What Does The Future Hold?

So what is the future for markets and are they still vulnerable to suffer from asset price bubbles? It would normally be safe to assume that after suffering so much pain and coming close to the collapse of the entire banking system investors would exercise more caution in the future. However history does not prove this to be the case. The DOTCOM bubble burst in the early 2000’s and investors lost much of their savings and pensions however the lure of quick, large and easy profits soon eradicated any thoughts of caution or rationality and once again we ended with another, even bigger bubble.

Looking toward the future many commentators and investors are already pointing towards the Gold price as being too high and remarking that this will soon burst. The widely known investor George Soros has stated many times that he believes the Gold price will correct soon and has even referred to it as the ‘ultimate bubble’. He has also reduced his holdings by 99 per cent! (See video below) Others have pointed to the entire Chinese economy as being a bubble. They claim that it is obviously not sustainable for the Chinese economy to continue with double digit levels of GDP growth and for their Government to keep the Renminbi, pegged at an artificially low level against the dollar. What will be the wider global consequences if the Chinese economy was to retract?

My concluding thoughts are that The Fed ultimately has responsibility for the wider economic stability of the system and it therefore has a duty to act if it feels any market could potentially damage the economy. The idea presented by the Efficient Market Hypothesis that investors make rational decisions based on all the information available is no longer valid. We all know from our daily lives that human beings don’t always make rational decisions and can be influenced by their background or others around them. However the argument that The Fed cannot prevent every increase in prices without damaging the economy is still valid and therefore presents the question ‘When should The Fed step in and when should they let the market run its course?’

I believe that the answer lies in whether or not the bubble is presenting a real threat to the wider economy. The housing bubble in the US was so dangerous because of the high levels of debt financing involved and the fact that in many cases either the underlying asset or the borrower was of low quality. However in the case of other bubbles such as the DOTCOM bubble in early 00’s or the potential bubble growing in the Gold market The Fed should let the market run its course as these do not present the same high level of risk to the economy. In these markets investors are mostly self-funded or use funds from their pensions and therefore run the risks and will ultimately face the consequences alone.

Are bubbles a preventable illness?

Throughout history ,financial crises often follow these asset price bubbles. The Fed ultimately has responsibility for maintaining the stability of the US economy, so should the central bank and government do more to prevent these bubbles from developing in the first place? In my previous post I outlined how I felt The Fed contributed to the housing bubble and I also touched on how political influence may make it difficult fopr The Fed to completely cut off any increase in asset prices. However I do believe that they could have acted differently in order to limit the boom in housing prices.

The first step (possibly the most simple and most important) would have been to acknowledge the existence of a bubble in the first place and at a much earlier stage. Working along with both the Federal Government and mortgage lenders they could have informed and educated the general population on the dangers associated with the bubble which was developing. They could have encouraged more caution on the part of both lenders and borrowers which may have somewhat curtailed the problem of irrational behaviour I discussed earlier.    

Secondly, as the regulator they could have issued specific regulations with regard to subprime lending. They could have specifically targeted the mortgage lending industry with increased standards which would have to have been met by borrowers. More specifically, dangerous products such as greater than 100 per cent mortgages could have been abolished and higher standards with regards to borrower suitability could have been introduced. Regulation could also have been used to influence the assets held by banks and their over all exposure to property backed assets could have been reduced.

Finally, and possibly the most extreme measure would have been to increase interest rates in an attempt to directly reduce mortgage borrowing. This step would have reduced to availability of funds to banks and therefore to individuals. This step however may also have had negative effects for the wider economy such as small businesses and therefore would have been unpopular with the Federal Government and the population.

On his blog (available here) Professor John Turner of Queens University Belfast recently posted a video of Adam Posen from the Monetary Policy Committee at The Bank of England discussing asset price bubbles. Mr Posen argues that it is not possible to tell the difference between a bull market and an asset price bubble before the bubble bursts and therefore central banks are not able to take pre-emptive action to deflate a bubble as this would damage real growth in the economy.

My own opinion at this stage is that for both practical and political reasons it can be difficult for central banks to prevent asset price bubbles, none the less, they should be extremely careful not to encourage bubbles to develop in the first place! 

US Property & The Fed

Alan Greenspan was chairman of the Board of Governors of the Federal Reserve form 1987 until 2006. A position he held during the terms of four different presidents and possibly more impressively during two asset price bubbles. He has been famously quoted in the past as saying, “We don’t perceive there to be a national bubble, but it is not hard to see that there are a lot of ‘local bubbles’. At minimum there is a little froth in this market.” When discussing US housing prices. He has also come under criticism in the media with Time magazine placing him third on a list of 25 people to blame for the financial crisis. I doubt if his successor, Ben Bernanke, has had a more popular beginning as he has went on record as saying “ There is no housing bubble to go bust.”

It is often too easy, with the luxury of hindsight, to look towards national government and place the blame for any problems or difficulties with the economy. So why has the finger of blame firmly been pointed Mr. Greenspan? Many argue the fact that in response to both the DOTCOM bubble and the Sept 2001 attacks the Fed cut the federal funds rate to 1.00% and by doing so lead to a surge in borrowing and refinancing. In 2004, Greenspan also championed Adjustable Rate Mortgages at a time when the Federal funds rate was still only 1.00%. However the rate was increased in the following two years to a high of 5.25% resulting with many subprime borrowers, who were initially able to meet their payments at the lower rate now being forced to default.

 

I believe that this prolonged period of record low interest rates contributed greatly to the amount of borrowing taken on by subprime lenders.  This resulted with an increase in house prices of more than 70% above the US rate of inflation by the peak of the asset price bubble in 2006. This artificial boom in prices influenced the overall US economy in two ways. Firstly, it fuelled the construction sector which accounted for a large proportion of the economy as new properties where built at near record levels. And secondly, the increase in prices increased the level of wealth for many individuals and household. Property owners felt that this increase in wealth was real and here to stay and therefore borrowed and consumed accordingly.

Any period of time during which the economy is doing well, with both low unemployment and high growth rates, sounds like music to the ears of politicians. This therefore makes it extremely difficult for the central bank to take action which may in any way jeopardise the governments popularity. My next post will discuss if the Fed could have done anything differently under Mr Greenspan and what lessons can be learnt for the future.

Irrationality of Investors

The underlying price of any asset is determined by the simple economic laws of demand and supply. If we apply this principle in the case of house prices we should conclude that the current price is that set by market forces and therefore should be close to the assets intrinsic value based on the fundamentals of the economy at the time. However in order to understand how this principle is violated and ultimately results in a bubble we must examine in detail the factors which can influence demand and supply. 

During the US housing boom it is safe to say that demand for property was at an all-time high. The government was actively encouraging first time buyers (all too often subprime borrowers) to make a move onto the property ladder and developers were purchasing investment properties with a view to let or sell the property in the future at a profit. The ability of the demand side to increase so dramatically was fuelled heavily by the availability of easy and cheap credit. Easy meaning that almost anyone could successfully apply for a mortgage (this lead to the widely used term ‘NINJA’ – No income, no job or assets) and cheap meaning low interest rates or interest only mortgages.

Allen and Gale (2000) point to the ability of borrowers to risk-shift as a major contributing factor to asset price bubbles. Borrowers can easily obtain funds and then invest in projects which will deliver the greatest return and because lenders cannot easily observe the riskiness of a project, there is an agency problem. However in the case of the housing bubble lenders felt that any project involving property was low risk as property prices had been increasing for many years and it was not uncommon for lenders to provide 110% - 120% mortgages.

It can be argued that this boom in demand was also caused by the psychological failings of investors and thus lead to irrational behaviour. Investors in property were over-confident about their predictions of the future. Simple terminology such as referring to a second home as an investment property instead of what it truly was – a speculative purchase, led many investors to feel they were guaranteed a profit. They also either, overestimated their ability to make repayments on mortgages or they predicted that house prices would continue to rise forever and it was therefore impossible for them to lose. There is also the idea of herding, whereby investors simply seen other people profiting from the housing boom and therefore decided to follow suit with little understanding of the market or actual risks involved.

It isn’t difficult to see how these factors influenced demand in the housing market and how this shift in demand was built on poor economic foundations. In my next post I will discuss the contribution made by the Federal Reserve towards the housing bubble and what if anything they could have done differently.

"Investors should try to be fearful when others are greedy and greedy when others are fearful" Warren Buffet 2004

Bubbles and History

The economic definition of an asset pricing bubble is that ‘Ex post asset prices are viewed as having been over-valued and not based on fundamentals’. This simple definition gives rise to a number of lines of thought. Firstly, can we only determine if changes in prices are bubbles after they have collapsed? Secondly, are all increases in asset prices harmful to our economy? Finally, are governments in a position to do anything to prevent bubbles from occurring and if so should they act? My aim in the forthcoming posts is to discuss each of these questions with respect to the US housing bubble and develop my opinion about  future bubbles.

Asset price bubbles have been witnessed many times over the last four hundred years, yet it seems they can still develop and grow with little pre-emptive action form politicians or central banks. This can then lead to devastating consequences for the economy if they are to burst. The earliest bubble was seen in the Netherlands with the dramatic increase in the price of tulip bulbs in 1936 and the subsequent collapse of prices by more than 90% the following year. This bubble lasted only a number of weeks and was limited to a small number of people involved in that particular market and it is therefore not generally regarded as an asset bubble in the modern sense by many such as Garber 1990. It is however in my opinion a good example of how human behaviour in a market can influence prices and how overconfidence can ultimate force prices above their intrinsic values. 

The most recent and possibly the most damaging asset bubble was that of the US housing market which came to a head in 2007 with huge effects globally. Since its inception in January 2000 the widely quoted Case–Shiller composite index for 20 major metropolitan areas in the United States (SPCS20R) seen constant growth in the first six and a half years increasing in value by over 106%. It reached its highest value of 206.52 in July 2006 before suffering just as dramatic a decline of over 20% to a value of 164.57 as of August 2008. (See diagram below) These dramatic changes in the price of assets call into question the rationality of investors and cast doubts over the reliability of some recent academic theories, most notably the Efficient Market Hypothesis.  

In the forthcoming posts I will discuss the housing bubble in the US and the action taken by the Fed both prior to and in response to the bursting of the housing bubble. I will examine in detail what drove the housing bubble and why these driving factors damaged the entire economy when the bubble collapsed. Finally I will examine if it is possible to predict the difference between a bull market and an asset price bubble and what can be done (if anything) to control the effects of bubbles by central banks.