May 16, 2013
Are the easy-money policies of the world’s central banks setting financial markets up for a crash? We would have a much better idea if we measured how much of the buying is being done with borrowed money.
In recent months, soaring prices of stocks and bonds have left many investors wondering whether the potential returns are worth the risk. The Standard & Poor’s 500 Index (SPX) is in record territory despite a weak economic recovery. Junk bonds included in a BofA Merrill Lynch index are yielding only 4.4 percentage points more than U.S. Treasuries, close to the narrowest spread since late 2007.
So is it a bubble? To get a sense, it is helpful to know what is driving prices higher. If investors are putting in very little of their own money and using a lot of borrowed money, also known as leverage, that can be a troubling signal.
When, for example, lenders allow people to buy a $100,000 house with a down payment of only $1,000, they give speculators immense power to bid up prices beyond the reach of those who want houses to live in. Similarly, if someone with only $1 million can borrow enough to buy $100 million in risky bonds, traders looking for quick gains can push prices up to levels that make little sense for people who want bonds as a source of fixed income.
Leverage makes the whole financial system more fragile. Investors who use only their own money can lose no more than 100 percent of what they put in. By contrast, an investor who uses $1 million of his own money and $99 million of borrowed money to buy $100 million in securities can be wiped out by a price drop of only 1 percent: The new value of the investment, at $99 million, is just enough to pay off the debt. Larger declines can force investors to sell other assets to pay their creditors — a dynamic that can turn seemingly isolated losses into widespread disasters.
Economists have long advocated that regulators pay more attention to leverage and do a better job of measuring it. In a 2011 paper, John Geanakoplos of Yale University and Lasse Pedersen of New York University proposed publishing a suite of leverage indicators. In consumer markets such as mortgages and auto loans, they would monitor down payments. In the so-called repo market, where investors put up securities as collateral for loans, they would track the “haircuts” that define how much money can be borrowed against different types of securities. Data on new transactions would offer insight into what was driving current buying, while averages for all loans outstanding would give a sense of the market’s fragility.
To a large extent, regulators are on board. The Office of Financial Research — which the Dodd-Frank act equipped with subpoena power to improve the quality and accessibility of financial information — has identified the paucity of leverage data as an important gap that needs filling. In a speech last week, Federal Reserve Chairman Ben Bernanke cited leverage as a vulnerability that can “amplify and propagate” financial shocks. The New York Fed publishes some limited information on repo haircuts.
Unfortunately, this sense of urgency might be getting lost in broader efforts to monitor systemic risk. The Office of Financial Research is spreading its resources across complex modeling and data standardization initiatives that, while necessary and promising, probably won’t provide useful real-time information for years. In trying to put the whole puzzle together, they could be missing an opportunity to do something useful right now.
Almost six years after the last financial crisis began, we are again reaching a point where robust, transparent measures of leverage would help regulators and investors understand whether markets are headed for trouble. The data would be relatively easy to produce, and officials have all the powers they need to do so. What are we waiting for?
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