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A tale of two debt crises: a stochastic optimal control analysis

Author

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  • Stein, Jerome L.

Abstract

Banks should evaluate whether a borrower is likely to default. The author applies several techniques in the extensive mathematical literature of stochastic optimal control/dynamic programming to derive an optimal debt in an environment where there are risks on both the asset and liabilities sides. The vulnerability of the borrowing firm to shocks from either the return to capital, the interest rate or capital gain, increases in proportion to the difference between the Actual and Optimal debt ratio, called the excess debt. As the debt ratio exceeds the optimum, default becomes ever more likely. This paper is A Tale of Two Crises because the analysis is applied to the agricultural debt crisis of the 1980s and to the sub-prime mortgage crisis of 2007. A measure of excess debt is derived, and the author shows that it is an early warning signal of a crisis.

Suggested Citation

  • Stein, Jerome L., 2009. "A tale of two debt crises: a stochastic optimal control analysis," Economics Discussion Papers 2009-44, Kiel Institute for the World Economy.
    • Handle: RePEc:zbw:ifwedp:200944
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    Cited by:

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    2. Samar Issa, 2022. "Financial Crises and Business Cycle Implications for Islamic and Non-Islamic Bank Lending in Indonesia," JRFM, MDPI, vol. 15(7), pages 1-32, June.
    3. Haluk Yener & Thanasis Stengos & M. Ege Yazgan, 2015. "Survival Maximizing Leverage of an Economy: The Case of Greece," Working Papers 1503, University of Guelph, Department of Economics and Finance.
    4. Samar Issa, 2020. "Life after Debt: The Effects of Overleveraging on Conventional and Islamic Banks," JRFM, MDPI, vol. 13(6), pages 1-46, June.
    5. Stein, Jerome L., 2011. "The crisis, Fed, Quants and stochastic optimal control," Economic Modelling, Elsevier, vol. 28(1-2), pages 272-280, January.
    6. Haluk Yener & Thanasis Stengos & M. Ege Yazgan, 2017. "Analysis of the seeds of the debt crisis in Europe," The European Journal of Finance, Taylor & Francis Journals, vol. 23(15), pages 1589-1610, December.
    7. Adil Naamane, 2012. "Peut-on prévenir les crises financières ?," Working Papers hal-01885154, HAL.
    8. Jerome L. Stein, 2010. "Greenspan's Retrospective of Financial Crisis and Stochastic Optimal Control," European Financial Management, European Financial Management Association, vol. 16(5), pages 858-871, November.
    9. Samar Issa & Hussein Issa, 2025. "Exploring Corporate Capital Structure and Overleveraging in the Pharmaceutical Industry," Risks, MDPI, vol. 13(2), pages 1-33, February.
    10. Stein, Jerome L., 2010. "Alan Greenspan, the quants and stochastic optimal control," Economics Discussion Papers 2010-17, Kiel Institute for the World Economy.
    11. Issa, Samar & Gevorkyan, Aleksandr V., 2022. "Optimal corporate leverage and speculative cycles: an empirical estimation," Structural Change and Economic Dynamics, Elsevier, vol. 62(C), pages 478-491.

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    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing

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