Unbelievable

A really nice paper on the unsustainability of the bubble is this 2006 paper by Robert Parenteau, US Household Deficit Spending. We were well into Minsky's ponzi finance regime where debt is acquired to pay off previous debt leading to a debt trap. Even if income increased with productivity, it could not sustain debt rising with asset values. Finance wasn't growing with the economy, it was the growth of the economy, it was growing at the expense of the economy. This is why it is so unbelievable so many failed to see it coming. They had to close their eyes really tightly.

Investment, Speculation, and Bubbles

Investors invest on a value basis for the long term. They try to determine what an investment is worth and value investments according to the income they expect. Speculators invest on a momentum basis for the short term. They try to determine what others think an investment will be worth and value investments according to the gain they expect. These are caricatures somewhat as many will consider themselves investors only to turn into or be turned into speculators after the market moves against them.

During a bubble there is a transition from assessing value to assessing other peoples assessment of value recursively providing convergence in expectations and a positive feedback loop for the explosion of prices. Eventually it runs short of new money or participants. Price increases start falling short of expectations. Speculators are forced out or start selling out. Prices start to fall. Expectations change. Feedback turns negative resulting in an implosion of prices.

In no place was the difference clearer than the housing bubble. Incomes never grew through it. The Fed has largely come to define income growth as inflationary and stemmed any real increase in it so no one should expect rapidly rising incomes. There was no investment case for housing in general. Lower interest rates meant property prices would increase, but also meant if they rose, prices would decrease. They could only always be worth more if one expected interest rates to keep falling. That is quite hard to swallow. The reason prices rose was because speculators were investing on a momentum basis and the reason they fell is because they were disinvesting whether due to being unable to carry them or on the same basis.

Under efficient markets, price is value, bubbles don't exist, and none of this makes sense, but to make sense of efficient markets one has to theorize investors had expectations prices would continue to rise, but how could prices rise without incomes to support them? Did they really believe the Fed would inflate to keep prices heading up after 20 years of disinflation? Could they really believe interest rates had only one way to go, even after the Fed began raising rates? Efficient markets strain credulity the same way lending standards strained credulity during the bubble. The only way to make sense of it is to assume limited rationality that makes momentum speculation reasonable. The only problem with that is it undermines and makes a mockery of efficient markets.

The Housing Mirage

In a notable piece of research reported in the WSJ, mortgage equity withdrawal, 25% to 30% of equity increases, may have contributed as much as 2.3% to gdp over 2002 to 2006. This is consistent with the reports of CalculatedRisk. If one also adds to this the amounts due to increases in the construction and finance and real estate industries over this period, perhaps 1.0% to 1.5% of gdp, there likely was no real growth over this period, none at all. Economic growth was a complete mirage due to the housing bubble. The question now will be whether there will be any going forward. I have my doubts, but at least we are no longer under any illusions.

Credit Crisis Continued

If only the Fed had ensured proper lending standards, it wouldn’t have been a housing bubble, but a sustainable rise in prices.

The presumption is often that rates were too low. In fact, they were too high, kept there by our ponzi financial system. Remember when Greenspan started raising rates, long rates fell. Bad lending was promising ridiculously high future returns which markets took at face value or ignored due to bad ratings and bad insurance. Bad lending increased leverage, reduced and eliminated qualification, promoted fraud and escalated asset prices. What started as a small problem was allowed to grow into a large problem (I would call $3T large) which was then compounded into an immense crisis when the Fed balked at covering those losses.

If only good lending had been allowed, rates would have had to have fallen much further to the point where it wouldn’t have been worth investing here and lenders would have had to choose between losing money, lending elsewhere (probably also losing money), investing elsewhere (risking losing money), or consuming more (spending money). Would this have just created a recession anyway? It could have as trade adjusted to the new reality, but it wouldn’t have led to a crisis of bad debt. Bad debt is bad enough, but when uncertainty exists as to how much, where, what, and who holds it, and how much punishment the Fed has in store, fear takes over. And it is not just about past losses, but also future losses due to breaking of the housing industry, breaking the consumption of asset price appreciation, and breaking of the financial sector’s means of revenue generation.

There were certainly failures all around. Much of the fraud was implicit and indirect. Don’t ask, don’t tell. Bad lending, bad ratings, and bad insuring were market failures due to agency problems and bad incentives. It was investors allowing bad ratings and bad insurance on bad lending to substitute for judgment. It was everyone trusting (wink, wink, nod, nod) everyone else to do their job. It was the market depending on the Fed to save them from their folly. And finally, since to coin money and regulate the value thereof is a governmental function allowing unchecked fraud and then allowing the economy to collapse from it are regulatory and monetary failures.

Tight money is the current, largest, and principal problem, though I lean in the direction it is tight because of lost faith in the ability to repay it, by both borrower and lender, but that is the reason it is all the more important for the Fed to change those expectations. Increasing credit is probably not possible currently due to this loss of faith. Reducing debt loads through refinancing with lower rates is also limited, collateral values being so reduced. Increasing money through asset purchases is possible but assets require management.

I have to say I have no better word than fraud for making loans that cannot be repaid other than through escalating asset prices. One can call it speculation, but there is no reason for the pretense of lending on speculation other than to mislead the ultimate lender into thinking the loan is safe and will be repaid. The entire prospect was oriented to disguise and hide risk and the fact that this was speculation from them. How much will you lend me to bet on black? I will offer a great interest rate but if it is red, sorry, you will be out of it. Even if prices escalate, even if there are some reasons to expect them to escalate, no one has any right to expect them to escalate forever and ever. Housing speculation was driving prices only I would not say it was only or even primarily borrowers speculating. It was as much lenders (intermediaries) speculating against each other. Home prices tripled or quadrupled in the most bubblicious areas. It was apparent there was not and would never be enough income to repay these loans. Even increased immigration increasing incomes comes up short when there are only so many families you can crowd into a home and no evidence of increasing incomes otherwise.

Don’t confuse the agents, the employees of these firms, with the firms themselves. No doubt they lost their jobs and some deferred compensation, but that was nothing compared to the money they took out of the system doing so. A half a billion dollar bonus goes a long way to alleviate any qualms. Finance operates under extreme discount rates, and are even higher for the individuals involved. So were the high salaries in finance due to their laughable brilliance or their employers incompetence? What market failure led to that? Yes, I am sure they all really, really, believed black would come up and keep coming up. It was just a case of bad luck. Heck, they didn’t even know red existed. Aw, shucks. Now that would be one for a movie script but no one would find it credible.

Debt Deflation Depressions

As Irving Fisher noted, depressions are always associated with high indebtedness. Attempts to liquidate this debt then induce deflation which actually increase real indebtedness. The only ways out of this are repudiation of the debt through default, reduction of the debt through inflation, or repayment of the debt over time. Is it possible or even desirable to prevent the rise of indebtedness?

The source of indebtedness changes between depressions. The Panic of 1837 centered on real estate, the Long Depression of 1873 on railways, the Great Depression of 1929 on stocks. Not that these areas alone were affected. Debt spreads to whatever can absorb it, it is just that there are not that many areas of sufficient capital value at a given time to absorb large amounts of debt. Real estate is a common one, as are large scale infrastructure such as canals and railroads, utilities such as electricity and telecommunications, to stocks. Only the largest, most capital intensive, most geographically extensive, most economically productive, most impressive new industries qualify, but as these are at the center of the economy, all others are encompassed by them.

The amount of lending reaches a climax, optimism reducing risk perceptions. Conservative lending can prevent credit bubbles by focusing on retrospective rather than prospective views, and based on income as much as asset values, but whether conservative lending can be maintained amidst the temptation of quick easy gains is difficult. Easy lending then chases out hard lending as easy lending increases all asset prices, even those hard lending lends on. Once the price of an asset becomes detached from the value of the income to pay for it, once the price comes from the gain expected rather than the dividend generated, a bubble becomes inevitable.

Some approaches to preventing this have been to limiting the amount of debt raised through debt covenants, limiting the debt leverage involved which was done in the case of stocks, and limiting the types of loans allowable such as requiring income documentation and requiring qualification at market interest rates, and these can work, but only if maintained and required. It will probably take another generation for people to forget and for the temptation of easy lending to arise and it will likely occur in some different area as yet untouched by it. A vigilant market and a vigilant regulator may keep it at bay longer, but when our guard is down and we least expect it, it may come again.

Double, double, toil, and trouble

Can bubbles be predicted? Can they be avoided? One of the key functions of the financial system is not to avoid bubbles but to blow them. The greatest profits are to be made in skimming money from fools and bubbles offer the ideal prospect. It is the why behind ponzi schemes. It is just most of the time the ability of finance to persuade others to bite is limited, the burden of defectors can be heavy, and all too easily you can end up the fool, the fool being the last one in and last one out.

There are two methods of profiting from bubbles, for investors it is timing them, and for dealers it is trading them. Timing is always difficult, but trading is always profitable. It is just necessary to avoid investing the profits into the bubble.

The book Contrarian Investment Strategies: The Next Generation by David Dreman, begins with a tale of casino with two rooms. The red room is crowded and exciting with large sums being won and lost but the house always gets their cut. The green room is sparse and quiet and actually rewards investors for playing but it is boring. Most people prefer the excitement of the red room to the dull rewards of the green room.

A successful theory of bubbles could be preventative. Yet it is always tempting to believe what you want to believe. Anyone looking at incomes and housing prices or equivalently debt from 2004 on knew we had a bubble. It was apparent they simply could not be afforded. Even knowing this doesn’t tell you how big the bubble will get, when it will burst, where the wreckage will end up, or how bad it will be afterwards. Some will avoid them, some will hope to get out before they burst, some will play them for what they are worth, some will misjudge them, and some will be suckered into them. Bubbles exist, but they are difficult to predict and difficult to profit from them.

I doubt most bubbles could be predicted but that is unnecessarily stringent. A theory might still be useful even if it only made predictions after one burst. One might not be able to avoid them but might still be able to address them after the fact. I don’t even see bubbles as something to be avoided at all costs. They may well play an important part in creative destruction.

Credit bubbles are an altogether different matter. They are tend to be easy to see and prevent by requiring lending be limited to retrospective rather than prospective views and based on income as much as asset values. All losses aren’t preventable but systemic losses usually are. Such a bubble could continue to grow, but only through equity rather than debt. Even this isn't foolproof, though, as debt can be floated rather than formally lent. Debt makes bubbles far worse because its systemic nature results in far larger bubbles, its rigidity makes it difficult to deal with, and its liquidation can lead to deflation.

I view bubbles as a transition from assessing value to assessing other peoples assessment of value, recursively providing convergence in expectations and a positive feedback loop.

Tell me Sammy, what do you know about the world of business

Did you know, beginning in the late 19th century, corporations were granted all the rights of the individual, but none of the annoying responsibilities. They lack, almost by design, any kind of moral compass, conscience, or compassion. Basically corporations are way to enact sociopathic behavior on a grand scale. In short, they're what makes this country so damn great!

-- The Devil, Reaper Season 2 Episode 12

It wouldn't be so hilarious if there weren't a bit of truth in it, at least from the Devil's point of view.


This illustration of the corporate hierarchy/social pyramid is that of GapingVoid