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“For decades policy makers thougth interest rates were the most important indicator of supply and demand in credit markets…. Now, Mr. Geanakoplos was saying that something else — lenders’ collateral or margin demands — could be even more important.”

Now that sounds like an article worth reading. I believe George Soros also recommended looking at collateral and margin demands as culprits for credit cycles.

In case you like the article below, I’ve researched professor Geanakoplos I believe he worked for Long Term Capital Managment.  Here is a brief list of links to Geanakopolos’ most interesting papers:

1. Liquidity, Default, & Crashes

2. Money & Production, & Liquidity Trap

3. Leverage Cycles & The Anxious Economy

4. Virtures & Vices of Equilibrium & The Future Of Financial Economics

5. International Finance In General Equilibrium

6. Generic Inefficiency Of Stock Market Equilibrium When Markets Are Incomplete

7. An Introduction To General Equilibrium With Incompete Asset Markets

On to the article….

Click Here To Read The Article: Crisis Compels Economists To Reach for New Paradigm!

Most Important Concept (Via WSJ)

In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them “natural buyers.”

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

Important Excerpts (Via WSJ)

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.

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

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.

Click Here To Read The Article: Crisis Compels Economists To Reach for New Paradigm!

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