At the epicentre of the crisis − a bursting bubble
In last week’s column I put forward the thesis that, the enormity of the global financial crisis and its associated credit cr-unch could be gauged from two indicators. Firstly from the carnage they have already wreaked on the United States’ financial system and secondly, the awesome scope of that government’s response. Without a doubt the United States is at the epicentre of the global meltdown. I have already considered the first of these indicators and in the process of doing this introduced two important financial precepts. One is that a credit crunch is different from a financial crisis. And, the other is that some financial firms are considered ‘too big to fail.’
The latter raises a number of systemic issues. One is that when firms take greater risks they expect increased profits for their risky behaviour. Such profits are privatized. When the risky behaviour fails and losses occur if the firm is considered ‘too big to fail,’ then taxpayers are expected to cover its losses. In such instances ‘losses are socialized.’ Such policies encourage firms to take risky behavior without risk to themselves. This is a clear instance of practising moral hazard.
Housing bubble
At the heart of the financial crisis in the United States is a private housing market bubble that has burst. And, because the United States is at the epicentre of the global crisis we can safely say that the proximate cause of the global meltdown is the bursting of the United States’ private housing market bubble. In order for readers to fully grasp the significance of this diagnosis that, at the heart of the crisis in the United States there is a housing bubble, which has burst I need to briefly indicate: what is a bubble?
This is a technical term used by economists to describe a situation in a market for any asset whose price or face value is rising rapidly and continues to do so with little or no regard to its underlying or ‘true’ value. This happens because purchasers of the asset and the financial firms that lend them the money to purchase the asset convince themselves that not only will the price of the asset continue to rise but that in fact it cannot fall!
In retrospect, after the bubble bursts it seems unbelievable that those involved in the market could not see the continuous deviation of the face value of an asset from its underlying or true value was unsustainable. However, it frequently happens.
What is a
bubble?
Let us look at an example of an asset with which most readers would be familiar even if they do not possess the asset themselves. If the shares in a company or titles to property have continuous rapid rises in their prices with no regard to the income derived from these, a bubble is in the making. The income from the share is the dividend it would pay and from the property the rental value it could command. To purchase shares or property titles, purchasers would normally borrow money from financial firms using the asset as collateral. These firms would be willing to lend because in the environment of rising prices for the asset, using it for collateral against the loan used to purchase it would seem to guarantee repayment. If the borrower defaulted the asset could easily be sold to recoup the loan.
The classic definition of a bubble is “tr-ade in high volumes in prices that are considerably at variance from intrinsic values.” To be sure bubbles can be based on any asset. Indeed the asset describes the type of bubble. Thus a housing bubble is based on housing titles (mortgages). Financial bubbles are based on the general class of financial instruments. Stock exchange bubbles are based on the general class of stocks and shares. There have also been bubbles based on technical innovation, the so-called ‘dot-com’ bubble of the 1980s. There have also been other housing bubbles, for example Japan in the 1990s. All these bubbles have a common thread. That is, there is a speculative element as purchasers in the market are buying with the intention of selling at a profit.
Bubbles go through three distinct phases. First, there is a phase when the price of the asset is continuously rising. Purchasers of the asset borrow money from financial firms in order to enter the market. Lenders are quite willing to lend as loans do not look risky at all. They expect rising prices to continue. This is called ‘inflation based lending’ and is in fact a very risky policy to follow.
In the second phase of the bubble it becomes evident that incomes in the broader economy cannot sustain the current rate of inflation in the price of the asset. The face value of the asset begins to taper off. Purchasers are no longer willing to buy. Demand for the asset falls and so does its price. Lenders then become worried. They shift from inflation based lending to the standard and less risky ‘cash flow based lending.’ Loans dry up. And, as the asset price falls panic and anxiety hit the market for the asset.
In the third phase, the bubble bursts. The asset price collapses. Lenders now hold an asset that is now vastly devalued. Naturally they are unwilling to lend at any interest rate as the risk of default is great. In this situation several purchasers and lenders become, effectively bankrupt because they are left holding assets, which were bought at phony values. In the United States millions of households have found that the value of their outstanding mortgages is greater than the value of their houses. Many of these mortgages have been foreclosed and could not recover the sale of the outstanding value of the mortgage from the sale of the house.
This is indeed the heart of the financial crisis and housing crunch in the United States.
Next week I begin to outline the government’s response to this situation.