Chapter Ǻ: Macroeconomics and Coordination ȀȃȀInvesting largely with borrowed money is “leverage.” “Deleveraging”
shook a multitiered structure of claims based on claims. Ļe marketability
of securities declined as their actual values became unknown.
Credit-default swaps are in effect insurance policies issued to cover
the risk of default on bonds and so make the bonds more marketable.
Ordinarily the insurance providers need not expect having to make good
on any substantial fraction of their policies at once, so they hold liquid
funds amounting to only a small fraction of their total potential liabilities.
“Ordinarily,” for in times of crisis the credit-default swaps enter into the
crumbling of the leveraged chain.
Ļe chain is more fragile than one might suppose on the grounds
that, indirectly and ultimately, houses largely back the bonds held by the
investors at the end of the chain. Ļe netting-out of intermediate stages
is not reassuring, for financial distress might strike any of the several insti-
tutions in the chain and break it.
Even so, compounded leverage is not inherently fraudulent; for it can
provide the benefits of sophisticated financial intermediation. It produc-
tively allocates the burdens of saving and risk-bearing to the parties most
able and willing to bear them in view of prospective returns. Complexity
breeds ignorance, however; and unscrupulous operators may exploit it.
Contagion marks booms and slumps. In times of exuberance, things
usable as collateral rise in price, permitting bigger loans. Furthermore,
lenders grant larger loans relative to collateral. Ļis expanded credit bids
up asset prices further. And so on upwards until the spiral goes into reverse.
Lenders become more demanding. Ļe troubles of operators holding
depreciating assets infect their creditors. Ļe multitiered leverage aggra-
vates the downward spiral (GeanakoplosȁǿȀǿ).
Mortgage foreclosures characterize just one channel of contagion.
Houses stand empty, lawns go untrimmed, the neighborhood depreci-
ates, house prices fall further and trigger further defaults, and holders of
mortgage-backed bonds suffer.
Structural contagion through these channels, as one might call it, is
joined by expectational and psychological effects. Ļe stock market is just
one of the things registering and perhaps intensifying optimism or pes-
simism. Investment fads and herd behavior are evident as people take
clues from one another. After a bubble collapses, fear engenders more
fear. Geanakoplos (ȁǿȀǿ) writes repeatedly of “scary bad news,” by which
he means news that is not merely bad but that intensifies itself by wors-
ening general uncertainty. Gorton (ȁǿǿȇ) emphasizes information and its