Leverage Bubble

TL;DR

This paper analyzes the 2008 repo market crash by applying the Johansen-Ledoit-Sornette bubble model, revealing LPPL patterns indicative of herding-driven leverage bubbles that preceded the crash.

Contribution

It introduces the application of the JLS bubble model to the repo market, demonstrating its effectiveness in identifying bubble dynamics before the 2008 crisis.

Findings

Significant LPPL behavior observed before the crash

Model predictions aligned with actual market crash timing

Herding behavior contributed to leverage bubble formation

Abstract

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 range of times predicted by the model for the end of the bubble is consistent with the observations.