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Asset Bubbles

November 3, 2011

My post Credit Creation and Allocation explains how banks prefer to extend credit for purchasing existing assets. This starts off a boom.

Extending credit for the purchase of fixed assets, such as land, property, or stocks and shares, which are of course in limited supply, drives up the price of these assets. This creates the perception that investment in these assets is attractive, and this stimulates demand for further credit, and so you have an upward spiral. Risks are initially assumed to be low because loans are secured against the asset purchased, which is appreciating in value.

Interest rate policy (the main tool for containing consumer price inflation) is unable to check this.

Ultimately the boom is unsustainable. The inflated prices of these assets do nothing to produce goods, services or future income. At some point the whole cycles goes into reverse. The price of the underlying assets falls, loan defaults increase and the collateral can become worthless. Investors become more cautious. Banks find that they cannot sell their loan assets, and thus face liquidity problems, or their asset are judged worthless and they become insolvent…

Triggers of the downturn are various e.g.:

a. In the case of the sub prime mortgage bubble – borrowers faced increasing interest rates, partly because of the general increase in US interest rates and partly because they had been suckered into unaffordable mortgages with low introductory rates. Some had hoped to refinance, but things had turned against them. Increasing defaults resulted.

b. In the case of a bubble based on stocks and shares, investors are induced to buy shares not for the dividend income, but to speculate on the value increasing. Ultimately as the yield (= dividend income as a percentage of share value) reduces, investors realise they would be better off in gilts, and share prices drop. You would think that capital gains tax would inhibit this. As I understand it, instead of the investor straightforwardly buying the shares with the money ‘borrowed’ from the bank ‘off balance sheet entities’ are created to avoid the CGT.

There are several reasons why risks are underestimated initially:

i A bank’s risk model will fail to take account of the effect that bank has in driving up asset prices.

ii The extreme complexity with which mortgages etc are parcelled up and securitised makes it virtually impossible for an investor to ascertain the facts upon which a good risk assessment could be made. [see the post Alphabet Soup]

iii Traders are wrongly incentivised to do deals regardless of risk.

iv The agent v. principal distinction: Fund managers (agents) do not have identical interests to their client investors such as pension funds. [see the post Agents v. Principals]

As most people will be aware the principal costs of a banking crash are not the costs of bailout but the knock on costs of lack of lending to business and hence a faltering economy.

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