It's all about leverage

Last weekend at the Santa Fe Institute, I had the pleasure of hearing Doyne Farmer talk about the role leverage played in the current financial crisis. He summarizes his thinking in this Nature book review:
It is well known that extremely large changes, and financial crashes in particular, are more frequent than would be expected from a 'normal' statistical distribution. Physicists tend to favour a 'power law' mathematical description to model the heavy tails of these distributions, giving a pessimistic view of the likelihood of large price movements. By contrast, the economists who led LTCM spoke about price movements in terms of standard deviations, a terminology that is only relevant for normal distributions. [...]

Without a proper understanding of extreme risks, people follow cycles in which leverage slowly creeps up during good times, until a big loss happens and leverage requirements drop to levels that are too low, exacerbating or even causing a financial crash. Excessively low levels of leverage, such as those we are experiencing now, make recovery even harder.
John Geankoplos, also affiliated with SFI, has a similar take:
John Geanakoplos has teamed up with two physicists to look at the natural competition that emerged among hedge funds as they competed to attract investors. The group is examining how hedge funds took on additional leverage during that process—and how the state of the market changed fundamentally as a result of the added debt.
If this is true, it suggests a different solution to the financial crisis. Rather than focusing on interest, we should reduce homeowner leverage by focusing on principal:
[...] Monthly default rates for subprime mortgages and other non-prime mortgages are stunningly sensitive to whether a homeowner has an ownership stake in his home. Every month, another 8 percent of the subprime homeowners whose mortgages (first plus any others) are 160 percent of the estimated value of their houses become seriously delinquent. On the other hand, subprime homeowners whose loans are worth 60 percent of the current value of their house become delinquent at a rate of only 1 percent per month.

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