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Leverage Bubble

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  • Wanfeng Yan
  • Ryan Woodard
  • Didier Sornette
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    Abstract

    Leverage is strongly related to liquidity in a market and lack of liquidity is considered a cause and/or consequence of the recent financial crisis. A repurchase agreement is a financial instrument where a security is sold simultaneously with an agreement to buy it back at a later date. Repurchase agreements (repos) market size is a very important element in calculating the overall leverage in a financial market. Therefore, studying the behavior of repos market size can help to understand a process that can contribute to the birth of a financial crisis. We hypothesize that herding behavior among large investors led to massive over-leveraging through the use of repos, resulting in a bubble (built up over the previous years) and subsequent crash in this market in early 2008. We use the Johansen-Ledoit-Sornette (JLS) model of rational expectation bubbles and behavioral finance to study the dynamics of the repo market that led to the crash. The JLS model qualifies a bubble by the presence of characteristic patterns in the price dynamics, called log-periodic power law (LPPL) behavior. We show that there was significant LPPL behavior in the market before that crash and that the predicted range of times predicted by the model for the end of the bubble is consistent with the observations.

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    File URL: http://arxiv.org/pdf/1011.0458
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1011.0458.

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    Date of creation: Nov 2010
    Date of revision: Nov 2010
    Handle: RePEc:arx:papers:1011.0458

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    1. Jiang, Zhi-Qiang & Zhou, Wei-Xing & Sornette, Didier & Woodard, Ryan & Bastiaensen, Ken & Cauwels, Peter, 2010. "Bubble diagnosis and prediction of the 2005-2007 and 2008-2009 Chinese stock market bubbles," Journal of Economic Behavior & Organization, Elsevier, vol. 74(3), pages 149-162, June.
    2. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
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