This is the graduation speech I gave on receiving an honorary doctorate at the University of Athens Economics and Business School. I talk about my Greek family, about how I got interested in economics, and then how in the 1990s I came to think about default, collateral, and leverage as the central features of the financial/macro economy, despite their complete absence (even now) from any textbooks. Finally I suggest that the Greek debt problem, and on a bigger scale, the American debt problem, can only be cured when lenders are prodded to forgive. That would be better for the borrowers but also for the lenders.Greek, Parents, Mathematical economics, Yale, Mortgage, Collateral, Securitization, Leverage, Foreclosure, Forgive, Principal

John Geanakoplos

English

Research Papers in Economics

 
 
 
GREEK DEBT AND AMERICAN DEBT: 
GRADUATION SPEECH AT THE UNIVERSITY OF ATHENS 
ECONOMICS AND BUSINESS SCHOOL 
 
 
By 
 
John Geanakoplos 
 
 
 
November 2011 
 
 
 
 
 
COWLES FOUNDATION DISCUSSION PAPER NO. 1837 
 
 
 
 
 
 
 
 
 
 
 
 
 
COWLES FOUNDATION FOR RESEARCH IN ECONOMICS 
YALE UNIVERSITY 
Box 208281 
New Haven, Connecticut 06520-8281 
 
 http://cowles.econ.yale.edu/  1 
 
Greek Debt and American Debt 
Graduation Speech at the University of Athens Economics and Business School 
June 2011 
John Geanakoplos 
 
Abstract:  This is the graduation speech I gave on receiving an honorary doctorate 
at the University of Athens Economics and Business School.   I talk about my 
Greek family, about how I got interested in economics, and then how in the 1990s 
I came to think about default, collateral, and leverage as the central features of 
the financial/macro economy, despite their complete absence (even now) from 
any textbooks.  Finally I suggest that the Greek debt problem, and on a bigger 
scale, the American debt problem, can only be cured when lenders are prodded 
to forgive.  That would be better for the borrowers but also for the lenders.  
 
Key Words:  Greek, parents, mathematical economics, Yale, mortgage, collateral, 
securitization, leverage, foreclosure, forgive, principal. 
 
JEL: D52, D53, E444, G01, G10, G12 2 
 
Greek Debt and American Debt 
Graduation Speech at the University of Athens Economics and Business School 
June 2011 
 
 
I am very honored to receive this honorary PHD here in Greece.  Were they still 
alive, my parents would have been very proud, just like your parents are today.  
Though my parents were born in the United States, they both grew up speaking 
Greek before they spoke English.  [In Greek: And I too learned Greek, but since I 
have not spoken regularly for forty years, I will continue in English].  My parents 
thought of themselves as Greek as much as American.  They told me my 
grandparents abandoned the country they loved in order to give their children 
and grandchildren an opportunity to do something important and noble that 
would be impossible to achieve from a little village.  I should grow up to enjoy life, 
my mother said, but a little anxiety is a good thing.  
 
My grandfather John Geanakoplos came to America in 1892 by himself when he 
was 12 years old from a tiny village near Sparta called Theologo.  He met his older 
brother in Chicago and the two of them moved to Minneapolis to set up a candy 
store.  With one other guy they were the first Greeks in Minneapolis.  They 
expanded their store into a factory called Geanakoplos Brothers and over the 
years they helped bring over 700 Greeks from Sparta to work in their factory.  3 
 
Together with his brother, my grandfather built the first Greek church in 
Minneapolis and was the first president of the Greek community of Minneapolis 
and for many years the treasurer of the church.  Though he had gotten quite 
wealthy, he told his sons that they should look for a purer calling than business.  
One son became a high school history teacher in Minneapolis, another son (my 
godfather) became a professor of chemical engineering, and my father became a 
professor of Byzantine history. 
 
My father Deno John Geanakoplos began his academic life studying the violin at 
the Julliard School of Music in New York.  He returned to Minneapolis to play first 
violin for the Minneapolis symphony, which was conducted by Dimitri 
Mitropoulos, soon to be conductor of the New York Philharmonic.  In 1942 my 
father volunteered for officer training in the American army and was sent to fight 
in North Africa, where he learned French.  He was in the first wave of American 
soldiers sent to fight in Italy, landing in Palermo.  Eventually he ended up as a 
captain in Pisa in charge of a shoe factory.  Not needing to do much fighting I 
guess, he learned Italian and ancient Greek at the University of Pisa, and in 1946 
he got his Phd from Pisa by writing a dissertation in Italian about Greek scholars in 
Venice.  He ended his career as professor of Byzantine history and Greek church 
history and Renaissance history at Yale Univesity.  His 15
th and last book, which he 
entrusted to me to get published after he died, was a history of the Greek church 
and its role in preserving Greek culture through the ages, especially during the 
Ottoman occupation.  4 
 
 
My mother’s parents were born in Constantinople, though they moved back and 
forth to a little village in Epirus, which is now part of Albania.   Forced to leave 
Constantinople in 1921 they emigrated to Worcester Massachusetts in America.  
My grandfather Basel Vranos hated America at first and wanted to return to 
Greece, especially during the Depression of the 1930s, but my grandmother 
Sophia insisted America was a big country with limitless opportunities, if not for 
them, at least for their children. She was President of the Worcester 
Massachusetts Greek War Relief during world War II.  My mother was very poor 
growing up and had a hard life.  Determined to make something of herself, she 
became the first woman to graduate from Clark University, and got her MA in 
social work at Boston University.  She was in the first group of Fulbright 
appointees to Greece where she helped to set up the XEN school of social work, 
the first such school in Greece. 
 
My sister and I wanted to be even purer than our parents.  She studied music at 
Julliard and philosophy at Yale and became a concert pianist, playing all over the 
world, including twice here in Athens many years ago.  I studied pure 
mathematics at Yale and then got a masters in mathematics at Harvard.  But 
along the way to my math degrees I also took courses from extraordinary 
teachers in economics, like James Tobin and Herbert Scarf at Yale, and then 
Kenneth Arrow at Harvard.  I realized that mathematics played an essential and 
beautiful role in economics, but that economics also touched on so many other 5 
 
things, like political philosophy and even business, that despite my grandfather, I 
was also interested in.  So I decided to get my PhD in economics, under Kenneth 
Arrow. 
 
I took my first job as assistant professor of mathematical economics at Yale in 
1980.  I was entranced by the beauty of general equilibrium and game theory that 
was taught in those days, and I didn’t care that it had little to do with the real 
world.  But in 1989 I had a sabbatical and I decided to spend it on Wall Street, 
since there seemed to be a lot of interesting mathematical economics happening 
there.   I was planning to go to Goldman Sachs, but at the last minute my little 
cousin from my mother’s side, Michael Vranos, who had taken a job straight out 
of college a few years before at Kidder Peabody, introduced me to Ed Cerullo, the 
head of Fixed Income at Kidder.  Cerullo told me that I would learn much more as 
the only professor talking to people like him who ran the businesses at Kidder 
Peabody than I would working on some mathematical problem at Goldman Sachs 
with 50 other visiting professors.  So I went to Kidder and talked to Cerullo and 
other traders.  At the end of the year Cerullo told me that he realized through his 
conversations with me that his research department was not sufficiently 
mathematical, and he asked me to hire him a new department.  After I returned 
to Yale he called and said that now that I had created the department, why didn’t 
I run it from Yale?  I agreed. 
 6 
 
My little cousin meanwhile had risen to head the mortgage trading desk.  This was 
the beginning of the first Securitization boom on Wall Street that I am sure you 
have all heard of now.  Homeowners had for years borrowed money in exchange 
for mortgage payment promises, pledging their houses as collateral.  Starting in 
the 1970s Fannie Mae and Freddie Mac would collect these promises into pools of 
promises, and then sell the pooled cash flows as pass-through Securities to 
individual investors.  Starting in the late 1980s investment banks like Kidder 
Peabody would sometimes buy the pass-through Security and then carve up those 
cash flows into more complicated securities called derivative securities or 
tranches, that promised money when the buyer really needed it.  For example, my 
cousin might buy a pool of mortgages that promised $1000 a month and from 
that create two tranches, a floater that promised $500 plus $100 x the change in 
the interest rate and an inverse floater promising $500 minus $100 x the change 
in the interest rate.  People who needed money when interest rates go up bought 
the floater tranche, and people who needed money when interest rates go down 
bought the inverse floater tranche.  My cousin could sell off the two pieces for 
more than he bought the underlying pool and make a profit.  
 
In reality there weren't just two pieces, there weren't just three pieces, there 
were 90 pieces. Well, my young little cousin got the idea that what Kidder could 
do, was to find a buyer for the riskiest of the 90 pieces.  Once he found the buyer, 
a place to put the riskiest piece, he would borrow the money to buy the pass 
through, and hold an inventory of all the other pieces. He knew that eventually 
we would be able to sell off all the other pieces. And so we had a tremendous 7 
 
advantage. While everyone else was looking for buyers for 90 pieces, we had to 
find a buyer for one piece.  My 27 year old cousin and Kidder came to dominate 
the multi-trillion dollar mortgage derivative business, producing fully 20% of all 
them in America. 
 
To run this operation, Kidder had to hold 89 slightly less dangerous pieces in its 
inventory.  So we needed a model to predict what the homeowners would do, 
whether they would default or refinance, depending on the interest rates, and 
how to hedge their behavior.  My research department was responsible for 
making these conditional predictions and figuring out hedge ratios, and so trading 
and research worked hand in hand. 
 
Competition between traders like my cousin raised the amount people were 
willing to pay for the mortgages because they can then buy them and split them 
up and sell them for more.  So that raises the price the homeowners can get 
selling their mortgage promises, which in turn lowers the interest rate that the 
homeowners have to pay.  The first wave of securitization improved the welfare 
of almost everybody. 
 
 
The mortgage market was a multi-trillion dollar a year operation and I realized, 
while I was there at Kidder Peabody, that this whole operation behind the scenes 8 
 
was invisible to everybody and was worth writing about.   It was bringing great 
welfare gain to the country and nobody quite knew about it.  So for me, it 
crystalized what the essence of finance is. The essence of finance is creating 
promises backed by collateral.  The houses back the homeowner mortgage 
promises, the mortgages back the pools, the pools back the tranches.   And the 
investors who buy the tranches are also borrowing money, using the tranches as 
collateral.  Collateral is a very important to running a financial system.  Yet 
collateral had never been mentioned in a single one of the many economics 
courses I took at Yale or at Harvard. 
  
So I published my first paper on collateral equilibrium in 1997.  And one of the 
questions I asked and answered was, how does supply and demand determine 
not only what interest rate people generally have to pay on loans, but also how 
much collateral they generally have to put up?  That was a question that nobody 
seemed to have asked before.  Even today you won’ find it in any textbook.  It was 
a question that I could have asked out of pure logic, and the answer I gave was 
purely mathematical.  Yet I never would have thought of the question if I had not 
worked in the business world of Kidder Peabody. 
 
The textbooks only write about the interest rate, and how the Fed or the ECB 
needs to monitor and regulate the interest rate in case the economy gets the rate 
wrong.  But a much more important variable is the collateral rate or leverage, 
which is just another word for the same thing.  What if the economy gets that 9 
 
wrong?  Somehow nobody at the Fed or the ECB ever talked about that question.  
Yet every businessman knows leverage is important.  Even Shakespeare 
understood that collateral is more important than the interest rate.  Who here 
can remember the interest rate Shylock charges Antonio in the Merchant of 
Venice?  But all of you remember the pound of flesh collateral. 
 
The economy often does get the overall leverage wrong, sometimes with 
terrifying consequences.  In 1994 Kidder Peabody went out of business after 135 
years because of losses in the government bond department.  At the time I didn’t 
understand what had caused the losses.  I had to invite the 75 people who 
worked for me in research into my office and tell them one by one you are fired.  
Then I went next door and my boss said you are fired. 
 
In 1995 my cousin and I and four others founded a hedge fund called Ellington 
Capital Management, whose business it was to buy the very derivative securities 
we had just been creating at Kidder Peabody.  On the heels of the 1994 crisis we 
made astounding returns on our investments and the new hedge fund grew 
rapidly to become the biggest mortgage hedge fund in the country.  All went well 
until October 1998 when the mortgage market seemed to crash.  The famous 
hedge fund Long Term Capital Management went out of business.  We barely 
survived.  But then in 1999 and 2000 we made tremendous profits again, quickly 
making back all the money we had lost in 1998. 
 10 
 
I decided that two such catastrophes could not be an accident.  I decided to write 
about the crashes that could be caused by leverage and securitization, that is 
about what could go wrong.  I developed a theory I called the leverage cycle.  
During periods of calm lenders ask for less and less collateral and leverage rises.  
Most importantly, because leverage raises asset prices rise.  Hedge funds and 
other investors do well.  Production increases.  But when there is scary bad news 
that frightens lenders, they raise collateral requirements much more than interest 
rates.  Because of the bad news, and because of the deleveraging, and because 
the optimists were leveraged so much before, asset prices not only fall, they 
crash.  Leveraged buyers go out of business. And with low asset prices, production 
grinds to a halt.  Those who survive the crash do amazingly well when the cycle 
begins again and leverage and prices rise.  The episodes of 1994 and 1998 were 
both leverage cycle crashes, the first in the government bond market and the 
second in the mortgage market (and actually more dramatically in emerging 
markets).  The crash stages in both passed over in just a few months.  But what if 
the next one was bigger and longer? 
 
Nobody paid much attention to my leverage cycle in 2003 when I published it.  
But it seems to describe recent events eerily well.  In America the average down-
payment on a house with non-government loans in 2000 was 14%.  In 2006 it had 
gone to 2.7%.  As leverage soared, housing prices went up 90% over the same 
period of time.  Then when lenders began to get nervous in late 2006, leverage 
collapsed and the down-payments lenders required went to 25%; sometimes no 
loan at all would be given.  Housing prices lost 30%-40%  of their value in one 11 
 
year.  Housing construction stopped and the American economy slumped.  
Unemployment soared to 10%.   Our hedge fund again nearly went out of 
business in 2007-8.  But again we had our best years ever right after the crash in 
2009-2010. 
 
The leverage cycle is most damaging when the aftermath is long, which happens 
when too many borrowers owe much more than they can pay, but have not yet 
defaulted.  Nobody will lend money to a homeowner who already owes more 
money than his house is worth.  And no homeowner will pay his own money to 
repair his house if he thinks he will eventually lose it anyway.  The same holds for 
businesses.  In America 2.5 million homeowners have been thrown out of their 
homes for not paying, but another 5 million are seriously delinquent and probably 
will be thrown out of their homes as well.  There are another 8.5 million 
homeowners who are underwater and owe more money than their house is 
worth.  Many of them will default.  As more people are thrown out of their 
houses, more houses come on the market and prices fall further, and still more 
people default.  Recall that each household contains around 3 people.  More 
people will be thrown out of their homes in America than there are people in 
Greece. 
 
The only way out of the aftermath of the leverage cycle is for the lenders to 
forgive part of the debts to give people a fresh start.  Most borrowers will not 
repay if the loan is too much higher than the value of the house.  If the lenders all 12 
 
forgave part of their loans, they would all end up with more.  Imagine a $160,000 
loan on a house that is now worth $100,000.  Lenders on average get less than 
25% of the loan back when a subprime borrower is thrown out of his home, 
meaning in this case the lender can expect $40,000.  Why?  Because it takes years 
to throw the family out of the house, during which time the owner does not pay 
his taxes or his mortgage, and the house is ruined.  If the loan had been written 
down to $80,000 the borrower might well have paid all $80,000 back, perhaps by 
selling the house, because then there would be $20,000 in it for him.  By 
demanding everything and then throwing the borrower out when he refuses, the 
lender loses even more.  As Portia says in very similar circumstances in the 
Merchant of Venice “The Quality of mercy is not strained …It helpeth him who 
gives and him who takes.”  The most catastrophic blunder the American 
administration has made is in not coordinating a forgiveness on mortgage loans 
by lenders. 
 
The situation is of course reminiscent of what has happened to Greece and other 
sovereign borrowers.  Lenders should never have lent so much money.  Now that 
the situation has become bad, the borrowers cannot possibly pay it all back.  Of 
course the borrowers must be forced to put their houses in order, and to pay as 
much as they reasonably can.  But to ask the impossible will work against even 
the lenders.  Eventually part of the Greek debt will have to be forgiven. 
 13 
 
If Greece makes the needed reforms, mostly by collecting taxes from the rich who 
evade them, and reforming the business sector, and if the Eurozone is rational, 
part of the debt will be forgiven.  Greece will get a fresh start.  And in this global 
economy there will be no reason for you to abandon a country you love to find 
opportunity elsewhere as my grandparents had to. 

Greek Debt and American Debt: Graduation Speech at the University of Athens Economics and Business School

http://cowles.econ.yale.edu/P/cd/d18a/d1837.pdf

Greek Debt and American Debt: Graduation Speech at the University of Athens Economics and Business School

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