Question

What is leveraging and de-leveraging? What was the role of leveraging and de-leveraging in tulipmania, and the Mississippi and South Sea episodes.

Answer 1

Leveraging is a process in which businesses and people borrow money for investment into something from which they expect the returns to be so high that they can not only repay the borrowed funds and interest payments, but also make some profit.

Deleveraging is a process in which debtors reduce their debt obligations by selling their assets.

Tulipmania was a kind of financial bubble that busted in Netherlands during the 17^th century when expectations of significantly higher returns in future led people and businesses to invest heavily in tulips. This raised the price of tulips to unprecedented levels. However, as the expectations faltered the price of tulips crashed and investors faced significant losses. So, while earlier they were leveraging, later when the prices collapsed they were forced to deleverage.

Mississippi Bubble was the financial bubble during the period of 1718-1720 which originated from France. The bubble was created when investors started investing in Mississippi Company owned by John Law that had exclusive right for the development of French Mississippi territory in North America. Given, the monopoly of the firm investors started leveraging on it. However, after the stock market crash due to the deteriorating financial health of French government and also faltering prospect of the company, the shares of the company collapsed causing the bubble to bust.

South Sea Episode was the financial bubble of 1720 that busted after the South Sea Company collapsed. Government of Britain in order to manage its debt called the South Sea Company, and under the arrangement the company offered its shares in exchange for the government’s debt obligations. Such debt-for-equity swaps created fertile ground for the financial crisis. While initially the government, the company, and investors felt happy, as government need to only deal with the company, while investors were getting not only dividend payments but also expecting capital gains, things turned ugly when the prospects of the company became bleak. South Sea Company was given monopoly contract to trade in slaves to Spanish colonies in the Americas. This created confidence among the investors who started leveraging on the company. However, after the share price collapse investors had to deleverage.