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New Perspectives on Asset Price Bubbles$
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Douglas D. Evanoff, George G. Kaufman, and A. G. Malliaris

Print publication date: 2012

Print ISBN-13: 9780199844333

Published to Oxford Scholarship Online: April 2015

DOI: 10.1093/acprof:osobl/9780199844333.001.0001

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PRINTED FROM OXFORD SCHOLARSHIP ONLINE (oxford.universitypressscholarship.com). (c) Copyright Oxford University Press, 2021. All Rights Reserved. An individual user may print out a PDF of a single chapter of a monograph in OSO for personal use. date: 24 July 2021

Leverage and Bubbles

Leverage and Bubbles

The Need to Manage the Leverage Cycle

(p.387) Chapter 15 Leverage and Bubbles
New Perspectives on Asset Price Bubbles

John Geanakoplos

Oxford University Press

This chapter examines leverage as a major cause of asset price bubbles. It outlines four reasons why the most recent leverage cycle was worse than previous cycles. First, leverage reached levels never seen before in previous cycles. Second, there was a double leverage cycle: in securities on the repo market and in real estate in the mortgage market. Third, credit default swaps (CDSs), which had been absent from previous cycles, played a major role in the financial crisis of the late 2000s. Fourth, extremely high leverage and low prices put a much larger number of people and businesses underwater than in earlier cycles. The chapter initially discusses the relationship between leverage and asset pricing before turning to a discussion of models of collateral and debt forgiveness (or punishment for default). It then suggests that collateral and leverage need to be integrated into macro models, and that by taking collateral seriously the effect on asset prices of new derivatives like CDSs can be properly assessed. Finally, it considers the optimal punishment for default and the adverse effects of debt overhang.

Keywords:   leverage, asset price bubbles, securities, credit default swaps, financial crisis, collateral, debt forgiveness, asset prices, derivatives, debt overhang

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