Wednesday, April 29, 2009

The Origin of Financial Crisis

I just finished reading The Origin of Financial Crisis by George Cooper and I highly recommend it. He explains very clearly how the basic laws of supply and demand are distorted by the use of leverage.

Let's start out by considering the case of a simple product like a loaf of bread. If the price of bread rises, the baker bakes more loaves thereby increasing the supply while buyers substitute other goods causing the price to return to its equilibrium level.

However, when you consider leveraged investments, the laws of supply and demand don't work in the same way. If the price of a piece of mortgaged real estate rises, the owner's equity in the asset rises. This makes him a better credit risk which induces the bank to offer him more credit at better rates. This in turn increases demand for real estate which lifts the price thereby starting the same cycle over again.

By the same token, when the price falls, the owner becomes under-collateralized. This makes him a worse credit risk causing the bank to demand more collateral and a higher rate of interest. This forces the sale of real estate thereby lowering the price and reinforcing the cycle.

As a result, the laws of supply and demand don't have the same effect on a leveraged investment that they have on a simple good like a loaf of bread. In the latter case, the market finds an equilibrium. In the former case, prices changes reinforce themselves.

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