How Big Must a Bubble Be to be Dangerous
Robert Waldmann
This is a brief follow up on my post on measuring bubbles. The amount lost due to sub-prime mortgages in default is tiny compared to the damage done. How large can the ratio of damage to losses be ?
My answer is it can be infinite — that it is possible for irrational investing to destroy the financial system, even if the financial system looses nothing on average when reality bites.
Let’s imagine a case in which big money center banks secretly bet each other tens of billions on the flip of the coin. Average gains and losses must be zero. However, if counter-parties don’t know who bet on heads and who bet on tails, the financial system will seize up as the solvency of all the gambling banks is in doubt.
In the real world, the coin flips were called CDSs. It was known that investment banks and hedge funds had huge positions in CDSs, but it wasn’t known who was long and who was short. When the price of CDSs written on CDOs made up of MBSs shot up there were winners and losers. However, unless and until a firm went bankrupt it was unclear who the winners were (after bankruptcy it is clear that the winners are lawyers and everyone else loses on average).
That’s enough to disrupt finance and cause a huge worldwide recession. I think that’s what did it. Not the average loss but the immense variance of losses across banks.
It’s true that banks lost on average. Partly the lost to some hedge funds. This hurts the system because hedge funds don’t provide financial services. However, I think the banks could have failed in their role in the economy by making stupid investments even if their losses had added up to zero.
Subprime triggered the crisis.
However, the real problems were that housing prices were far above where they should have been and people and firms were overleveraged.
The trillions in losses in MBS occurred because people realized the houses they were based on were not worth what they thought and the ability to pay of those with mortgage was less than thought.
Subprime was only a small part of this.
It’s true that UNCERTAINTY caused the financial markets to freeze up, but the uncertainty was much more caused by the underlying debts, not the CDS that insured them. CDS’s brought down only one firm – AIG.
Good post, and I will highlight leverage. Leverage is often at the root of many crises, and the level can dictate the magnitude.
Here is a chart from Calculated Risk:
http://cr4re.com/images/HouseholdValueDebtGDPQ307.jpg
I say monitoring various debt ratios may hold the key for magnitude, and level of risk.
I agree with Sammy. I would add though a little more because this post is so misleading. Beyond the underlying debts there was an unsustainable trend variance between incomes and housing costs, and between incomes and consumer credit debts. It was also obvious that the US economy had become too dependent on growth via the financial services sector. Without the leverage and all of the ‘innovations’ the economy would have simply failed much sooner. Most investors in the upper echelons understood all of these factors full well at the time in question and so the ‘uncertainty’ came from a combination known factors. It is also important to consider the important role that foreign in-flows played although it is enough here to say that the system was overwhelmed with investment capital. I don’t know whether savvy investors understood this aspect as things were crashing although I would guess that at least some did (Goldman Sachs folks knew). I do know however that it is not ‘popular’ to bring up the fact that too much capital might be a problem because this invokes scrutiny of wealth distribution issues.
Well, eventually we are going to find out, when the derivatives bubble busts. Total derivatives are estimated in the 600-700 T (yes, that’s a “T”), it would only take a relatively minor % to blow up in order to cause some real trouble in the world. And you know the old saying in the theater, “If there’s a gun on stage, count on it going off.”
You left out the link between bubbles and gambling between financial firms. Could you flesh that out more, please? Thanks. 🙂
This is the “Maximally Inefficient Market Theory?” — Participants in the markets are so incompetent at setting prices that they may set the price of perfectly sound operations to zero based on bad guesses?
More probable I think is the “They’re all liars” hypothesis. Most operations being priced in the markets are lying non-stop about assets and profits. Market participants (“marks” for short) suspect this to be the case, but can neither prove it nor identify actual assets and profits/losses. When solid evidence of trouble surfaces, estimates of actual assets and profits are reset and the resulting prices are lower. Since IOUs based on future profits and asset values are an important element of commerce, business slows, jobs are lost, prices are driven still lower by negative feedback.
Codger,
Another interesting cycle dynamic is that labor exploitation peaks just before all hell breaks loose. A $$ incentive exists to play out this cycle because with costs rising and labor stagnant the profit margin increases and so irrational exuberance is maybe not so irrational as it ‘might’ seem. ~ ray
when you say ‘i think that’s what did it’ do you have any evidence? you have rough outlines of a hypothesis, for sure.
i have been wondering myself why the collapse of lehman was so bad. i don’t think it was just cds. there is a lot of other fragility in the financial system (rehypothecation is one example).
***i have been wondering myself why the collapse of lehman was so bad.***
STLATF (Stayed Too Long At The Fair) syndrome perhaps? When Lehman was allowed to collapse, it looked like the entire financial pyramid scheme might follow it. A lot of folks who sort of knew they should have gotten clear 6 or 12 or 36 months earlier decided to cut their loses and get out right now if not sooner?
Then the government stepped in and propped things up.
CDSs get sold as insurance but what they really provide is a vehicle to hide losses by stuffing the counterparties with the pain. A CDS seller knows they are deals that are going to go south eventually, so they sell them to buy insurance, in the end the nieve counterparty pay the price.
The problem is that those niave counterparties are pension funds, municiple funds, money market funds, etc. They gladly buy the CDO to get the easy interest streams, thinking they are maximizing alpha while minimizing beta. Not realizing the opposite is the case. A fund manager is prased for instant earnings garnered by the fund, and not policed for how sound that investment truly is in the long term.
You can play this game forever, until forever ends. And when forever ends Minsky is proven right.
Same idea behind CDS as CDOS, CMOS, etc. CDS is just squaring the deal, sending it to another level.
All these posts are completely valid! what is a bubble??? ” My answer is :1 when there is no control over the leverage of the bet and no balance of the sides & the $’s aren’t equal, a problem is evident. Solution is all bets in cash.
2 We have a bubble in our stock market right now! as any expectation of return not associated with further ballooning of P/E ratios is absurd. Solution ???” SEC ” could jawbone and advertise what the real expectation of what % return on investment is possible when the P/E exceeds 15 to 20 times earnings . Anyone will realize they are better off in bonds, or real estate.
The real problem is that there is more money out there trying to manufacture a return than can be usefully employed ,or that can be absorbed by any useful investment. I can remember when P/E ratios of 6 to 15 were normal and interest rates didn’t vary 20 basis points in a few years. That’s been a while ago.
In 200 years we have gone full circle from not enough money to even keep society functioning; to more money than can be usefully employed to produce an oiled social structure. Then in the 80’s when taxes were considered, the talk went to “American Industry Needs more Investment, and needs tax relief and they got it, then used it to send jobs overseas.
Most nations are in need of of green infrastructure now. Certainly the USA has had little or none since the early 80’s The solution is Tax and spend on infrastructure / Education / tax away all the gambling money and put it to work building a green tomorrow. The Fed has spent 2+ trillions and counting to save a financial system we don’t need and will continue to glorify itself by inventing more ways to SIV,CMO, CDS a financial hydra that we don’t need and have created legal nightmares for pension fund , Insurance Companies and others that must keep liquid reserves to protect contingent commitments. Return to the policies of the 40’s and 50’s heavily subsidized College for anyone who qualifies. Build national infastructure and rationally designed energy efficient buildings. Elininate most cars by providing green mass transit not just fast transit. Life isn’t better when you “increase its speed”. Work ethic is just as valid when applied to scientific research as to Investment banking! Sciences objective is to make people safer better fed and healthier as opposed to working more hours to invent deviations, or obstruct regulations we hope will keep our majority healthy in affordable homes and expecting a future without having to “caveat emptor” every decision they make whether on health care or home purchase.
Convert all this mischief- making wealth into productive opportunities for everyone.