According to the Wall Street Journal (subscription) John Geanakoplos, a Yale University academic is refocusing economic thought on the role that collateral plays in the boom-and-bust cycles. According to Mr. Geanakoplos, investors -- or in the case of the current economic mess, home buyers -- who are able to borrow too freely will drive prices of the collateral far too high. The collateral in this case being real estate.
In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them "natural buyers."
Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.
"It was evident to me that there was a cycle going on, not just in my little market, but all over the world," says Mr. Geanakoplos, who is still a partner at Ellington Capital. The "leverage cycle," he called it.
Up until 2007 it was quite common to hear radio ads, one in particular featured Donald Trump, urging the listener to dial call some 800-number for a DVD that would explain how to make millions in real estate. You could make your millions because you could buy houses with little or no money down and flip them for a profit. The ever rising real estate market made it all possible.
But the market stopped rising, as markets always do. When inflated real estate prices began to sink, suddenly a fairly large number of loans no longer had enough collateral backing them up. Homeowners who were forced to sell -- lost a job, company transfer -- could not get enough for the house to cover the original mortgage. Foreclosure resulted in further erosion of home values as houses went to auction.
This hit the financial system hard because home mortgages where packaged up and resold as mortgage backed securities that became collateral in securities lending deals. Overnight credit began to dry up, and businesses that depended on their ability to get credit were threatened.
As a nation we've been down this road before, and the result of that trip was the Securities and Exchange Act of 1934, which among other things, attempted to prevent over-leveraging of investments by limiting the amount an investor could borrow from a broker-dealer to buy stocks.
Prior to the stock market crash of 1929, there was no limit on how much investors could borrow using shares. That, in turn, fueled a stock market bubble, as investors put up very little very capital but took on large positions of stocks at inflated prices.
Today, Federal Reserve rules establish a limit to how much investors can borrow to buy securities. These rules are embodied under Reg T, which requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities for buying stock on margin securities. For example, an investor borrowing on margin to buy $10,000 worth of stock is required to put up 50% collateral, or $5,000.
In other words, an investor who buys securities on margin has to have 50% down. There should be a similar requirement for home buyers.
Requiring a higher down payment from home buyers would do two things. First it would put a damper on demand by limiting the amount of money going into the home buying market. Demand had become dangerously high, until the bubble burst anyway, and drove prices ever higher. Second, higher down payments would provide a cushion for the buyer in the event of a fall in housing prices. A buyer who put 15% down on a $100,000 house would borrow $85,000. If housing values were to fall by 10% a buyer who is forced to sell could still get $90,000. It would still be a loss, but it would be enough for the to pay off the mortgage loan and avoid foreclosure and possible bankruptcy.
If you protect the original mortgage investment you protect the mortgage backed securities.
But it would seem that Mr. Geanakoplos is not focused on the home buyer either. While acknowledging that low-margin, easy borrowing fueled the real estate bubble, the Journal article does not mention higher home buyer down payments as an antidote to the erosion of value from mortgage backed securities.
Mr. Geanakoplos is convinced such a paradigm shift is under way. He hopes it will prove beneficial in protecting people from the excesses of the financial markets. To that end, he believes central bankers should collect and publish data on the amount of leverage in the system, and intervene if it gets out of line.
Right now, that would require the Fed to step in where banks fear to go by lending against risky assets such as mortgage bonds, but it would also mean limiting investors' ability to use leverage in exuberant times.
"Our policy seems geared largely toward rescuing banks and bankers," Mr. Geanakoplos says. "If we could manage these cycles better, I think we'd all be better off."
Maybe policy should also consider the home buyers. Perhaps pre-tax savings accounts for building the down payment could be the vehicle for assisting lower income home buyers. But home owners should have the stake in their investment that a down payment provides, as well as the cushion it provides against the price swings. We ought to have some kind of home buyers Reg T.
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