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.