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Leverage Bubble

Leverage is strongly related to liquidity in a market and lack of liquidity is considered a cause and/or consequence of the recent financial crisis. A repurchase agreement is a financial instrument where a security is sold simultaneously with an agreement to buy it back at a later date. Repurchase agreements (repos) market size is a very important element in calculating the overall leverage in a financial market. Therefore, studying the behavior of repos market size can help to understand a process that can contribute to the birth of a financial crisis. We hypothesize that herding behavior among large investors led to massive over-leveraging through the use of repos, resulting in a bubble (built up over the previous years) and subsequent crash in this market in early 2008. We use the Johansen-Ledoit-Sornette (JLS) model of rational expectation bubbles and behavioral finance to study the dynamics of the repo market that led to the crash. The JLS model qualifies a bubble by the presence of characteristic patterns in the price dynamics, called log-periodic power law (LPPL) behavior. We show that there was significant LPPL behavior in the market before that crash and that the predicted