Financial Theory with John Geanakoplos - 25. The Leverage Cycle and the Subprime Mortgage Crisis

Financial Theory (ECON 251) Standard financial theory left us woefully unprepared for the financial crisis of 2007-09. Something is missing in the theory. In the majority of loans the borrower must agree on an interest rate and also on how much collateral he will put up to guarantee repayment. The standard theory presented in all the textbooks ignores collateral. The next two lectures introduce a theory of the Leverage Cycle, in which default and collateral are endogenously determined. The main implication of the theory is that when collateral requirements get looser and leverage increases, asset prices rise, but then when collateral requirements get tougher and leverage decreases, asset prices fall. This stands in stark contrast to the fundamental value theory of asset pricing we taught so far. We'll look at a number of facts about the subprime mortgage crisis, and see whether the new theory offers convincing explanations. 00:00 - Chapter 1. Assumptions on Loans in the Subprime Mortgage Market 18:27 - Chapter 2. Market Weaknesses Revealed in the 2007-2009 Financial Crisis 29:00 - Chapter 3. Collateral and Introduction to the Leverage Cycle 38:53 - Chapter 4. Contrasts between the Leverage Cycle and CAPM 43:36 - Chapter 5. Leverage Cycle Theory in Recent Financial History 01:03:55 - Chapter 6. Negative Implications of the Leverage Cycle 01:14:14 - Chapter 7. Conclusion Complete course materials are available at the Open Yale Courses website: http://open.yale.edu/courses This course was recorded in Fall 2009.