Leverage Cycle: An Explanation of Financial Crises
Main Takeaways:
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Leverage cycle theory offers a unique perspective on financial crises, different from psychological or behavioral explanations.
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Emphasizing the procyclical nature of leverage, the theory underscores leverage's significant impact on market volatility.
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Four different phases exist within the leverage cycle: initial calm, expansion, depression and recovery.
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Understanding the leverage cycle offers policymakers insights into monitoring market conditions and implementing counter-cyclical regulations.
Explaining Financial Crises
What caused the 2007-2009 financial crisis? The roots of the crisis are usually traced back to what Keynes termed "animal spirits," a phrase that points to human psychology and behavioral biases. According to this behavioral theory, the overconfidence of property investors, the greed of mortgage brokers, the flawed practices of rating agencies and the frenzies of speculators worked together to create the irrational exuberance and resulted in the following meltdown. Similar stories echo through history, from the tulip mania in the seventeenth century to Japan’s land bubble in the 1980s.
Although there is certainly some truth to this behavioral explanation, it offers only a partial picture. Beyond individual behavior, one important but often overlooked element lies in the broader economic and financial environment, namely the leverage cycle. Central to this alternative theory of financial crises is the assertion that the procyclical expansion of leverage fosters and magnifies market bubbles and volatility.
Recognizing the role of leverage and its procyclical nature is crucial, because it unveils pathways to crafting more resilient economic policies. While human nature may remain inherently prone to greed and irrationality, prudent regulatory measures can mitigate risks and temper the volatility that characterizes modern economies.
Basic Concepts: Collateral, Margin and Leverage
Before we start our exploration of the leverage cycle, let's first establish a solid understanding of some foundational concepts, including margin and leverage. They are easier to grasp with a straightforward example:
When a homeowner takes out a loan using a house as collateral, she must negotiate not just the interest rate, but how much she can borrow, namely leverage. If the house costs $100 and she borrows $80 from banks and pays $20 in cash as a down payment, we say that the margin (or haircut) of the loan is $20/$100 = 20%, the loan-to-value (LTV) ratio is $80/$100 = 80%, and the leverage — as the reciprocal of the margin — is $100/$20 = 5.
So, margin, LTV, and leverage are simply different ways to express the same idea — a ratio that measures borrowing power. Changes in leverage can have profound effects on market dynamics. For instance, let's say borrowing becomes easier, with leverage = 10 and margin = 10%. Now, with $20 on hand, our homeowner can access a total of $200 ($20 * 10) in funds, borrowing $180 and potentially buying two houses at $100 each. Even without changes in interest rates, this surge in borrowing capacity can drive up demand for housing, consequently pushing up prices.
Remarkably, the influence of high leverage on market prices doesn't require widespread participation. When high-leverage loans are available, even a small group of optimistic investors with a high tolerance for risk can exert significant influence. Facilitated by high leverage, they can now access substantial financial resources, allowing them to outbid competitors and drive prices upward. This phenomenon manifests not only in real estate markets but also in equity and derivatives markets.
Leverage Cycle: The Theory
This microeconomic scenario lays the groundwork for our understanding of the macroeconomic relationship between leverage and market volatility. Although cycles lack distinct starting points, considering an initial stage still helps us better observe the typical evolution of a leverage cycle.
Figure 1: Dynamic Leverage Cycle
Source: John Geanakoplos (2023)
1. Initial Stage: At the outset, the economy enjoys tranquility, is buoyed by good news, and is characterized by low volatility in prices. Lenders have confidence in economic prospects and display little concern for loan defaults. Consequently, they require lower collateral and extend high leverage to borrowers. (Low Volatility → Flat Credit Surface → High Leverage in Figure 1)
2. Expansion Stage: In the second stage, as high-leverage lending injects capital into the financial market, demand for assets increases and pushes asset prices higher as a consequence. This can result in overvaluation and the formation of bubbles. The surge in activity also amplifies market volatility, making it more susceptible to bad news and negative shocks. (High Leverage → High Price → High Volatility → Steep Credit Surface)
3. Depression Stage: As the cycle progresses to the third stage, lenders begin to have doubts about the sustainability of the market's boom. With concerns about potential defaults, they adopt a more cautious approach, demanding increased collateral and reducing leverage. Their reaction to an overheated market exerts downward pressure on prices, because less favorable borrowing conditions can result in less funds available in the market, thus constraining the demand for assets. This often accelerates the onset of a depression that is already looming. (Steep Credit Surface → Low Leverage → Low Price)
4. Recovery Stage: In the fourth stage, the market undergoes a corrective phase after the crisis, prompted by lenders' increased caution and reduced leverage. This corrective phase marks a return to stability, as asset prices adjust to reflect a more sustainable level, resetting the stage for a new cycle to begin. (Low Price → Low Volatility)
Empirical Evidence
To summarize, the leverage cycle demonstrates the procyclical nature of credit and its intricate ties to asset prices, market volatility, and external shocks. But how robust is this theory when confronted with real-world data?
The first piece of evidence emerges from the housing market. Figure 2 shows the evolution of leverage on non-government mortgages (pink line) alongside the Case-Shiller housing index (green line) in the US from 2000 to 2009. Initially, in 2000, mortgage down payments averaged around 12%, with relatively low leverage levels of approximately 8 to 9 (calculated as 100%/12%). However, from 2000 to 2006, leverage steadily increased in tandem with the home price index, reaching a turning point in 2006 when both metrics experienced a sudden decline, signaling the bursting of the housing market bubble. In this graph, the early 2000s can be identified as the initial stage of the leverage cycle, which progressed into the expansion stage from 2002 to 2006 and reached the depression stage in 2006.
Figure 2: Leverage and Housing Prices
Source: John Geanakoplos (2023)
This positive correlation between house prices and household leverage is further supported by data from various other countries (Figure 3). While establishing causal relationships between price movements and leverage remains challenging, it's very likely that the fluctuations in housing prices (upturn/downturn) and credit dynamics (expansion/contraction) often reinforce each other and generate endogenous oscillations. Additionally, research on economic cycles has revealed that "more credit-intensive booms tend to be followed by deeper recessions and slower recoveries." This finding underscores the procyclical role of leverage in exacerbating market volatility.
Figure 3: Household leverage and the run-up in house prices (1997-2007)
Source: John Geanakoplos (2023)
A second strand of evidence comes from the commodities market, highlighting the positive relationship between (expected) asset price volatility and margin requirements, the amount of money investors must deposit with their broker as collateral. One notable example occurred following the Russian invasion of Ukraine in February 2022. The invasion triggered unprecedented volatility in European natural gas prices, significantly impacting the Dutch TTF natural gas futures market. In response to heightened price volatility, Central Counterparties (CCPs) raised initial and variation margin requirements to cover short derivatives positions in commodities. Similar adjustments in margin requirements were observed in the Brent crude oil market, where sharp fluctuations in prices also necessitated adjustments in margin requirements to mitigate risk exposure (Figure 5).
Figure 4: Realized Volatility and Margin Requirements in Commodities Market
Source: John Geanakoplos (2023)
Figure 5: Prices and margin scanning range of front-end futures: TTF gas and Brent oil
Source: Bank Underground
Bottom line
If the leverage cycle theory holds, it provides economists and central banks with valuable tools to monitor market dynamics more closely. Sharp increases in credit and leverage could serve as early warning signals of bubble formation and financial vulnerabilities, even in periods where the near-term inflation outlook appears stable. As a result, policymakers have the opportunity to implement counter-cyclical leverage regulation policies that "lean against the wind." By reducing leverage during economic booms, policymakers can mitigate risks and prevent a hard landing when bubbles burst. Conversely, enhancing credit conditions during downturns can facilitate smoother recoveries and mitigate the severity of recessions. Although it seems impossible to prevent future financial crises entirely, hopefully, we can still glean some valuable insights from those costly past experiences.
