Wednesday, September 9, 2009

The Debt Cycle: Loan Duration and Credit Crisis

I'll be honest. I'm pretty proud of this one. After flipping through all of my economics books and numerous google searches I can confidently say that I've devised an original visual representation of debt in the business cycle. If any of my readers have seen such a representation elsewhere, feel free to burst my bubble in the comments section.

What prompted this maddening exercise in MS Paint was a bit of an epiphany: the asset bubble didn't have to pop because of price alone.

An entire plethora of reasons has been named for the asset bubble of 2008. Among these are lying, lack or government regulation, and irrational market expectations. These are all very large reasons for the market to have collapsed but why does the reason have to be large? What about the proverbial hair that broke the camel's? The pebble that triggered the avalanche? What I'm saying is that, at the heart of the cause of the crisis, somebody didn't pay.

Timing is very important to businesses. It is of little consolation to a restaurant owner to have people line up for breakfast the day after her business was taken over by the bank. In the above diagram you can see three businesses, their own debt cycles, and the interaction between these cycles (note that > is forward in time). Assuming an interest rate of 0%, this economy is at equilibrium. As an interesting side note, one can see that what banks really do is facilitate commerce by creating open contracts amongst businesses.

Think of the above cycle of transactions as gears. I've sized them all the same meaning that the maturity on the debt for all three businesses is of the same duration. Thus the gears mesh well and the machine turns. What would happen, however, if one of those gears were to be smaller and the corresponding business's debt maturity shorter? If the time horizon for business 3 to sell to business 2 were shorter such that business 3 had to sell its good prior to business 2 being ready to buy, it would go bankrupt. The gears wouldn't turn and, if enough events such as this one occured, the whole system would grind to a halt.

I don't fully grasp the realizations of this approach but I'd be willing to make the following bet. Prior to the crisis two things happened in the morgtage backed security market: average loan duration fell and time remaining to maturity also fell.


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