Manmohan Singh and James Aitken of IMF have written a nice paperwhich explains more problems with deleveraging. ( I had warned you that expect a lot of stuff from IMF, they have been doing some great research at a greater pace recently)
The authors looks at the practice of Rehypothecation. It is like a vicious circle. Crisis lowers Rehypothecation and Rehypothecation then leads to deleveraging which then worsens the crisis. The abstract explains the paper really well.
Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to their prime broker to be used again as collateral by that prime broker for its own funding. In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets. And moreover, there are no customer protection rules (such as in the United States under the Securities Act of 1933). The paper shows evidence that, following Lehman’s bankruptcy, the extent of rehypothecation has declined substantially, in part because investment firms fear losing collateral if their prime broker becomes insolvent. While less rehypothecation reduces counterparty risk in the system, it also reduces market liquidity.
Rehypothecation had increased quite a bit before the boom. One security kept changing hands . In UK Rehypothecation was free for all but there were some restrictions and regulations in US. So as Lehman fell, the customers of Lehman UK were in complete trouble but some solutions were available for Lehman US. Now as Lehman collapsed Rehypothecation declined as people didn’t accept security collaterals and demanded cash collaterals. This led to a vicious circle as suddenly people either didn’t have enough original good collateral or didn’t have enough cash.
Leveraging is so easy to build but once deleveraging starts (which has to happen as it is a cycle) it poses numerous problems. Another problem of asymmetry in financial markets. As a result, we keep hearing from various economists to put some cap on leverage ratio. It was completely unthinkable till this crisis . As Rodrik puts in this presentation (slide 17):
We can be certain that no future regulation will prevent similar occurrences unless leverage (i.e., borrowing) itself is directly restrained.
A good paper which explores the actual practices in financial markets and then explains the problem.