The anatomy of a financial bubble’s boom and bust: Part 2

Published 7:00 am Saturday, October 4, 2014

The housing bubble of the 2008 crash followed the script described in part 1 very closely because real estate was said to be a “safe investment” that never lost value because “home prices never fall”. The same was said of the complex securities built out of thousands of mortgages.

From such beginnings, financial disasters follow along a predictable path. As credit becomes cheap and abundant, the desired asset becomes easier to buy. Demand for the asset rises and outstrips supply; consequently, prices rise. Because assets at the heart of the bubble can typically serve as collateral, and because the value of the collateral is rising, a speculator can borrow even more money. Borrowers become highly “leveraged”, or highly indebted.

From the year 2000, this pattern played out in America as home prices rose and wages stagnated. Consumers used their homes as collateral to borrow more, most often in the form of home equity loans.

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By the fourth quarter of 2005, home equity loans peaked at an annualized rate of $1 trillion, enabling millions of households to live well beyond their means. However , this debt financed increased consumption, had real positive effects on America’s broader economy. The increased consumption by households’ and firms’ purchasing goods and services fueled economic growth across the economy.

In the typical boom and bust cycle, investors and consumers are still saying “This time is different” and claim that the boom will never end. Even though the elements of a financial disaster and a growing evidence of reckless and fraudulent behavior were in place, investors and homeowners continued to believe that home prices would increase 20% per year indefinitely. Therefore the process continued.

This same excitement held sway in America’s shadow banking system of hedge funds, investment banks, insurance companies, money market funds, and other firms that held securities that appreciated as housing prices boomed.

Remember the basic Law of Supply and Demand and its seesaw effect: if supply is high, and demand is low, prices are low; if supply is low, and demand is high, prices are high.

At some point, the bubble stops growing, typically, when the supply for the bubble asset is greater than the demand. So then with high housing supply, and low demand, housing prices begin to fall. Confidence begins to fade, and borrowing becomes more difficult.

A bubble must have borrowers and easy money to flourish. When those dry up, prices begin to fall, and borrowers and lenders back off from the frenzy. That process began in the U.S. when the supply of new homes outstripped demand. The excessive number of homes built during the boom collided with diminished demand, as excessively high prices and rising mortgage rates turned buyers from the market.

The falling value of the asset at the root of the bubble, eventually triggers panicked “margin calls”, which are requests by lenders for borrowers to put up more cash or collateral to compensate for falling prices.

Part 3 will pick up here to conclude The Anatomy of a Financial Bubble’s Boom and Bust. Take heed of 2 Chronicles 7:14.

By Aaron Russell, Sr.