Friday, April 10, 2009

Collateral is king

Over 400 years ago Shakespeare explained that to take out a loan one had to negotiate both the interest rate and the collateral level. It is clear which of the two Shakespeare thought was the more important. Who can remember the interest rate Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed on as collateral. The upshot of the play, moreover, is that the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral level. The Fed too should sometimes decree different collateral levels.
--John Geanakpolos, "The Leverage Cycle," on the importance of collateral

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