The "haircut" on risky assets stops you leveraging it too much. I think it's about 5% for US treasury bonds. So for every 100 I want to finance I need to have 5 cash on hand. Itsuch higher for riskier assets and that keeps leverage down. Also when things start to get edgy banks demand a bigger haircut further reducing the available leverage forcing you to delever (e.g. March)
If you step through the arithmetic, you see that a 5% haircut can take you to 20x leverage. It's a geometric series.
That means that investors' internal risk limits are the binding constraint, not repo haircuts.
It's another way of saying that the financial sector sets its own leverage. Historically, that has not turned out well. It's why Dodd-Frank included a leverage rule for large banks.
> That means that investors' internal risk limits are the binding constraint, not repo haircuts.
While part of risk, expected return is a larger binding constraint in most cases over risk limits. I'm probably not going to lever up 20x for an tiny expected return. On the other hand, I may very well lever up 5-10x on something 50x more risky than treasuries if the 10yr is yielding 0.725%.
Aha. Is this how folks actually attain worthwhile rates of return on very low-return, low-risk investments?
[EDIT] well no that can't be it because it requires even more money coming in for those loans, which can't provide more expected return than the bonds they're buying or the whole thing would be pointless.
