Sunday, August 26, 2007

Another asset bubble - how come?

In today's (Sunday August 26th) New York Times, it said that "Many government officials and housing-industry executives had said that a nationwide decline would never happen."

So, what happened?

Cheap credit which brought higher risk borrowers into the mortgage market.

Where did the cheap credit come from? Who wanted to take on higher risks at lower prices? It doesn't make sense.

Actually, very smart people came up with this seemingly unwise investment proposition. In fact, they were basically the same very smart people who lead the investment boom of companies and telecoms and the irrationally exuberant markets of the mid to late 1990s.

In the United States housing market, new sources of liquidity were found. Home mortgages were sold by the original lenders in large numbers of separate mortgages to investment brokers who aggregated them into packages of income and secured assets (the homes) supporting securities. Investors bought the securities, sending new flows of liquidity into the home mortgage market. This is creative financing that brought money and home ownership to millions of Americans previously left out of the home mortgage market. In short, the creativity of brokers in putting together new contractual arrangements for the sharing of risk in exchange for money was of great benefit to many.

But too much money flowed in for too much risk and when the excesses were discovered, the money flow dried up.

A second force building the credit bubble supported by home equity values also came from smart people - they arranged a sharing of the risk so that the high risk could be put off on to the shoulders of those who had the financial assets to absorb it should things go wrong. Or, at least that was the theory.

The theory didn't work. Just as previously the equity markets for dot.coms and telecom companies (and Enron and WorldCom) didn't hold up as promised either.

The recurring weakness of free market financial capitalism (the tulip bulb mania in 17th century Holland; the South Sea Company Bubble in London of the 1720's; and regularly thereafter) is the market's inability to sustain equilibrium in liquidity expansion. Enthusiasm for speculation takes over and the best and the brightest go hog-wild over getting on the bandwagon to ride the market up.

When the fever is on the market, new sources of liquidity come into play, driving up prices as more and more players seek to profit from the mania. Then, as always, liquidity runs out; the smart money people realize that there is no "there" there and pull back. Prices fall until a stable point is reached were market values more correctly approximately intrinsic values.

Now private equity, hedge funds, and buyouts have piled on where home mortgage lending lead the way. Too much leverage, too much debt in relation to the underlying fundamentals.

So now we are in a necessary correction for a time.

The real correction, necessary, however, is to figure out some self-correcting prudence that could be built into financial markets and temper episodes of "irrational exuberance."

Steve Young


Anonymous said...

Hi Stephen, Colleagues,

In an opinion piece in one of Canada's leading newspapers, I have drawn the ethics link between the ethics and reputational damage of the subprime debacle and the toxic imports from China see the following website:

Unknown said...

"The real correction, necessary, however, is to figure out some self-correcting prudence that could be built into financial markets and temper episodes of "irrational exuberance."

Wasn't the answer to previous episodes of 'irrational exhuberance'the requirements for internationally recognised standards and above all timely transparency/disclosure e.g. The Sarbanes-Oxley Act(2002). The market responded by developing new opaque investment vehicles and so here we are again awaiting another vast swathe of 'cosmetic' legislation to control the uses of credit derivatives in the sub-prime market.This is why the Caux Princple No 3 is right to aspire to urge us to go beyond the letter of the law to trust, and trust begins with transparency on the part of buyer and seller alike.

meambobbo said...

the methods of financial stability you are talking about are NATURAL interest rates and bankruptcy.

without the FED's creation of artificial credit, lower interest rates do not result in cyclical boom-bust activity. this goes for speculative bubble activity too - a product of distorted economic calculation due to increasing stocks of money.

if businesses were always allowed to fail when the market refuses to loan bad businesses money, businesses would have much less incentive to take on such risks. they would use higher interest rates to exclude credit risks from borrowing.

let's get rid of the FED and government money and regulation on banking. then we'll see if these bubbles and risky lending occurs in a free market. i'll bet one of my kidneys it doesn't.