Leverage cycle

Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.

Conventional economic theory suggests that interest rates determine the demand and supply of loans. This convention does not take into account the concept of default and hence ignores the need for collateral. When an investor buys an asset, they may use the asset as a collateral and borrow against it, however the investor will not be able to borrow the entire amount. The investor has to finance with their own capital the difference between the value of the collateral and the asset price, known as the margin. Thus the asset becomes leveraged. The need to partially finance the transaction with the investor’s own capital implies that their ability to buy assets is limited by their capital at any given time.

Impatient borrowers drive the interest rate higher while nervous lenders demand more collateral, a borrower’s willingness to pay a higher interest to ease the concerns of the nervous lender may not necessarily satisfy the lender. Before the financial crisis of 2008 hit, lenders were less nervous. As a result, they were willing to make subprime mortgage loans. Consider an individual who took out a subprime mortgage loan paying a high interest relative to a prime mortgage loan and putting up only 5% collateral, a leverage of 20. During the crisis, lenders become more nervous. As a result, they demand 20% as collateral, even though there is sufficient liquidity in the system. The individual who took out a subprime loan is probably not in a position to buy a house now, regardless of how low the interest rates are. Therefore, in addition to interest rates, collateral requirements should also be taken into consideration in determining the demand and supply of loans.

Consider a simple world where there are two types of investors – Individuals and Arbitrageurs. Individual investors have limited investment opportunities in terms of relatively limited access to capital and limited information while sophisticated “arbitrageurs “ (e.g.: dealers, hedge funds, investment banks) have access to better investment opportunities over individual investors due to greater access to capital and better information. Arbitrage opportunities are created when there are differences in asset prices. Individual investors are not able to take advantage of these arbitrage opportunities but arbitrageurs can, due to better information and greater access to capital. Leverage allows arbitrageurs to take on significantly more positions. However, due to margin requirements, even arbitrageurs may potentially face financial constraints and may not be able to completely eliminate the arbitrage opportunities.

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Wikipedia