset
Another factor that dramatically increased overall leverage prices might never have gotten so high. But their appearance at
in the system is the credit default swap, which I discuss shortly. the very top of the cycle guaranteed that there would be a fall.
Not only did CDS allow pessimists to leverage for the first
time, it also allowed them to leverage more than optimists.
When a bond trades near 100, but there is a perceptible chance
4.2 Housing and the Double Leverage Cycle of a big drop in price, then in a rational world the writer of
insurance is almost always going to be asked to put up much
Leverage on houses got to be much higher in this leverage cycle.
more collateral than the buyer of insurance, because his
In the recent leverage cycles, ending in 1994 and 1998,
potential liability is so high. A small group of pessimists can
homeowner leverage did not get remotely as high as it did in the
therefore have an outsized negative impact on prices by
recent cycle. In 2006, many homeowners were borrowing with
leveraging their CDS positions, since traders on the other side
basically no money down, or as little as 3 percent, as we saw in
will need far more capital to offset those positions.
Chart 1.25 New mortgages like option arms were invented,
A second reason why CDS made the fall much worse is that
which abetted this mad rush to loan homeowners all or nearly
in practice they allowed optimists to leverage even more than
all of the purchase price. Whereas previous cycles’ leverage
they had before. To the extent that CDS did not lower prices
25
See Haughwout, Peach, and Tracy (2008) for details on leverage used for before any bad news, it was because leveraged optimists
nonprime borrowers from 2001 to 2007. increased their leverage by taking the other side of the CDS, on

top of their leveraged purchases of the underlying assets. But reaction is more direct: Firm B loses the money irrespective
this made the crash much bigger once the bad news hit. CDS is of market prices. The implication I draw later is that there are
a kind of insurance market for bond defaults, but instead of benefits from CDS being traded on an exchange instead of
cushioning losses, it made them much worse because often the in bilateral contracts, both to ensure that collateral is always
buyers of the bonds did not buy the insurance, they sold it.26 posted by the writer of the insurance and to make sure losses
One might mistakenly think that CDS should just wash out. are netted.
In other words, for every dollar lost on the insurance, there Another benefit of putting CDS on an exchange would be
should be a dollar gained by the recipient. But the optimistic the ease with which size and leverage could be monitored by
writers of insurance are very different from the pessimistic regulators. In traditional insurance law, as I understand it,
buyers of insurance. When the bad news hits, the former lose there is a prohibition against overinsuring by taking out
and must reduce their purchases of assets; the latter gain, but insurance for more than the underlying asset, precisely because
still will not buy the assets. Writers of CDS insurance expose of the moral hazard such practices entail. Similar prohibitions
the economy to the same problems of excessive leverage I could be adopted for CDS.27
described earlier.
This brings us to the question of just how much leverage one
could actually obtain via the CDS market. Imagine a bond with
$100 face value that is trading for $98, and imagine a CDS 4.4 Counterparty Risk
insurance contract promising $1 for every $1 the bond defaults.
The $98 price suggests expected losses to the insurance writer of In bilateral CDS contracts, it was often the case that the insurer
$2. If the bond rises to $99, the seller of insurance effectively did not post enough initial margin collateral to guarantee
makes a dollar and if the bond price falls to $97, the insurance payment after a big move in default probabilities. This CDS
writer effectively loses $1. Thus, writing insurance is tantamount problem illustrates a more general flaw in the whole system of
to owning the bond. One can therefore compare the collateral a contracting on Wall Street. These contracts to a great degree
writer of CDS insurance had to put up with the down payment a were written in such a way that only one side of every
transaction was presumed liable to default, so that only the
buyer of the bond would have had to make to see where leverage
other side needed protecting. For example, in the repo market,
was higher. It now appears that leverage was higher with CDS.
a hedge fund borrower gets a loan from an investment bank,
Many firms, like AIG, were allowed to write CDS insurance with
and puts up collateral at the bank worth more than the loan.
little or no initial margin. If enough collateral had been put up by
The investment bank is protected against the potential default
AIG, there would have been no reason to bail it (or more to the
of the hedge fund, because in that event the collateral can be
point, all its counterparties) out.
sold to recover the loan amount. But the contract does not
The failure of some buyers of CDS insurance to insist on
contemplate the bankruptcy of the investment bank. What
proper collateral from the writers of the insurance was made far
recourse does the hedge fund have if the investment bank goes
worse because the gains and losses from CDS are not netted.
out of business, shutting its doors and swallowing the collateral
A Firm B that was neutral, betting one way against Firm A on
security? Following the Lehman bankruptcy, traders who never
tranche BBB, and betting the opposite way on the same tranche
before had to give a second thought to these counterparty risk
against Firm C, could come out a loser anyway. If Firm A
questions suddenly had to reevaluate all their contracts, with
defaults on its insurance payment, then B will be unpaid by A
disastrous effects on liquidity and price discovery.
but still on the hook for paying C. So instead of just one Firm A
Now, this unplanned-for counterparty risk has become the
going bankrupt and another Firm C going unpaid in the
primary rationale for the government’s seemingly unending
absence of collateral, as would happen with netting, another commitment to inject capital into “too-big-to-fail” institutions.
Firm B might also go bankrupt, closing shop, firing workers, “We can’t afford another Lehman,” is the common refrain;
and creating other social costs. we had to intervene with AIG not because it was so vital, but
Losses by leveraged buyers of assets can cause a chain because if it defaulted a chain reaction might ensue.
reaction when a margin call forces a leveraged buyer to sell, The prospective solution to the counterparty risk problem
which might lower the price and force another leveraged buyer is to ensure that both sides put up enough collateral. Of
to sell and so on. But with uncollateralized CDS, the chain course, people are now more alert to their counterparty
26 vulnerability than they were before, and thus pressure will
Of course, there were undoubtedly some hedge funds that bought bonds they
thought were undervalued, and bought insurance on similar bonds in order to grow, for example, on repo lenders to warehouse the
hedge their position against the risk of a market downturn. These are the
27
leveraged buyers that survived the crisis without a bailout. AIG is a classic See “A Daring Trade Has Wall Street Seething,” Wall Street Journal, June 12,
example of a writer of CDS insurance on mortgages that also held mortgage 2009, about a writer of CDS insurance who found a way to make the bond pay
securities (see Congressional Oversight Panel Report, June 10, 2010). off to avoid paying the overinsurance.
collateral at a third site that would not be compromised by the guarantees for entities that were considered too-big-to-fail.
bankruptcy of the lender. This raises questions about whether Fannie Mae and Freddie Mac grew bigger and bigger. The
there is enough collateral in the economy to back all the presumed government guarantee on their promises enabled
promises people want to make, which I discuss at length in them to leverage their assets to 30 or more, and still issue debt
Geanakoplos (1997) and Geanakoplos and Zame (2009). But just above Treasury rates. Without this implicit government
I believe there could be a government initiative to move as backing, they would never have been able to borrow so much
many bilateral contracts onto exchanges as possible; agents with such little capital.
trading with the exchange will be required to put up Many investment banks were allowed to write CDS without
collateral, and the netting through the exchange will collateralizing their implicit promises, as I observed before. It
economize on the collateral. As for any finance-related seems virtually inexplicable that Wall Street overlooked this
bilateral contracting so particular that it could not be moved counterparty risk; more likely, many counterparties assumed
to an exchange, the parties could either accept strict that these firms were implicitly backstopped by the Fed or the
disclosure requirements and limits on how much of this Treasury. And indeed, despite some doubts when Lehman
contracting they could engage in or accept doing without the collapsed, that expectation proved correct.28
instruments altogether.
4.6 The Rating Agencies Effectively

4.5 Government Laxity, Deregulation, and Increased Leverage
Implicit Guarantees Increased Leverage
The expansion of the mortgage market into less creditworthy
households made it more likely that a shock would someday be
The mildness and shortness of the crisis stage of the last two
“big and bad and scary,” creating more uncertainty and more
leverage cycles, in 1994 and 1998, may have led many people,
disagreement. The anticipation of that, however remote the
perhaps including the regulators, to ignore leverage altogether.
possibility seemed, should have made lenders nervous and
The abrupt tightening of margins in 1998 was explained by the
caused them to put a brake on leverage. This rational concern
supposed irrationality of lenders, who it was said reacted by
was dramatically reduced by a faith many investors had in the
raising margins after the fact, that is, after the fall in prices had
rating agencies and their default models, which were widely
already occurred. It appears that virtually no lenders lost
relied upon by market participants (and the rating agencies
money on loans against mortgage securities in that crisis. The
themselves), but which failed to account adequately for the
run-up in asset prices and home prices during the current cycle
probability that defaults in certain circumstances would be
was attributed mostly to irrational exuberance, instead of being
highly correlated. Some investors forgot the incentives of the
understood, first and foremost, as an inevitable consequence of
rating agencies and the incentives of many market actors to
the increase in leverage. Partly as a result of this faulty narrative,
downplay seriously the probability of highly correlated
government authorities did nothing to curtail the dramatic
defaults. In the face of a long history of low defaults and with
growth in homeowner leverage, or consumer leverage more
billions of dollars of deals waiting on the blessing of a small
generally, or corporate leverage, or securities leverage. Banks
handful of rating agency actors, it would have been astonishing
were allowed to move assets off their balance sheets and thus
if ratings had been as tough as they should have been. The same
avoid capital requirements, further increasing their leverage.
lesson applies to the mortgage brokers who were able to collect
Not only did the Fed (and everyone else) react passively to
fees for signing up borrowers without facing any losses
the rising leverage pervading the system, it encouraged the
themselves if the borrowers defaulted.
deregulation that unleashed the leverage inherent in outsized
credit default swaps. As I mentioned earlier, outsized CDS
contracts seem on their face to be either gambling or writing
insurance in excess of the value of the property being insured. 4.7 Global Imbalances Increased Leverage
Under either interpretation, they would have run afoul of state
laws prohibiting gambling or overinsurance. Thus, it took a Caballero, Farhi, and Gourinchas (2008), Caballero (2010),
positive act of Congress to pass legislation in the Commodity and others have suggested that the enormous savings glut
Futures Modernization Act of 2000 exempting CDS from those
28
limitations. Bear Stearns was sold to J.P. Morgan, which took on Bear’s obligations, but
only after the government guaranteed $29 billion of Bear’s assets. Many other
Perhaps the most important and unwitting government investment banks, like Goldman Sachs, were given emergency injections of
stimulus to the increased leverage was the implicit government $10 billion of Troubled Asset Relief Program (TARP) money.

coming from Asia increased the demand for safe assets. This Nobody doubts that Wall Street understood that there was
presented a profit opportunity to American financiers, who considerable risk in subprime mortgage pools. That is why they
were thus stimulated to engineer the securitizations that were tranched into different tiers, called AAA, AA, and down to
created apparently safe bonds out of risky assets. It is hard to BBB. And these bonds were all senior to residual pieces and
assess how important this factor is, but surely a gigantic overcollateralization, which together provided another 8 per-
demand for safe bonds would indeed give a big incentive to cent of protection. So, the question is really not whether Wall
create those bonds and thus inevitably to concentrate more risk Street overlooked the risk, but rather how did it come to be that
in other bonds. However, that leaves unexplained why Wall Street so badly underestimated the size of the risk?
investors were willing to buy those other bonds, or why The answer, I believe, is that it was nearly impossible to
investors bought so much of the new, “safe” AAA-rated bonds foresee the devastating consequences of the multiple feedbacks
even when their yields revealed that the market did not think between securities and houses embodied in the double leverage
they were perfectly safe. The Chinese, for example, did not buy cycle. Complex adaptive systems are notoriously hard to
these bonds and they did not lose money when they predict. Contrary to the myth that nobody imagined that
subsequently defaulted. The global-imbalances hypothesis housing prices could go down as well as up, I suspect that
relies on an additional mechanism for its power: global virtually every large bank and hedge fund considered a scenario
imbalances created lower, truly safe rates, which led American in which housing prices went down at least 10 percent. Recall
investors pursuing absolute yields to leverage more, for that if 25 percent of the loans result in homeowners being
example, by buying the new, “safe” bonds with borrowed thrown out of their houses, with 25 percent losses on each
money to leverage their tiny excess spreads. Thus, we come foreclosed home, that amounts to losses of just 6.25 percent =
back to leverage. .25 x .25 for the pool as a whole, which would leave the rated
bonds unscathed. Better still, if 70 percent of the homeowners
refinanced according to historical patterns, then even with
50 percent defaults and 50 percent losses on the remaining
4.8 All Upside Down 30 percent of the loans, losses would come only to 6.75 percent
= 30 percent x .5 x .5. But how many anticipated that at the
The upshot of the huge credit boom and the plunging prices same time as housing prices went down mortgage down
was that an extraordinary number of households, businesses, payments would rise to the point that subprime refinancing
and banks ended up upside down or underwater, that is, with virtually stopped, dropping from 70 percent to zero? Or that
debt exceeding their assets. According to First American subprime mortgage originations would cease, causing further
CoreLogic, about 13 million of the 55 million mortgage holders house declines? And that at the same time servicers and banks
were underwater in early 2010. According to Lender Processing would refuse to write down principal, leading to more
Services, about 2 million families have lost their homes since foreclosures and further house declines? And that in the face of
2007, 2.5 million more are in foreclosure, and another 3 million so much homeowner misery and the destruction of so much
are not currently paying their mortgages. property, the government would wait until March 2009—more
The government has assumed trillions of dollars of than two years after the crash of the subprime ABX index in
mortgage debt through its guarantee of Fannie Mae and January 2007—to launch its Home Affordable Modification
Freddie Mac and through its Federal Housing Authority (FHA) Program (HAMP)?
loans, and has invested hundreds of billions of dollars
supporting banks and firms like AIG; in addition, on account
of the huge number of failing banks, the Federal Deposit
Insurance Corporation is on the verge of borrowing from the 5. The Solution to the Crisis:
Treasury. A problem of too much private debt has morphed A Multi-Pronged Approach
into a problem of too much government debt.
Once the economy is plunged into circumstances as dangerous
as we saw last year, the government has no choice but to act
boldly. The correct course of action is to reverse the final stages
4.9 Why Didn’t Wall Street Risk Managers of the crisis and thus stop the panic. At the outset of this crisis,
Anticipate the Collapse? I recommended the three-pronged approach I present here—
a thematic solution to the crisis that addresses in order of
Having discussed many of the factors that exacerbated the crisis importance all aspects of the final stages of the leverage.29
of 2007-09, I am now in a position to assess the widely held
29
view that nobody saw it coming. See Geanakoplos (2008).
As I explained above, all leverage cycles end with 1) bad 5.1 Step One—Addressing the Precipitating
news creating uncertainty and disagreement, 2) sharply Cause of the Crisis: “Scary Bad” News
increasing collateral rates, and 3) losses and bankruptcies
(Massive Uncertainty) about Housing
among the leveraged optimists. These three factors reinforce
and feed back on each other. In particular, what begins as
and the Assets Built on Housing
uncertainty about exogenous events creates uncertainty about
endogenous events, like how far prices will fall or who will go To foster recovery from the dramatic final stage of a leverage
cycle as large as the one we have just experienced, the
bankrupt, which leads to further tightening of collateral, and
thus further price declines and so on. In the aftermath of the government must address the cause of the uncertainty that
crisis, we always see depressed asset prices, reduced economic triggered the end stage. Without that, the efforts taken thus far
to bring margins down and recapitalize banks, even had they
activity, and a collection of agents that are not yet bankrupt but
hovering near insolvency. How long the aftermath persists been perfectly implemented, would not be enough to reverse
depends on the depth of the crisis and the quality of the the cycle and restore the economy to health. In this crisis, with
its roots in housing, that means doing something for housing
government’s response. Whether we find ourselves in a similar
crisis in the future depends on whether, understanding how prices and homeowners. This makes undeniable sense in this
leverage got us here, we adopt reforms that require supervisors crisis, not just because addressing the cause of the uncertainty
and disagreement (the scary bad news) is critical to reverse any
to monitor and regulate leverage in good times. First, I take up
what government actions could have been taken, and in what leverage cycle, but because the biggest social losses will
order, to address the final stage of the double leverage cycle that probably come from the displaced homeowners. And, of
course, the biggest reason for the tumbling mortgage security
the government was called on to address in 2007.
The thematic solution once the crisis has started is to reverse prices, and the resulting insolvency of the banking sector, is
the three symptoms of the crisis: contain the bad news, fear that housing prices will keep falling.
intervene to bring down margins, and carefully inject
“optimistic” equity back into the system. To be successful, any
government plan must respect all three remedial prongs, and Saving the Homeowners: Stemming the Tsunami
should be explainable and explained to the public in terms that of Foreclosures to Come
it can understand. Without public confidence, which can only
flow from public understanding, any federal government One of the saddest stories in this financial meltdown is that
millions of homeowners are being thrown out of their homes
(hereafter, “government”) plan undermines its own objectives
and limits its prospects for success. The government’s actions for defaulting on their mortgages. Throwing somebody out of
thus far have not addressed all three prongs adequately and his home is tragic for the homeowner, but also very expensive
for the lender. One of the shocking aspects of the foreclosure
policymakers have thus far largely failed to explain how their
various solutions are tied to the roots of the crisis we face. crisis is how low the recoveries have become on foreclosed
Unfortunately, the TARP, the government’s first properties, after expenses. (Interestingly, the mortgage bond
intervention plan to buy distressed assets, was not clearly index markets anticipated these bad recoveries.) Nobody gains
when the homeowners are thrown out and the banks and/or
thought through and neither it, the ostensible solution, nor
the problem that required a solution were clearly explained. investors collect pennies on the dollar for the money they
After its announcement, asset prices fell further. But even now, loaned. Yet, as we saw, 2 million homeowners have already
been evicted, another 2.5 million are seriously delinquent and
after the panic has subsided, we must ask who or what is the
government trying to save? Many in the public have come to almost surely will be evicted in the near future, and at least
believe it is merely trying to save banks, or some big banks, another 3 million will eventually default and be evicted if trends
continue. Without much bolder action than has thus far been
from failure because somehow their failure would signal a
catastrophe for the American brand, to be prevented at all taken by the government, the stream of evictions and bad
costs.30 The confusion about the government’s goals has recoveries for lenders will continue and accelerate, becoming a
torrent that will further depress housing prices and impede
created its own set of problems, which we can ill afford.
economic recovery.
Clarifying the government’s goals will be harder now, but it
Negative equity is a key driver of mortgage defaults. When
remains an indispensible step.
faced with an income shock, borrowers who are in positive
30
equity have the option to sell the house rather than default.
“Sixty-seven percent (67 percent) of adults believe Wall Street will benefit
more from the new bank bailout plan than the average U.S. taxpayer.” Borrowers who are underwater (in negative equity) may
Rasmussen Reports, February 2009/56. choose to default even in the absence of an income shock.

The connection between LTV and default is illustrated in Chart 8
Chart 8. For each mortgage in the First American CoreLogic Monthly Net Flow (Excluding Modifications) from
LoanPerformance Data Base, the current LTV is estimated by Less than Sixty Days to Sixty or More Days Delinquent
Based on Performance from November 2008 to January 2009
taking the appraisal value of the house at the moment the first
for All Deals Issued in 2006
loan was given, and then assuming thereafter that the house
changed in value according to the Case-Shiller index for houses Monthly default rate (percent)
8
with the same Zip code. Option Subprime
7 adjustable-rate
As the chart shows, homeowners who have positive equity mortgage
6
in their homes default infrequently. But for homeowners with
negative equity, the rate of default is staggering. For subprime 5 alt-A
borrowers with a 160 percent loan-to-value ratio (that is, the 4
ratio of all the mortgages on the home divided by the current 3 Prime
home price), the default rate is 8 percent per month. 2
These findings seemed surprising when I first presented 1
them in a New York Times editorial written with Susan Koniak 0
on March 5, 2009 (Geanakoplos and Koniak 2009). But 0 50 100 150 200 250
nowadays, many other researchers are reaching the same BHPA-adjusted CLTV (percent)
conclusion.31 The conclusion is an inescapable matter of Note: Circles indicate median combined-loan-to-value (CLTV) ratios
incentives. It may not be economically rational for a by product.
homeowner to continue to pay off a $160,000 loan when his
house is only worth $100,000.32 Mortgage loans have turned
out to be no-recourse—after seizing the house, the lender Foreclosures are horribly expensive for the lender. At the
almost never comes after the borrower for more payments. present time, subprime lenders collect about 25 cents per dollar
Besides the ability to live in the house, the only other thing the of loan when they foreclose. For example, if the loan is for
homeowner loses by defaulting is his credit rating, but $160,000 and the house has fallen in value to $100,000 and the
especially for a nonprime borrower with a low credit rating to homeowner defaults and is evicted, the lender can expect to get
begin with, how much can that be worth? Finally, a choice back $40,000. It takes eighteen months on average to evict a
today by a negative equity borrower to default may be moving homeowner, and during that time he does not pay his mortgage
up in time a necessity to default at some point in the future. In or his taxes, the house is often left empty and vandalized, a
this case, the borrower’s credit rating will likely be damaged realtor must be hired to sell the house, and so on. Of course, the
anyway. main reason the average recoveries are so low is that the
defaulters are the homeowners who are furthest underwater
(see Chart 8).
31
Haughwout, Peach, and Tracy (2008) stress the importance of negative In a rational world, many foreclosure losses would never
equity as a determinant of early defaults among nonprime borrowers. The happen. The lenders would renegotiate the loans by reducing
Congressional Oversight Panel cited negative equity as the single greatest
predictor of default in its report of March 6, 2009. It included the data I provide the principal so the homeowners could pay less and stay in their
here as evidence of this fact, data that I supplied to the Panel in advance of its homes, and the lenders would actually get more by avoiding the
report, as well as data from an array of government agencies, all of which losses from legal fees and bad home price sales. If the above
corroborated the Ellington Capital Management data presented here. That is
not to say that joblessness is not now having a significant effect on default rates.
loan were written down to $80,000, the homeowner would
It is. But even now, negative equity is the best predictor of default and many likely find a way to pay it, or else fix up the house and sell it for
Americans with jobs are defaulting, and will continue to default, not just the $100,000. Either way, the lender would get $80,000 instead of
unemployed. See generally the Congressional Oversight Panel’s Report of
$40,000. That would have the further benefit of keeping many
October 9, 2009, on the continuing foreclosure problem and the unimpressive
results from government foreclosure prevention efforts taken thus far. Finally, homes off the market and thereby aid in the stabilization of
to the extent that job loss has become (it was not at the start of this crisis) a home prices.
significant cause of defaults, strong effective measures to eliminate the scary The Home Affordable Modification Program pays servicers
bad news—that is, efforts to stabilize the housing market—will help the
economy recover faster and thus help the employment rate. to temporarily reduce interest payments and to extend the term
32
The implication of this statement is that the HAMP plan of reducing interest of the mortgage in order to reduce the monthly payments on
rates to lower mortgage payments to homeowners who are underwater is, at the mortgage, but does not incentivize servicers to cut princi-
least for those seriously underwater, an invitation or encouragement to act in a pal. Cutting monthly payments by half will temporarily reduce
manner that may make no or little economic sense, that is, stretching to make
mortgage payments, albeit lowered from their highs, on homes those people the homeowner’s payments by the same amount that cutting
will never own when many of them might be able to rent more cheaply. principal by half would. But under the government’s plan, the
cut is temporary, not permanent, and thus is likely to lead to The design of any modification program must recognize
many more defaults in the long run than cutting principal that the servicers have incentives that at times put them at odds
would as soon as the interest rate goes back up.33 In fact, since with bondholders and homeowners, so that they may actually
the homeowner will still be underwater, he will not in any prevent modifications that would help lenders and home-
meaningful sense own his house. He will be less likely to make owners but hurt servicers. In the case of many nonprime
repairs, he will not be able to give the house to his children, he borrowers, the loans have been pooled in a trust, and their
will not be able to sell it if he gets a job in another city.34 In principal has been tranched into many different bonds, each
short, there is every reason to think he will likely default even held by a different investor. The lenders are the bondholders,
before the interest rate goes back up. For loan modifications but they are numerous and dispersed and by contract have
where there is no principal reduction, the redefault rate is given up the legal right to renegotiate with homeowners,
above 50 percent within nine months.35 Indeed, because the delegating that right to an agent.37 That agent is the servicer,
government’s present plan allows servicers to increase who has a fiduciary responsibility to act in the interests of the
principal while cutting interest by adding fees and other costs bondholders in the trust.38 In “normal” times, this
to the old principal amount, the plan is likely to leave more arrangement worked tolerably enough. But in this crisis, with
homeowners underwater than there would be absent the plan so many mortgages in or near default, it has failed miserably for
and others more deeply underwater—that is, with even less at least four reasons, all traceable to a misalignment of interests
chance of ever owning their homes and thus less incentive to between servicers and those whose interests they are supposed
keep up with mortgage payments—than they would have
to protect, which has now ruptured with terrible effects.
without this government “rescue” plan.
First, modifying loans is a time-consuming and expensive
HAMP started off slowly and only recently is beginning to be
operation. The servicers who have the legal right to make
able to process a larger flow of mortgages. In the first six months
modifications do not get paid directly for improving the cash
of the plan, according to the Congressional Oversight Panel’s
flows to loans. It is generally cheaper for them to move into
October 2009 report, only 85,000 mortgages had been modified,
foreclosure. In particular, they have no incentive to set up the
and of those only 1,711 were “permanent” modifications (that is,
huge infrastructure and to hire and train the extra staff
permanent/temporary, since interest rate reductions under the
required to make sensible modifications on a grand scale.
plan are designed to end in a few years), and of those only 5
Second, modifying the loans has different effects on different
involved principal reductions.36 As of May 2010, HAMP had
bondholders. It has proved difficult to modify loans in a way that
started trial modifications on 1,244,184 loans, of which 429,696
pleases everyone. The servicers say they are terrified of lawsuits
had been canceled and 340,459 had been converted into
from the bondholders if their modifications help most
permanent modifications. Again, virtually none of the
bondholders but hurt others. For example, writing down
permanent modifications involved principal reduction. Of the
principal immediately may make more money for the trust as a
5.7 million loans that were delinquent sixty or more days in May,
whole, but it would immediately wipe out the BBB bonds and
only 1.7 million were eligible for HAMP modifications.
possibly other lower level bondholders. Letting the borrowers
33
Haughwout, Okah, and Tracy (2009) find in a sample of pre-HAMP
remain in their houses without paying during the foreclosure
subprime mortgage modifications that reducing principal is twice as effective process means that during all that time all the bondholders,
as cutting the interest rate in terms of reducing the post-modification redefault including the BBB, get their coupons paid in full from servicer
rate.
34
advances. The servicers then recoup their advances, at the expense
See Gyourko and Saiz (2004).
35 of the trust, when the house is finally sold.39 In reality, servicers
See “OCC/OTS Mortgage Metrics Report,” 2Q 2009.
36
To be clear, my criticism of HAMP is not based on the number of the time- 37
limited “permanent” modifications completed, but rather is centered on the It should be noted that this right was given up to avoid the collective action
near-exclusive concentration on interest reduction and, as I explain in the text problems inherent when the lenders are numerous and dispersed, and thus was
below, on leaving the servicers in charge of the modification decision. I could given to a third party (the servicer) to be exercised on the lender’s behalf, the
find no updated information in the report on how many, if any, of the trial or servicer acting as a fiduciary for the lenders. It was not given to the servicer to
permanent modifications involved principal reduction as opposed to interest be used to benefit the servicer’s interests at the expense of the principals (the
reduction, and I have no reason to assume that the percentage of modifications lenders), and using the discretion to modify or foreclose that way is self-dealing
with principal reductions has increased. It is also worth noting that in the on the part of servicers and a breach of their obligation to the lenders.
38
Congressional Oversight Panel’s Report of October 2009 (p. 127), the Panel See Alan Kronovet, “An Overview of Commercial Mortgage Backed
notes that the apparent rise in modifications due to the administration’s plan Securitization: The Devil Is in the Details,” 1 N.C. Banking Inst. 288, 311
might be overstated, as there was some evidence of a “substitution effect,” that (1997), explaining fiduciary duties of servicers. Section 1403 of the new
is, the number of “voluntary” modifications by servicers (or modifications housing bill that was signed into law on July 30, 2008 (HR 3221, the Housing
made outside of the administration’s plan) went down in the first six months and Economic Recovery Act of 2008, P.L. 110-289), lays out the fiduciary
of the plan, suggesting that the gross number of modifications attributable to responsibilities of servicers of pooled mortgages.
39
the plan itself might be exaggerated. The new report by the government does This requires that the servicers have access to capital to finance the coupon
not provide data from which one can assess any substitution effect. payments until the foreclosure process is concluded.

were not deterred only by potential lawsuits. That was revealed far enough.43 The pathology this time is, if anything, more
when Congress passed legislation that freed servicers from distressing. It appears that the banks, abetted by the suspension
lawsuits by bondholders.40 Principal reduction modifications of mark-to-market rules, are unwilling to fully recognize the
did not follow. To put it all another way, there is a complex losses that have occurred on their residential mortgages.44 They
negotiation that is not taking place, and the government needs may prefer to keep a mortgage on their books at $160,000, even
to intervene to break an impasse for the public good. though it will eventually bring them only $40,000, than to
Third, now that HAMP, which is based on interest reduce the principal to $80,000 and mark the loan at this value
reductions, has given the servicers cover to reduce interest today. The suspension of mark-to-market rules has also fed the
instead of principal, they can be counted on to do the former pathology discussed above on second-liens. Perpetuating a
and eschew the latter. Cutting the principal by half, for conflict between the economic value and the accounting value
example, immediately reduces the servicer’s fee by half (since of an asset is bad government policy when it leads to actions
the fee is computed as a percentage of principal), while cutting that further reduce the asset’s value. This conflict is also
interest does not. Moreover, cutting principal increases the obscuring the value of bank assets, many of which are being
likelihood that the homeowner will sell or refinance, which guaranteed by the government, and thus in turn obscuring the
would cause the servicer to lose his fee entirely. value of mortgage assets now owned by the government. In my
Fourth, the biggest servicers happen to be owned by the terms, this only ensures the continuation of “scary bad” news
biggest banks, which in turn own a huge number of second-lien (uncertainty), when the goal should be for government plans to
loans. Cutting principal on first loans almost implies cutting the clarify the situation (the value of assets) that keeps leverage
principal drastically, if not to zero, on second loans. But that severely constricted.
would mean that the banks could no longer hold the second- Insuring that economically efficient mortgage
liens on their books at potentially inflated prices. The banks want modifications are made for borrowers can be greatly facilitated
desperately to postpone the write-down of those second-liens, by placing the decisions with impartial agents. In October 2008,
which is to say, they have yet another powerful motive not to do Susan Koniak and I urged the government to take the
what is in the interest of lenders, homeowners, and the economy reworking process out of the hands of the servicers and put the
as a whole: reduce principal on the first-lien loans they are decision into the hands of government-hired trustees. In our
servicing. By contrast, cutting interest on first-lien loans makes it approach, the government-hired trustees would be told only
easier to justify carrying the second-liens on bank balance sheets about the homeowners, and would be blind to the bonds built
at higher values for the near term (which is what matters to the atop the loans. Their job would be to choose modifications or
foreclosure, whichever they judged would lead to the greatest
banks), as homeowners are more likely to be able to make the
recovery for the lenders on the original loan. They would thus
lower monthly payments (from lower interest rates) than their
be carrying out the duties of the servicers exactly as they were
original payments, at least in the short run.41
intended, but free from the conflicts of interest and perverse
Another indication that servicers have bad incentives is that
incentives that have prevented the servicers from carrying out
when the big banks hold the same kind of loans in their private
their mission.45
portfolios, they do reduce principal. During the second quarter
If there is a second-lien loan, the government trustees would
of 2009, 30 percent of all modifications done to loans directly
make the same calculation, deciding what modification, if any,
held in bank portfolios involved some principal reduction.
would maximize total revenue. If this involved reducing
During that same quarter, the servicers reduced principal on
principal, then the second-loan principal would be reduced to
0 percent of their loan modifications, as did the government-
owned agencies Fannie Mae and Freddie Mac.42 43
At first, it appeared that they were not being written down at any greater rate
Loans that have not been securitized and are held entirely than securitized loans, although the data are not perfect on this. Foote et al.
(2009) argue that this showed there was no real incentive to write down loans.
by banks (whole loans) are also not being written down fast or
Now, again based on imperfect data, there seems to be some evidence that
principal on whole loans, at least at some banks, is being written down more
40
See Section 201 of the Helping Families Save Their Homes Act of 2009, often than principal on securitized loans (which effectively never see
preventing lenders/bondholders from suing servicers who modify mortgages reductions in principal), although reductions in principal on whole loans are
under a qualified mortgage modification plan, which is defined in the Act still much less frequent and much less widespread than one would expect to see
broadly enough to include all economically sensible modifications, that is, given the economics of the situation, that is, that reducing principal for many
those with a reasonable prospect of returning more money to the lenders than underwater homeowners will yield much more money than foreclosure or
a foreclosure. (over the long term) interest reductions.
41
Cutting the monthly payments will also push the likely default further into 44
Banks may also still be holding out for some more direct government subsidy
the future. Under current accounting rules, this reduces the loss reserves that for their failing whole loans, either through government assumption of the
the banks have to hold against these loans. mortgage risk or some other form of direct payment for anticipated whole loan
42
See OCC/OTS Mortgage Metrics Report, Q2 2009. losses.
zero. The second-loan holder could still receive some cash, experts and community bankers in place as government
however. I would recommend distributing the same percentage trustees, not bankruptcy judges who are neither numerous
of the monthly payments to the second loan as it was getting enough to handle the number of defaulting homeowners who
before principal was reduced for a period of, say, two years. should justifiably qualify for principal reduction nor as
After that, the second loan would be completely extinguished knowledgeable as the personnel I would put in charge.47 If my
and all cash flows would flow to the first-loan holder. plan were indeed up and running, bankruptcy might be
For a vast number of homeowners now upside-down in something worth considering as a true last resort for those
their mortgages, that is, owing more than their home is already deeply in default. Finally, bankruptcy involves all kinds
presently worth, this process would likely result in a reduction of hidden costs, like lawyer fees and trustee expenses (on top of
of principal. Why? Because reducing principal rather than the costs associated with the experts required to advise the
cutting interest rates would be more effective at preventing bankruptcy judges) that are unnecessary and wasteful for the
defaults and would yield investors/lenders more money than vast majority of homeowners and lenders who should be able
foreclosing, as we have seen.46 to make a win-win deal without incurring those costs.48
If the government handled this correctly, most homeowners My original plan called for legislation to cut through the
who were unable to pay the original loan but were willing and able agency-problem mess in securitized pools of mortgages by
to pay a modestly lesser amount would get to stay in their homes, eliminating contract provisions in pooling arrangements that
the bondholders collectively would get more payments than they now enable servicers to act contrary to the interests of the
are currently expecting (though some tranches would be hurt), investors that the provisions were originally designed to
and the government would not have to invest any capital. protect. Thus, I envisioned that the government trustees would
This plan is not the same as “cramdown” in bankruptcy, only be empowered to modify securitized mortgages. This
which Congress has thus far rejected and which entails costs would leave unsolved the problem of whole loans that banks
and creates some perverse incentives that my plan avoids. are still refusing to modify sensibly, by writing down principal
Giving reductions in principal through bankruptcy (assuming for underwater homeowners.
the law were changed to allow that) would encourage I believe, however, that once a government program of
homeowners now current on their mortgages but underwater modifications for securitized loans proved its worth by
and thus likely to default sometime in the future to default resulting in more recovery for investors, banks would be likely
immediately to support their petition for bankruptcy relief. to adopt similar standards to modify whole loans. Nonetheless,
However, my plan, as originally conceived, does not build in a solid government plan to force sensible principal reductions
any incentives for the borrower to default in order to increase for securitized loans would, I believe, go a long way toward
the chance that the mortgage will be modified. Principal convincing the banks that no better deal from the government
reductions would be done first for homeowners who have not was forthcoming, particularly if the government clearly
defaulted yet, and only later for homeowners who have articulated that this was so, and would exert discipline on the
defaulted under some special hardship. It would give valuation of the whole loans and second loans on the banks’
underwater homeowners now holding on for the short term a balance sheets. Obliging the banks to mark to market would, of
continued incentive to keep paying until the government course, also push them to get the most value out of their loans
trustees could evaluate their loans and circumstances for a by writing down principal for underwater homes.
reduction in principal. Second, my plan differs from Finally, what if home prices vastly appreciate by the time the
bankruptcy in that it does not subject homeowners to the homeowner sells his home? To prevent unwarranted windfall
shame and devastating harm to future credit and thus to their profits to homeowners, the government plan could easily
economic circumstance that a bankruptcy proceeding entails. require the homeowner to share 50/50 with the lenders any
Third, my plan contemplates putting local housing market appreciation in home price up to the full amortized value of the
original mortgage, and the plan might even provide that, for
45
See Geanakoplos and Koniak (2008). Under this plan, the servicers would houses sold for more than the original loan price, lenders
still collect the servicing fees they do now. They would continue their duties of receive a greater percentage of the appreciation.
sending letters to homeowners, collecting the monthly payments and
47
distributing them to bondholders, evicting homeowners who did not pay, Indeed, it is highly doubtful that our bankruptcy courts could handle the job
selling their homes, and so on. The only change is that the mortgage loan Congress would be giving them if so-called cramdown legislation were
modification would be taken out of their hands and put into the hands of the adopted, at least not if it were adopted without first having a plan like the one
government trustees. This reassignment of a particular duty in the contract is I propose up and running to handle the vast majority of underwater
not a “takings” from the servicer, among other reasons because the servicers homeowners.
have failed to carry out their fiduciary obligations to the bondholders who 48
My plan envisions the government paying for the trustees (community
employ them to get the most possible value out of the loans. See Dana bankers) to decide on whether principal modification would bring in more for
(forthcoming). bondholders than foreclosure, but I estimate that government expenditure
46
See Haughwout et al. (2009) for evidence based on subprime modifications. should come to less than $5 billion.

A Floor to Housing Prices and Restarting Private the low down payment lending practices that got us here. It
Lending on Mortgages: Government Equity Stake exposes the government to a huge risk of default, and does
in Homes nothing to stimulate private mortgage lending.50
The government has also tried to stabilize housing prices
There are at least four reasons to support housing prices
through its efforts to keep mortgage interest rates low and
directly, in addition to doing so through effective foreclosure
thereby encourage purchases and refinancing. To this end, the
relief. First, if housing prices held firm, fewer homeowners
Federal Reserve’s Large-Scale Asset Purchase program has
would be underwater; thus, more would have an incentive to
purchased $1.25 trillion of agency mortgage securities. Like the
make their payments. That would keep them in their homes.
HAMP modification program, this choice reflects once again
Second, firm housing prices would staunch the losses on
a concentration on interest rates rather than on the collateral
mortgage securities even if there were foreclosures. Third, once
(leverage) effects that are at the core of my argument. The
there is a floor to housing prices, pessimistic lenders would be
Large-Scale Asset Purchase program appears to have lowered
relieved of the disaster scenario for many mortgage securities,
mortgage interest rates, but surprisingly few homeowners were
and margins on mortgage securities would come down
able to take advantage of the lower rates by refinancing because
significantly, enabling optimistic buyers to purchase them
they could not come up with a down payment and/or their
using leverage, pushing up the price of mortgage securities.49
credit had deteriorated.51 One might worry that as the
Fourth, the leverage cycle is less severe for housing than
purchases wind down, mortgage rates may go back up.
for mortgage securities, so it can be fixed more easily by
A third government initiative is to give an $8,000 tax credit
government intervention, because home buyers generally lock
to buyers of homes. This tax credit does appear to have been
in their loans and leverage for the duration of time they live in
more successful at stimulating home purchases. But the tax
the house. Only new buyers of homes, and those who want to
credit has no upside for taxpayers and it does nothing to
change homes, need to confront the tougher margins. Existing
reinvigorate private lending since most of the new mortgages
homeowners cannot be forced to put more money down,
were guaranteed by the FHA. If $8,000 were spent on 7 million
whereas mortgage security holders who borrowed on one-day
homes, the cost to taxpayers would come to $56 billion. By
repos have found that they now face tougher margin require-
contrast, the equity stake plan I propose below is a purchase of
ments that involve putting more money down. Thus, there are
value for value; in the long run, it may cost nothing and actually
fewer homes in play than there are mortgage securities.
have upside for taxpayers. It should also stimulate demand, and
The government has recognized the need to try and support
it would reinvigorate private mortgage lending.
housing prices. A concern is that the measures taken will As I observed earlier, toughening margins have affected
expose the government to the risk of billions of dollars of future housing prices, because many homeowners can no longer put
losses, in addition to substantial current costs, while leaving up the cash payment needed to buy new homes. New
private mortgage lending dead in the water. We simply cannot homeowners are being asked to put as much as 30 to 40 percent
sustain a situation where all mortgage lending is done by the down if they cannot get a government loan. The government
government. The plan I propose helps to stabilize housing could stimulate demand for new purchases, and also mitigate
prices and to reinvigorate private lending. And in the long run, the margin problem, by offering to buy a 20 percent equity
it may cost the government much less, possibly even making stake in any new home purchase (under some maximum price,
money. as with agency conforming loans). Thus, suppose a house is
Current government FHA policy is to make mortgage loans purchased for $100. The government pays $20 and gets a
with as little as 3.5 percent down. In addition, borrowers can 20 percent equity piece, which it collects whenever the
finance some of their closing costs as well as the up-front homeowner sells. If down the line, the house sells for $200,
mortgage insurance premium. As a result, the effective LTV on the government gets $40. The government is thus earning the
new FHA mortgages can exceed 100. These homeowners start home price appreciation on its piece, without having to bear
with little incentive to continue making payments, particularly the expense of maintaining the house. The homeowner gains
in rough economic times. Given the transaction costs of selling
50
a house, absent a rise in housing prices these borrowers will For more on FHA risk, see Aragon et al. (2010).
51
See Caplin, Freeman, and Tracy (1997) for a discussion of down payment
remain underwater and thus create a new source of future
constraints on refinancing and Peristiani et al. (1997) for a discussion of credit
defaults. This policy is a repetition (albeit on a smaller scale) of constraints. To address this concern, the administration started the Home
Affordable Refinance Program, which allows borrowers with prime mortgages
49
As I discuss below, margins must in the future be monitored by the Federal to refinance with current LTVs as high as 125. In addition, the FHA introduced
Reserve to assure that they do not once again get excessively low, precipitating a “streamline refinance” program for borrowers with high-LTV FHA loans to
another massive and dangerous leverage cycle. refinance to a new FHA loan.
because he gets to live in the whole house while paying for only 5.2 Step Two—A Fed Lending Facility
80 percent of it. If the home buyer needs a loan to get the house, to Help Restore Reasonable Leverage
the government equity piece reduces the down payment the
buyer must make, and the ongoing mortgage payments he The most easily implementable step and the second priority,
must make. And if we make the government’s equity piece after addressing the source of the uncertainty (the scary bad
the second loss piece, it leaves the lenders in a very, very safe news), in responding to the final stage of any leverage cycle
position, encouraging lending. In effect, it lowers the margin could be government action to decrease astronomical collateral
to the borrower, and raises the margin of safety to the lender. rates. Thus, in October 2008 I suggested that the most
Here is how it works.52 immediate step the Federal Reserve could take was to lend
Under the plan, the home buyer who wanted a loan to money using the so-called troubled assets (those that suddenly
purchase the house would be allowed to borrow at most became nearly impossible to use as collateral, as I explained
80 percent of the $80 of the house he bought, or $64. He would earlier) as no-recourse collateral. I suggested 50 percent
have to put up 20 percent x $80 = $16 of his own cash. The margins on average, a reasonable halfway level between the
homeowner would then have a big incentive to make his 5 percent margins required at the peak of the leverage bubble
payments. If he walks away from his debt, he can save $64, but and the 70-90 percent margin rate demanded in 2008. The
he has to give up living in a $100 house on which he had an $80 Asset-Backed Securities Loan Facility (TALF) and the Public-
ownership share. But if the borrower does default, and if the Private Investment Program (PPIP), announced in early 2009
lender has to foreclose, the lender would be able to collect his at what turned out to be the bottom of the price cycle, embody
debt out of the house sale proceeds ahead of the government the spirit of my recommendation. Indeed, the PPIP did lend on
equity piece. The government would collect next, and lastly the these bonds at exactly 50 percent margins. The turnaround of
buyer would get any leftover cash. If the house sold in
prime mortgage security prices (displayed in Chart 2) after
foreclosure (net of expenses) for $82, the lender would get his
these programs were announced seems to me to be some
$64, the government would get $18, and the homeowner
evidence for the wisdom of the intervention. But in terms of
nothing. The effective margin for the homeowner is thus
some important details, those programs did not go as I would
16 percent on the asset price of $100, but the margin of safety
have recommended. In any case, it now appears that having
for the lender is 36 percent. This should make the lender feel
achieved their purpose, they have been drastically attenuated.
very safe and encourage private lending on mortgages. The
Lending with smaller margins (haircuts) than the market is
homeowner’s down payment of 16 percent on the total home
willing to offer to borrowers who might not repay is a great
price is about half the down payment many nongovernment
departure from the traditional role of the Federal Reserve. The
lenders are demanding now. On top of that, the new buyer’s
orthodox view is that the Fed injects liquidity into the system
mortgage payments would be 20 percent lower than before,
by lending money to banks and others with impeccable
because he would be paying on a loan of $64 instead of $80.
reputations for repaying so as to reduce the riskless rate of
What about the costs of my plan? Last year, there were
interest on very short-term loans. The banks would then
5.5 million new home purchases, down from a high of 7 mil-
presumably turn around and relend that money to investors, at
lion. Even if the government had to buy the equity in the entire
a lower interest rate than would have obtained absent the Fed’s
7 million, at an average home price of $200,000, it would cost
intervention. However, the great bulk of lending in the
$280 billion. But the government would own equity, and be
investment world is not based on the reputation of the
protected by the homeowner’s down payment. Housing prices
borrower but based instead on the value of the collateral. The
would need to fall another 16 percent before the government
lesson of the leverage cycle is that when lenders demand too
lost equity value. As housing prices stabilized, the government
much collateral for their loans, liquidity dries up. The Fed
would gradually phase out the program, in all likelihood in a
cannot undo this by making riskless loans at a lower interest
year, at most two, after adoption. To lower the government’s
rate than the market, because in liquidity crises it is not the
overall equity investment, the program could be limited to
interest rate the banks charge that impedes investor borrowing
first-time home buyers.
but rather the amount of collateral they require. The Fed needs
to step around the banks and make risky loans directly to
investors with smaller haircuts than the market demands, if
it is to have the desired effect.
52
Equity sharing arrangements could also form with private investors. For a The mechanics of such a massive lending program require
discussion, see Caplin et al. (1997). some careful thought, but nothing compared with the

difficulties of directly buying. The Fed could simply announce guarantee a certain percentage of the principal payments.
that any arm’s-length buyer of any designated security could, at Private lenders could then lend this much without any risk of
the moment of purchase, take that security to the Fed and default. Of course, on some securities the government might be
receive a five-year loan of 50 percent of the price in exchange able to lend much more than 40 percent and still regard the
for putting the security up as collateral. The Fed would not money as safe.
need to price the security itself. The market would have just At 50 percent margins, buyers would be able to purchase
done the pricing. With a 50 percent margin, the government securities using only half the cash they need to put up at the
money is still quite safe. Remember, the 50 percent loan is bottom of a cycle when margins might become 100 percent.
against the price the securities will be traded at, not against the Aside from allowing investors’ own cash to go further, this
original price when issued. The government could thereafter borrowing allows investors to earn leveraged returns. If they
monitor prices, periodically demanding more cash from the think the security trading for 60 might only rise to 66 in the near
borrower to maintain its 50 percent margin, which would make future, they can buy it with 30 down and earn a return of
the government lending safer and more responsible.53 20 percent when it rises to 66 instead of a return of 10 percent.
Monitoring the collateral price is a much easier job than Buying will be stimulated and the depressed prices at the
deciding the price to buy, since there is a 50 percent margin of bottom of the leverage cycle will be pushed back up. Again, with
error: the price monitoring only has to be half right. And the this potential for private profit, the program would make more
government could consider charging a slightly higher interest political sense if a somewhat higher interest rate for the loans
rate than the fed funds rate or discount rate, thereby potentially were charged, thus building in a real chance for taxpayer profit.
making a profit for taxpayers. That would also make the Lending is better than the government’s first (and quickly
program easier for the public and politicians to accept. shelved) idea, as proposed by former Treasury Secretary Henry
Needless to say, the 50 percent margin cannot be applied Paulson, of buying up the “troubled assets.” As I explained in
to all bonds. Some bonds have such high volatility in their October 2008, lending against collateral does not require the
cash flows that even a 50 percent margin is unsafe. Other government to choose what prices to pay, as it would have to if
bonds can safely be leveraged much more. The Fed must the Treasury directly bought securities. Moreover, lending,
exercise its own expertise in setting these margins, as I discuss unlike buying, is direct action to restore leverage and restoring
later. But in a crisis, they should be set at levels substantially leverage is the thematic solution to the leverage cycle crisis. It is
more generous than the market is offering, and significantly not some stop-gap band-aid invented only under the pressures
less generous than the market had been offering in the of the moment.
ebullient stage before the crisis. Further, lending puts taxpayer money at far less risk than
The five-year term can also be chosen flexibly. But it is buying does. Assuming the Fed lends at 50 percent margins,
important that there is a longish term commitment to every dollar the government lends using the targeted assets as
borrowers that the loan will not be pulled from under them. collateral will necessarily be matched by money the investor
The last thing a buyer wants to do in a crisis is leverage to buy spends on those assets. The government can say its money is
and then have his financing pulled, or his margins increased. Of being leveraged. The investors who avail themselves of the
course, the Fed needs to worry about its exit strategy; if it lends government lending will still have their money at risk. Because
too much money long term, it will not be able to reel it all back these investors, and not the government, will do the buying,
in should inflation pick up. However, by lending at margins there is little, if any, chance that this action will push prices
and interest rates that are favorable in the crisis but that
to outrageous levels and enrich undeserving sellers.
borrowers will find onerous once markets pick up, and by
The Fed has boldly gone a long way in this direction, further
making margin calls, the Fed can count on most borrowers
than any previous Fed. Through the TALF and the PPIP, the
refinancing their loans privately once the market heats up.
Fed and the Treasury, respectively, have indeed embodied
The government might even arrange all this lending without
many of these ideas. The PPIP lends at 50 percent margins
having to come up with the money. Under this alternative, the
on troubled mortgage securities, just as I recommended. Its
government could loan slightly less, say, 40 percent, and give
announcement, I believe, played a pivotal role in starting what
up the right to make margin calls. The loan could then be
is now more than a year-long rebound in security prices. Given
securitized, guaranteed by the government, and sold off to the
the condition of the asset markets in early 2009, the rebound in
private sector. With the government guarantee, the money
prices seems almost miraculous, and in many ways one must
would easily be raised. Or even more directly, for some bonds
judge the TALF/PPIP a resounding success.
where this makes sense, the government could simply
Nevertheless, I believe that the Fed-Treasury leverage
53
Even if the securities gradually lost all their value, the Fed would still not lose intervention would have been better if it had been
any money if it made frequent margin calls. implemented somewhat differently. This difference is
important to bear in mind not just for this crisis, but also in leverage on the new securities at astronomical 20:1 ratios. If
case there is another crisis in which prices do not rebound as instead the Fed would give much lower and safer 2 to 1 leverage
quickly after a leverage intervention. In my opinion, the two on the legacy assets, it would raise the legacy asset prices, and
programs did not encompass a wide enough set of assets or a thus even the new security prices, because it would remove the
wide enough set of borrowers, they took too long to get going, bargains investors are seeking in the legacy assets.55 The new
and in some cases TALF actually took leverage up almost to the assets would not need so much leverage, and the risk to the
crazy levels it had been before. Had TALF started earlier, and taxpayers would be reduced. This would also go a long way to
had it lent on more assets, it would not have been forced to give solving the bank lending problem. As I show again in
such high leverage on the narrow band of assets it did lend Geanakoplos (2010) (in a stylized example, to be sure), despite
against. lending on a much larger scale, by allowing leverage at 2 to 1 on
In the emergency stages of the leverage cycle, the Fed should a wide array of assets rather than at 20 to 1 on a narrow set of
have extended lending on more kinds of collateral. TALF assets, the Fed could actually reduce its expected defaults while
restricted leverage mostly to new securities, or to securities that increasing the prices of all the securities. A year later, it now
were still AAA-rated. As more and more mortgage securities appears that the Fed will not face significant losses on these
get downgraded below investment-grade status, they lose their TALF loans, and private leverage is also returning. But had
ability to be used as collateral even in the private sector. things gone worse, the Fed might have been stuck with some
Lending against the most toxic securities is actually necessary to dangerous loans.
maintain their value.54 In the crisis stage, the Fed needs to go around the banks and
The TALF program made government loans on new credit lend directly to more investors. In theory, the Fed could make
cards, auto loans, college loans, and other securitizations at 20 no-recourse loans only to a few banks, who would turn around
to 1 leverage. In my opinion, this repeats the error of the FHA and relend to everyone else. But the banks are nervous about
mortgage program, lending at the same inflated leverage that showing too much lending on their books, they ask for too
got us into trouble in the first place. The Fed has rightly much collateral, and now the Fed is giving them more
observed that propping up new security values is more profitable ways to make money than by lending; so the Fed
important than propping up legacy security values, because must reach out directly to more borrowers. Curiously, the PPIP
new securities represent new activities. When new prices go has been restricted to ten potential borrowers/investors,
down, new securities are not issued and the underlying activity making its scope and size in the end less than what was
for which the securities would be issued (students going to anticipated. Also, with only ten investors taking government
school, cars being purchased, new houses being built, money, the potential for conflicts of interest seems very high,
consumers buying with credit cards) stops. However, as I argue as I discuss later.
more formally in Geanakoplos (2010), in the depths of the The TALF and PPIP programs took too long to get up and
leverage cycle, the Fed could raise the price of new securities running. Hopefully, at the bottom of the next leverage cycle, or
further by leveraging them less, if it would also leverage the even earlier, similar programs could be implemented sooner.
legacy securities to modest levels. The reason is that potential I recommend that the Fed keep a standing, permanent lending
buyers of these new securities are tempted instead to put all facility up and running. In normal times, it would lend a little
their capital into the depressed legacy assets where they are bit across a wide range of assets, to be ready to spring into
nearly sure of a high return. This indeed is one of the main action if private collateral rates became too high. This facility
reasons banks stop lending to businesses or homeowners: they could be administered directly by the Fed, by people it hired, or
can get better returns by buying depressed legacy assets. Given it could be run through the repo desks of the Wall Street banks.
the depressed legacy security prices, the only way TALF could In the latter case, it would be wise to insist that the banks put
redirect this private money into new securities was by giving some of their capital at risk along with the Fed money. The
advantage of using repo desks is that they are already staffed
54
Again, such lending would be much less risky if the government had adopted with trained personnel, who have great expertise in making
a sensible plan to staunch foreclosures and stabilize housing prices, such as I margin calls. Duplicating that expertise would be expensive.56
have just outlined, because such a plan would reduce the toxicity of the The advantage of a permanent facility is that the Fed would be
securities at issue. And the quicker the government moves to do that, the less
risky such lending will become, not to mention the good it would do for the ready to quickly lend on a grand scale, on many securities, and
value of the toxic securities the government now owns through one program to many lenders, in the next crisis.
or another or now guarantees, representing continuing and enormous
55
government money still at considerable risk. This point is why I stress the Another reason why it actually could raise new security prices is that by
importance of understanding the nature of the crisis in crafting sensible leveraging the legacy securities at 2 to 1, it will free some investor equity to put
solutions and how failing to address one part of the problem, in our case the into the new securities.
56
failure to adequately address housing, limits the good that otherwise sensible I presented this proposal for a lending facility to the Liquidity Working
programs might make. Group at the Federal Reserve Bank of New York in early 2009.

5.3 Step Three—Restoring “Optimistic” Treasury might want to intervene, as the Fed did last year, on a
Capital case-by-case basis. But, if that approach is used, important
issues are the degree to which the shareholders have to give up
Lending will not by itself bring the prices of assets to their old their shares and the bondholders lose their value, and whether
levels (which is okay, given that “old” values were inflated by new management should be put in place. Even in cases where
excessive leverage, as I have explained). But that means that the old management is not that old, that is, cannot be reasonably
most optimistic buyers, unfortunately including some of the charged with responsibility for all the excess, replacing
biggest and most prominent financial institutions in America, management may be wise, if only to help bolster public support
have irretrievably lost a huge amount of capital. Not only is for the government’s actions and expenditures of taxpayer
their capital no longer available to spend on these securities, funds. It is also imperative that the government decide as
but similarly the money they borrowed to spend on these quickly as possible after a crisis presents itself (and on grounds
securities has also disappeared. that can be explained as fair and objective), who it will let fail,
The most obvious thing the government could do, it did: and then coordinate an orderly liquidation. Quite possibly the
inject money into financial firms. The idea was that then the biggest public relations risk the government runs in the bottom
firms would continue to function as optimistic buyers and their of the leverage cycle is to appear to be bailing out ailing firms
workers would not join the ranks of the unemployed. But the on too generous terms.
main problem with the way the government injected capital is If instead of injecting funds into an ailing firm the
that this injection of capital was not coordinated with vigorous government takes it over, it must quickly decide what it will do
programs to address the two other prongs of the end of any with the creditors. Once it guarantees their debts, there is no
leverage cycle: the source of the scary bad news (here, housing) turning back when the full extent of the firm’s asset value
and the precipitous drop in leverage, which I have just becomes clarified. In the case of AIG, it now appears that the
addressed in my discussion of Fed lending. government will lose much less money than was initially feared.
In the absence of vigorous programs to address the first two But in the case of Fannie Mae and Freddie Mac, where the
prongs of any leverage crisis, injecting capital does nothing but stakes are orders of magnitude bigger, we still do not know
push an ultimate reckoning down the road. Without steps one what the government losses will be. It is conceivable they may
and two, the true financial status of our financial institutions approach $1 trillion, though that does not seem likely at the
is unknown and unknowable because there is no reliable way moment. This is another reason why steps one and two are
to price many of the assets they hold. The danger is that the urgently needed at the very outset of the crisis to clarify prices.
injection of new capital keeps the banks from failing immedi-
ately, but it is not enough to restore their previous activities,
leaving them in a kind of limbo and actually creating more
Government Purchases of Assets
uncertainty in the system about whether they will survive. As
long as no one knows whether and to what extent our biggest The government could replace the lost optimistic capital by
financial institutions are sound, our economy cannot recover. buying distressed securities directly. In effect, the Treasury
would take conservative and pessimistic taxpayers’ money that
would never be invested in these securities, and invest it there,
assuming, of course, that it did so with the expertise necessary
Bailouts with Punishment to make reasonably sound judgments on which securities to
After a double leverage cycle as outsized as we have just been buy and how much to pay for them. This was the plan that
through, it is likely that even with a lending facility established, Secretary Paulson originally proposed.
and capital injected properly into the system, some, maybe Government buying plans are a risky approach—riskier
many, firms would still fail. In general, that is what we should than the steps I have laid out above—and thus, if ever used,
want. The government cannot afford to make good must be implemented with extreme care. An argument that is
everybody’s debt. Some debtholders must lose when a financial often blithely made for government buying is that when
system is allowed to become bloated by artificially high prices security prices are terribly depressed in “fire sales,” the
maintained by excess leverage from the ebullient stage of the government might make some good investments. It is likely,
leverage cycle. In the ebullient phase of this cycle, too many the argument goes, that the general taxpayer is too
people were drawn into the financial sector by the resultant conservative, and by transforming pessimistic capital into
artificial profits. Failures will remove many of these excesses. optimistic capital, the government might even be directly
But what if those institutions are seen by the government as, helping the taxpayer, while at the same time staunching the
in current jargon, systemically important? For those firms, the collapse of security prices.
Forcing natural pessimists into purchases they fear, however and returns of these companies very public. These managers
much potential financial upside, may well undermine public would then be competing with each other on a world stage to
confidence in government, especially if the investments start to see how their investments performed. A more conventional
go bad. But even if taxpayers were on board, caution should be incentive device would be to say that a manager gets no fees
the watchword. The lending mentioned earlier (a much more until the return on the assets passes some hurdle. Only after the
direct approach to restoring leverage) would probably raise taxpayers make money would the managers earn any fees.
security prices, so the government purchases would not be at The PPIP embodies a number of the same principles I
rock-bottom prices. Private investors (naturally more agile and advocated. Under the PPIP plan, the government has set up
quicker than the government), knowing that the government accounts with professional money managers in which each
would be buying, would rush to buy first, reducing potential government equity dollar is invested side-by-side in the same
government profits. Of course, that, in some sense, would be securities with a dollar of investor capital. (This is in addition
what the government would want to happen because it would to the money loaned to the managers.)
mean that security prices would rise more quickly. But it might Should another crisis arise, the government must be aware
also result in taxpayers getting stuck with the worst assets, of the pitfalls of a large government buying program. The
causing public outrage and charges of foul play. government cannot appear to the public as enriching the
The biggest obstacle and the one that apparently stopped managers it entrusts with its money with fees that are too high.
Secretary Paulson’s original plan to buy the troubled assets is However, they must be given incentives to perform well.
the enormous challenge of deciding what to buy, and at what Otherwise, they might be tempted to spend taxpayer money
price. We must not forget that the downward swing in the buying portfolios sold by the failing companies of their cronies,
leverage cycle is always triggered by genuine bad news, which I in exchange for favors later on. Or they might pay less attention
call scary because it creates more uncertainty. Private investors to the government investments than to the investments of their
hold back for fear of “catching a falling knife”; the government fee-paying clients. Or they might buy for the government with
has far less expertise than these private investors. Since the an eye toward benefiting their private clients by raising prices
distressed mortgages are very heterogeneous, it is not at all clear of assets the clients hold, or in some other way. These conflicts
how the government acting alone could figure out what prices of interest become more acute to the extent that the number of
to pay. Indeed, since Secretary Paulson’s call for government managers is small and to the extent that they each have a huge
purchases of distressed securities, a large number of them
amount of government money to wield. For example, a big
(including most CDOs) have continued to lose value, with
enough buyer with government money could conceivably offer
some even going to zero. In retrospect, a program of
to rid a bank of toxic assets, at favorable prices, in exchange for
indiscriminate buying might have been a disaster. But how
favors like easier credit later on.
could the government decide what to buy, and at what prices?57
Another potential pitfall in government buying is the
The dangers of government buying look so profound that in
perverse incentives it might set up among sellers eager to get
October 2008, I recommended that if the government were to
their securities purchased. For example, it may be that the
buy at all, it would be better for the government to invest
banks were waiting for the government purchase not just of
through professional money managers, again piggy-backing on
securities, but shaky whole loans too, and that hope may have
the choices they make to invest their own capital.58 To help
contributed to their failure to modify whole loans in a rational
ensure that money managers had the right incentives, I also
manner.
recommended dividing the government money up among a
Thus, even with all the advice I have offered about how the
large number of private managers and making the investments
government should buy if it must, buying may still not be a
57
One suggestion that was made is by reverse auction. The government would wise policy, particularly not as a substitute for an adequate
divide the securities into different categories, and then buy from each category lending program, such as I described above.
those securities that the current asset holders are willing to sell for the lowest
price. But how would the government decide what the categories are and how
much to spend on each? And how would it be protected from sellers’ efforts to
unload the worst securities in each category? If the purchases were to be made
by an auction mechanism, I would have suggested a variation in which private
bidders were allowed to enter the auction, not just private sellers. I would have 6. Moral Hazard
recommended that the government commit to buying half the winners’
purchases, at their winning prices. That way, the government could ride on the It is often said that with every bailout comes a moral hazard
expertise of the private buyers. Still, even that solution could be gamed, that leads to a bigger problem the next time. The problem
particularly given that some private buyers might hold other positions—I am
thinking of CDS here—that made it worthwhile for them to overbid in a
would be that bailing people out in this crisis would lead to
manner that might not be easy to deter or discover. higher leverage in the next cycle. There really is only one
58 reliable antidote to that, and that is regulation of leverage.
See Geanakoplos (2008).

One observation, which appeared in Geanakoplos and I discussed at great length in Sections 3 and 4 how CDS
Kubler (2005), is that general systemwide interventions, like contracts provide an opportunity to leverage, so these must
restoring sane leverage, in the crisis do not always create be monitored as well. Putting them on an exchange would
deleterious incentives in the long run. Surviving a crisis means facilitate monitoring, as well as netting and ensuring enough
tremendous profit opportunities in the good phase of the next collateral is posted. All too often CDS insurance buyers allowed
cycle. If a systemic intervention gives prudent firms a chance to the writers of insurance to get away without actually putting up
survive, rather than everyone going under, those firms will the collateral. Repo lending too must be reorganized so that
have an increased incentive to be prudent. Bailouts that rescue borrowers are protected in case the lenders go bankrupt and
firms, no matter how imprudent they have been (in fact, swallow up the borrower’s collateral.
precisely because they in particular were imprudent), are the Transparency about actual leverage could bring a great deal
source of moral hazard. of discipline to the market, and warn investors of impending
Some have suggested that writing down principal on trouble. In my earlier leverage charts, one can see the
mortgage loans will also cause moral hazard. They say it will tremendous spikes in margins during the crisis stages of the last
encourage homeowners to behave badly, and the government two cycles. One can also see a drift down in haircuts in the
to intervene in too many markets, and threaten the sanctity of ebullient stage of the last cycle.
contracts. I disagree, because the writing down of principal But transparency alone is not enough. Some investors will
could be done as a function of the decline in some index of not curtail their leverage, no matter how much scrutiny by the
housing prices. The index is beyond the control of the public, and how far out of line with recent practice they
homeowner, so it does not distort homeowner incentives. become. Put bluntly, the market alone will not take care of
Moreover, it could be done first for homeowners who have not outsized leverage. It is thus imperative that the Fed put outside
defaulted yet, and only later for homeowners who have limits on leverage. It will still be necessary to regulate leverage.
defaulted under some special hardship. It could only be done, The lesson of the leverage cycle is that there are many
as I have said, if it promises to bring more money to the lenders. externalities (eight that I listed), and we should always expect
A good test of whether it is a good idea is whether it would be cycles of too much leverage followed by too little leverage.
written into the contract in the first place if people had thought The most direct way to regulate leverage might be by
of the possibility of this much home price decline. I agree with empowering a “leverage supervisor” who could simply forbid
Shiller (2008), who suggests that just these kinds of mortgages, loans at too high leverage in ebullient times, setting different
with principal automatically reduced if some housing index leverage limits for different security classes. Banks would
falls enough, could and will likely become the standard simply not be allowed to lend 97 percent of the value of the
mortgages of the future. house, and repo lenders would not be allowed to reduce
haircuts too far.
Many people have argued that setting margin limits is
difficult because securities are so heterogeneous. But I believe
7. Managing the Ebullient Stage this problem will eventually be solved once the haircut data
of the Leverage Cycle history becomes more public. It was not obvious how to
manage interest rates either. But little by little, the Fed has
After this crisis passes, we must prepare for the next leverage gotten better at it. The same will be true with leverage. The
cycle. The first step is to constantly monitor leverage at the combination of security leverage data, investor leverage data,
securities level, at the investor level, and at the CDS level. CDS leverage data, and asset price data could give the Fed
Every newspaper prints the interest rates every day, but tremendous information for managing future leverage cycles
none of them mentions what margins are. The Federal Reserve that it did not have, or chose to ignore, in this and in past
needs to settle on a menu of different security classes, monitor leverage cycles. The critical thing is that with the data in hand,
their haircuts daily by talking to all the big lenders and the Fed will be able to monitor dramatic changes in leverage
borrowers, and then make averages public on a regular and asset prices, and therefore will easily recognize when we are
schedule, say every month or quarter. reaching either end of the cycle.
The leverage of money managers could also be public. Another way of controlling leverage is to tax firms that
Moreover, legislation and regulations could contain strong and borrow excessively, or that borrow excessively on their
clear prohibitions against misleading the public or regulators collateral, or that lend excessively on collateral. (The tax rate
on the degree of leverage. again would have to differ depending on the kind of
borrowing.) A very small tax might go a long way to discourage different securities. Setting an absolute leverage limit like 15,
excessive leverage, and might also change the maturity independent of the portfolio mix, might induce banks to shift
structure, inducing longer term loans, if it were designed their investments into securities with higher embedded
properly. Another advantage of the leverage tax is that revenues leverage. Fourth, a focus on securities leverage would lead to
from it could be used to finance the lending facility the Fed derivatives such as CDS becoming part of the leverage
would need to keep at the ready in anticipation of the downside numbers. As we saw, writing CDS insurance is like owning the
of future leverage cycles. underlying bond, so taking the ratio of the collateral required
Yet another way of controlling leverage is by mandating that on the CDS to the cash price of the bond gives a good measure
lenders can only tighten their security margins very slowly. of the CDS leverage. Fifth, it is harder to hide securities leverage
Knowing they cannot immediately adapt if conditions get more than investor leverage; for one thing, there is a counterparty to
dangerous, lenders will be led to keep tighter margins in good, each security transaction reporting the same number that can
safe times. be used by regulators as a check on reported numbers. Finally,
Leverage constraints have been proposed at the investor a leverage supervisor managing securities leverage numbers
level for selected financial firms. Congress is considering a hard might be less vulnerable to political pressure because his
cap on bank leverage of 15. There are six potential advantages, mandate would be more technical.
however, to limiting leverage at the securities level instead of at
the investor level. The first is that many people can leverage;
limiting leverage at banks or at a few other financial institutions
might just induce leveraged purchases to move somewhere 8. Conclusion
else. Second, the leverage of an investor is often a meaningless
number, at least as an indicator of credit tightness, since just The leverage cycle brought us to the edge of a cliff. We have
when things are getting bad, and margins on securities are moved back from the precipice, but unless we understand the
tightening and the whole economy is being forced to features of the leverage cycle and design our responses to
deleverage, many firms will appear to be more leveraged address the specific problems that characterize the end stage
because their equity will be disappearing. (It has become of an outsized leverage cycle, we are left hoping for a miracle
fashionable nowadays to say that leverage regulation should be to restore our financial prosperity. Marking time and waiting
countercyclical, by which people mean that investor leverage for the miracle of things getting better appear to be part of the
should be allowed to go up in bad times and down in good current government policy, at least as it relates to housing and
times. Enforcing a hard cap on investor leverage would foreclosures. That miracle, if it comes, will be nothing more
paradoxically exacerbate the leverage cycle by forcing firms to than the start of another cycle, maybe one even worse than
sell at the bottom of the cycle, even if they had long-term loans the one we have just experienced. My recommendations for
that did not require rolling over.) Third, different securities solving the present crisis and managing the leverage cycle
include different amounts of “embedded leverage.” Thus, it in its ebullient stage might prevent such an outcome.
makes sense to mandate different leverage numbers for

References
Adrian, T., and H. Shin. Forthcoming. “Liquidity and Leverage.” Ferreira, F., J. Gyourko, and J. Tracy. Forthcoming. “Housing Busts
Journal of Financial Intermediation. and Household Mobility.” Journal of Urban Economics.
Aragon, D., A. Caplin, S. Chopra, J. V. Leahy, Y. LeCun, M. Scoffier, and Foote, C. L., K. S. Gerardi, L. Goette, and P. S. Willen. 2009. “Reducing
J. Tracy. 2010. “Reassessing FHA Risk.” NBER Working Paper Foreclosures.” Federal Reserve Bank of Boston Public Policy
no. 15802, March. Discussion Papers, no. 09-02.
Backman, A., and G. O’Connor. 1995. “Rating Cash Flow Transactions Fostel, A., and J. Geanakoplos. 2008. “Leverage Cycles and the Anxious
Backed by Corporate Debt: 1995 Update.” Moody’s. Economy.” American Economic Review 98, no. 4 (September):
1211-44.
Bernanke, B., M. Gertler, and S. Gilchrist. 1996. “The Financial
Accelerator and the Flight to Quality.” Review of Economics and Geanakoplos, J. 1997. “Promises, Promises.” In W. B. Arthur,
Statistics 78, no. 1 (February): 1-15. S. Durlauf, and D. Lane, eds., The Economy as an Evolving
Complex System, vol. 2, 285-320. Reading, Mass.: Addison-
———. 1999. “The Financial Accelerator in a Quantitative Business Wesley.
Cycle Framework.” In J. B. Taylor and M. Woodford, eds.,
Handbook of Macroeconomics, vol. 1C, 1341-93. Elsevier. ———. 2003. “Liquidity, Default, and Crashes: Endogenous
Contracts in General Equilibrium.” In M. Dewatripont, L. P.
Brunnermeier, M. K., and L. H. Pedersen. 2009. “Market Liquidity and Hansen, and S. J. Turnovsky, eds., Advances in Economics and
Funding Liquidity.” Review of Financial Studies 22, no. 6 Econometrics: Theory and Applications, vol. 2, 170-205.
(June): 2201-38. Econometric Society Monographs: Eighth World Congress.
Cambridge University Press.
Caballero, R. 2010. “The ‘Other’ Imbalance and the Financial Crisis.”
VOX, January 14. ———. 2008. “Solving the Present Crisis and Managing the Leverage
Cycle.” Remarks delivered at the Board of Governors of the Federal
Caballero, R., E. Farhi, and P.-O. Gourinchas. 2008. “An Equilibrium Reserve System, Washington, D.C., October 3.
Model of ‘Global Imbalances’ and Low Interest Rates.” American
Economic Review 98, no. 1 (March): 358-93. ———. 2010. “The Leverage Cycle.” In D. Acemoglu, K. Rogoff, and
M. Woodford, eds., NBER Macroeconomics Annual 2009,
Caplin, A., S. Chan, C. Freeman, and J. Tracy. 1997. Housing vol. 24, 1-65. Chicago: University of Chicago Press.
Partnerships: A New Approach to a Market at a
Crossroads. Cambridge, Mass.: MIT Press. Geanakoplos, J., and S. Koniak. 2008. “Mortgage Justice Is Blind.”
Editorial. New York Times, October 30.
Caplin, A., C. Freeman, and J. Tracy. 1997. “Collateral Damage:
Refinancing Constraints and Regional Recessions.” Journal ———. 2009. “Principal Matters.” Editorial. New York Times,
of Money, Credit, and Banking 29, no. 4, part 1 (November): March 5.
496-516.
Geanakoplos, J., and F. Kubler. 2005. “Leverage, Incomplete Markets,
Dana, D. Forthcoming. “The Foreclosure Crisis and the Anti- and Pareto Improving Regulation.” Unpublished paper.
Fragmentation Principle in State Property Law.” University of
Chicago Law Review. Geanakoplos, J., and H. Polemarchakis. 1986. “Existence, Regularity,
and Constrained Suboptimality of Competitive Allocations when
Farhi, E., and J. Tirole. 2009. “Collective Moral Hazard, Maturity the Asset Market Is Incomplete.” In W. P. Heller, R. M. Starr, and
Mismatch, and Systemic Bailouts.” NBER Working Paper D. A. Starrett, eds., Social Choice and Public Decision
no. 15138, July. Making: Essays in Honor of Kenneth J. Arrow, 65-96.
Cambridge University Press.
References (Continued)
Geanakoplos, J., and W. Zame. 2009. “Collateralized Security Kiyotaki, N., and J. Moore. 1997. “Credit Cycles.” Journal of
Markets.” Unpublished paper. Political Economy 105, no. 2 (April): 211-48.
Gromb, D., and D. Vayanos. 2002. “Equilibrium and Welfare in Minsky, H. P. 1986. Stabilizing an Unstable Economy.
Markets with Financially Constrained Arbitrageurs.” Journal New Haven, Conn.: Yale University Press.
of Financial Economics 66, nos. 2-3 (November-December):
361-407. Myers, S. C. 1977. “Determinants of Corporate Borrowing.” Journal
of Financial Economics 5, no. 2 (November): 147-75.
Gyourko, J., and A. Saiz. 2004. “Reinvestment in the Housing Stock:
The Role of Construction Costs and the Supply Side.” Journal Peristiani, S., P. Bennett, G. Monsen, R. Peach, and J. Raiff. 1997.
of Urban Economics 55, no. 2 (March): 238-56. “Effects of Household Creditworthiness on Mortgage
Refinancing.” Journal of Fixed Income 7, no. 3
Haughwout, A., E. Okah, and J. Tracy. 2009. “Second Chances: (December): 7-21.
Subprime Mortgage Modification and Re-Default.” Federal
Reserve Bank of New York Staff Reports, no. 417, December. Shiller, R. 2008. The Subprime Solution: How Today’s Global
Financial Crisis Happened and What to Do About It.
Haughwout, A., R. Peach, and J. Tracy. 2008. “Juvenile Delinquent Princeton, N.J.: Princeton University Press.
Mortgages: Bad Credit or Bad Economy?” Journal of Urban
Economics 64, no. 2 (September): 246-57. Tobin, J., and S. S. Golub. 1998. Money, Credit, and Capital.
New York: McGraw-Hill/Irwin.
Holmstrom, B., and J. Tirole. 1997. “Financial Intermediation,
Loanable Funds, and the Real Sector.” Quarterly Journal
of Economics 112, no. 3 (August): 663-91.
The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in
documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

Solving The Present Crisis and Managing The Leverage Cycle: John Geanakoplos

Uploaded by

Copyright:

Available Formats

Solving The Present Crisis and Managing The Leverage Cycle: John Geanakoplos

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Solving The Present Crisis and Managing The Leverage Cycle: John Geanakoplos

Uploaded by

Copyright:

Available Formats

John Geanakoplos

Solving the Present

T he present crisis is the bottom of a leverage cycle.

FRBNY Economic Policy Review / August 2010 101

FRBNY Economic Policy Review / August 2010 103

FRBNY Economic Policy Review / August 2010 105

2.2 The Crisis Stage

FRBNY Economic Policy Review / August 2010 107

housing index for 2000-09. It begins at 100 in 2000:1, reaches

Margin down payment required 90

Sources: Ellington Capital Management; J.P. Morgan.

On the left vertical axis, I give the loan-to-value, or,

FRBNY Economic Policy Review / August 2010 109

course greatly exacerbated by the terrible consequences of 0.1 2007

FRBNY Economic Policy Review / August 2010 111

FRBNY Economic Policy Review / August 2010 113

4.6 The Rating Agencies Effectively

FRBNY Economic Policy Review / August 2010 115

FRBNY Economic Policy Review / August 2010 117

FRBNY Economic Policy Review / August 2010 119

FRBNY Economic Policy Review / August 2010 121

FRBNY Economic Policy Review / August 2010 123

FRBNY Economic Policy Review / August 2010 125

FRBNY Economic Policy Review / August 2010 127

FRBNY Economic Policy Review / August 2010 129

FRBNY Economic Policy Review / August 2010 131

You might also like