Interest rates versus leverage

(hat tip ronin 8317…A very good paper by John Geanakoplos on the leverage cycle..)

John Geanakoplos on the leverage cycle

At least since the time of Irving Fisher, economists, as well as the general public, have regarded the interest rate as themost important variable in the economy. But in times of crisis, collateral rates (equivalently margins or leverage) are far more important.

Despite the cries of newspapers to lower the interest rates, the Fed would sometimes do much better to attend to the economy-wide leverage and leave the interest rate alone. The Fed ought to rethink its priorities.

When a homeowner (or hedge fund or a big investment bank) takes out a loan using say a house as collateral, he must negotiate not just the interest rate, but how much he can borrow. If the house costs $100 and he borrows $80 and pays $20 in cash, we say that the margin or haircut is 20%, and the loan to value is $80/$100 = 80%. The leverage is the reciprocal of the margin, namely the ratio of the asset value to the cash needed to purchase it, or $100/$20 = 5. In standard economic theory, the equilibrium of supply and demand determines the interest rate on loans. It would seem impossible that one equation could determine two variables, the interest rate and the margin. But in my theory, supply and demand do determine both the equilibrium leverage (or margin) and the interest rate.

It is apparent from everyday life that the laws of supply and demand can determine both the interest rate and leverage of a loan: the more impatient borrowers are, the higher the interest rate; the more nervous the lenders become, the higher the collateral they demand. But standard economic theory fails to properly capture these effects, struggling to see how a single supply-equals-demand equation for a loan could determine two variables: the interest rate and the leverage. The theory typically ignores the possibility of default (and thus the need for collateral), or else fixes the leverage as a constant, allowing the equation to predict the interest rate.