The Leverage Cycle

Equilibrium determines leverage, not just interest rates. Variations in leverage cause fluctuations in asset prices. This leverage cycle can be damaging to the economy, and should be regulated.Leverage, Collateral, Cycle, Crisis, Regulation

Trade in secured debt, adjustment in haircuts and international portfolios

I study the composition of international portfolios under collateral constraints and the implied cross-border transmission of shocks. I develop an international portfolio model with these features, in which leveraged investors seek diversification in both assets and secured liabilities and in which the pledgeable portion of assets adjusts to the state of the economy, reflecting borrowers’ credit risk. The new analytical results are as follows. First, agents choose endogenously how much to borrow from each country. Second, the collateral constraint, being a contractual link between secured and unsecured financial instruments, permits to compute portfolios without an arbitrage condition between those classes of assets. Finally, haircuts adjust endogenously through the change in the collateral values. After estimating the parameters governing this adjustment, I find that both portfolios and international transmission mechanism are quite sensitive to leveraged investors’ funding. As for portfolios, secured bonds have particularly effective hedging properties in managing the terms of trade risk. As for the international transmission, tightening haircuts affect the economic slowdown: initially severe contractions are followed by quick reversions to the long-term equilibrium. On a cumulative basis, these two effects compensate if haircuts adjust precisely to the economic state. But in case of uncertainty about this adjustment, collateral constraints are a source of risk which cannot be internationally diversified.Financial flows, borrowing limits, creditworthiness, risk premia, international business cycle, macroeconomic interdipendence.

Collateral Shortages, Asset Price and Investment Volatility with Heterogeneous Beliefs

The recent economic crisis highlights the role of financial markets in allowing economic agents, including prominent banks, to speculate on the future returns of different financial assets, such as mortgage-backed securities. This paper in troduces a dynamic general equilibrium model with aggregate shocks, potentially incomplete markets and heterogeneous agents to investigate this role of financial markets. In addition to their risk aversion and endowments, agents differ in their beliefs about the future exogenous states (aggregate and idiosyncratic) of the economy. This difference in beliefs induces them to take large bets under frictionless complete financial markets, which enable agents to leverage their future wealth. Consequently, as hypothesized by Friedman (1953), under complete markets, agents with incorrect beliefs will eventually be driven out of the markets. In this case, they also have no influence on asset prices and real investment in the long run. In contrast, I show that under incomplete markets generated by collateral constraints, agents with heterogeneous (potentially incorrect) beliefs survive in the long run and their speculative activities permanently drive up asset price volatility and real investment volatility. I also show that collateral constraints are always binding even if the supply of collateral assets endogenously responds to their price. I use this framework to study the effects of different types of regulations and the distribution of endowments on leverage, asset price volatility and investment. Lastly, the analytical tools developed in this framework enable me to prove the existence of the "generalized" recursive equilibrium in Krusell and Smith (1998) with a finite number of agents.

The cost of banking panics in an age before “Too Big to Fail”

How costly were the banking panics of the National Banking Era (1861-1913)? I combine two hand-collected data sets - the weekly statements of the New York Clearing House banks and the monthly holding period return of every stock listed on the NYSE - to estimate the cost of banking panics in an era before “too big to fail.” The bank statements allow me to construct a hypothetical insurance contract which would have allowed investors to insure against sudden deposit withdrawals and the cross-section of stock returns allow us to draw inferences about the marginal utility during panic states. Panics were costly. The cross-section of gilded-age stock returns imply investors would have willingly paid a 14% annual premium above actuarial fair value to insure $100 against unexpected deposit withdrawals The implied consumption of stock investors suggests that the consumption loss associated with National Banking Era bank runs was far more costly than the consumption loss from stock market crashes.National Bank Act ; Financial crises

Financial crashes versus liquidity trap : the dilemma of monetary policy

URL des Documents de travail : http://centredeconomiesorbonne.univ-paris1.fr/bandeau-haut/documents-de-travail/Documents de travail du Centre d'Economie de la Sorbonne 2010.14 - ISSN : 1955-611XThis paper considers a two-period monetary double auction with incomplete markets of securities and derivatives. Players may share heterogenous beliefs. Short positions in derivatives are constrained by collateral requirements. A central Bank stands ready to lend money or engage in unconventional monetary policy such as quantitative easing. In sharp contrast with the usual picture of equilibrium properties, I show that only three scenarios are compatible with Nash equilibrium condition : 1) either the economy enters a liquidity trap in the first period ; 2) or the money injected by the Central Bank fuels a financial inflation driven by "rational exuberance", whose burst leads to a global crash in the next period, 3) else a significant inflation of commodity prices accompanies the functioning of markets. In particular, neither Friedman's golden rule, nor the Taylor rule turn out to be compatible with the third scenario : Both inevitable lead to a liquidity trap. An example shows that quantitative easing does not provide, in general, any escape from the monetary dilemma.Cet article considère une enchère double à deux périodes avec des marchés incomplets d'actifs et de dérivés financiers. Les joueurs peuvent entretenir des croyances hétérogènes. Les ventes à découvert d'actifs dérivés sont limitées par des contraintes de collatéral. Une Banque Centrale prête de la monnaie et peut s'engager dans des politiques monétaires non-conventionnelles comme le quantitative easing. A rebours de l'image usuelle d'un équilibre général , je montre que seuls trois scénarios sont compatibles avec les conditions de l'équilibre de Nash : 1) ou bien l'économie entre dans une trappe à liquidité ; 2) ou bien la monnaie injectée par la Banque Centrale nourrit une inflation financière caractéristique d'une forme d'exubérance rationnelle, donnant naissance à une bulle dont l'éclatement provoque un krach global dans l'un des états de seconde période ; 3) à moins qu'une inflation suffisante des biens de consommation domestique permette le fonctionnement normal des marchés. En particulier, ni la règle de Taylor, ni celle de Friedman ne sont compatibles avec le troisième scénario : toutes deux conduisent immanquablement à une trappe à liquidité. On montre, par un exemple, que le quantitative easing ne permet pas, en général, d'échapper au dilemme monétaire

Three essays on sovereign default and collateral constraints

This thesis consists of three self-contained chapters. Chapter two introduces a novel solution method for dynamic general equilibrium models. This solution method is tailor-made for models where the optimization problem of agents involves inequality constraints (e.g. borrowing or collateral constraints). Chapter three explores the effect of collateral requirements on asset prices. We consider a Lucas tree economy with heterogeneous agents that face collateral constraints. The methods used to compute equilibria for this model rely on the solution method developed in Chapter two. We obtain our main results in a setting with two assets where we show that changes in the collateral requirement for one asset have a strong impact on the volatility of the other asset. Finally, Chapter four develops a new theory about sovereign debt defaults. In a small open economy setting we show that default on government debt can be optimal under full commitment of the government because it allows for increased risk diversification

Financial crashes versus liquidity trap : the dilemma of monetary policy

This paper considers a two-period monetary double auction with incomplete markets of securities and derivatives. Players may share heterogenous beliefs. Short positions in derivatives are constrained by collateral requirements. A central Bank stands ready to lend money or engage in unconventional monetary policy such as quantitative easing. In sharp contrast with the usual picture of equilibrium properties, I show that only three scenarios are compatible with Nash equilibrium condition : 1) either the economy enters a liquidity trap in the first period ; 2) or the money injected by the Central Bank fuels a financial inflation driven by "rational exuberance", whose burst leads to a global crash in the next period, 3) else a significant inflation of commodity prices accompanies the functioning of markets. In particular, neither Friedman's golden rule, nor the Taylor rule turn out to be compatible with the third scenario : Both inevitable lead to a liquidity trap. An example shows that quantitative easing does not provide, in general, any escape from the monetary dilemma.Central Bank, gains to trade, liquidity trap, collateral, default, crash, Taylor rule, deflation, bubble, rational exuberance, heterogenous belief.