It’s not Just Interest Rates – It’s Collateral — Must Read, Folks

Download 2009-11-3 Crisis Compels Economists To Reach for New Paradigm – WSJ.com

The result was a new orthodoxy, known as "rational expectations," that still dominates, underpinning everything from the way pension funds invest to how financial analysts put values on securities. Among its main branches is the idea that markets are "efficient," meaning that even an uninformed investor can get a fair shake, because the price of any security tends to reflect all available information relevant to its value.

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See a video of John Geanakoplos and Robert Shiller discussing the crisis.

Mr. Geanakoplos didn't buy it. A former U.S. junior chess champion schooled in math and economic theory at Harvard, he had spent much of his career looking for holes in the dominant theories. His skepticism was seasoned with real-world experience, as head of fixed-income research at the now-defunct brokerage house Kidder, Peabody & Co. and after 1995 as a partner at a hedge fund that specializes in mortgage-backed securities, Ellington Capital Management.

On Wall Street, Mr. Geanakoplos, now 54 years old, noticed what he saw as a serious market limitation: There weren't enough houses and other forms of collateral to back all of the large amounts of debt securities that bankers might want to create. So when investors demanded more "asset-backed" securities, bankers had to find ways to "stretch" the available supply of collateral.

One way was to make collateral do double-duty. For instance, mortgage loans the banks made became collateral themselves for complex debt securities, known as collateralized mortgage obligations.

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GeanakoplosJesse Neider for the Wall Street Journal

Yale professor John Geanakoplos's 'leverage cycle' theory might help fix central-bank economic models that couldn't handle the financial crisis.

Geanakoplos

Geanakoplos

Another way of stretching collateral was to lend more against it. For example, if a bank lowered the down payment on a $100,000 house to 5% from 20%, it could have $95,000 in loans against the house instead of $80,000. In a similar way, banks could lower the down payments, or "margins," they required of investors who use borrowed money to buy bonds and other securities.


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