Resident fellow Alex J. Pollock describes the current instance of the cycle of bubbles and busts in financial markets. During the twenty-first century housing bubble, house prices rose dramatically, and mortgage investors engaged in short-term financing. When house prices fell, fear pervaded the markets, and short-term lenders withdrew. Will financial markets learn an enduring lesson from this bubble and bust? Historical precedent says that they will not.

Resident Fellow Alex J. Pollock

The young 21st century has delivered a notable financial bubble as well as its inevitable bust. It has done this despite amazing computer power, reams of data, and sophisticated models operated by exceptionally bright Wall Street analysts. It is an expensive lesson in the fact that computers and data do not make us wise--especially in that form of group behavior known as financial markets.

Or as an old boss of mine, looking me earnestly in the eye, pointedly said about a proposal I had made at the cusp of the 1980s bust: "Alex, it is much easier to be brilliant than right." About this he was entirely correct, and I have thought of his dictum hundreds of times over the years of my own career, as financial fads were replaced by financial crises, followed anew by enthusiasms. May all the readers of the Harvard College Economics Review take his insight to heart.

Many brilliant people helped create the recent bubble and the current bust in housing and mortgage finance. These events display all the patterns of recurring credit over-expansions and their painful aftermaths, as colorfully described in classic discussions by Walter Bagehot, Charles Kindleberger, and Hyman Minsky. [1]  Such expansions are always based on an euphoric belief in the ever-rising price of some asset class--in this case, houses and condominiums. This appears to offer a surefire way for buyers, borrowers, lenders, investors and speculators to make money, and indeed they all do--for a while. As long as the prices rise, everyone is a winner.

To some astute observers, it was apparent by 2005 that the great American house price inflation of the new century, along with the efflorescence of subprime mortgage credit, had created a bubble. Nonetheless, the bubble continued to grow. The expansion of credit both fed the house price increases and seemed justified by them. A good example of this bubble spirit was the 2005 book by a prominent housing economist: Are You Missing the Real Estate Boom? Why the Boom Will Not Bust and Why Property Prices Will Continue to Climb Through the Rest of the Decade. As it turned out, this was not too good of a call!

Because so many people are making money from them while they last, bubbles are notoriously hard to control. As Bagehot so rightly wrote in 1873:

All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while. [2]

Bagehot further observed that:

The period of rising prices. . . naturally excites the sanguine and the ardent. . . and the ablest and the cleverest the most. . . Every great crisis reveals the speculations of many houses which no one before suspected. [3]

This time of what was apparently the greatest house price inflation in US history naturally excited the lenders, the loan brokers, the bond salesmen, the mortgage investors, the borrowers, the speculators, the homebuilders and the flippers. The value of residential real estate almost doubled between 1999 and 2006, increasing by about $10 trillion. With a peak value of about $22 trillion, residential real estate, which has since fallen about 10%, was and still is a huge component of household wealth. The US residential mortgage market is the largest credit market in the world, with outstanding loans of more than $10 trillion, $1.3 trillion of which represents subprime mortgages. Securitized US mortgages, prime and subprime, are owned by investors around the world.

The unexpected acceleration of subprime mortgage losses and of falling house prices has led to a credit contraction in spite of expansionary central bank actions. The consequences have been far-reaching: the closing or bankruptcy of about 200 subprime lenders; large losses and a deep recession in the homebuilding industry; more than $150 billion of announced losses or write-downs by US and foreign financial firms; heavy losses by private mortgage insurance companies and giant government-sponsored mortgage companies such as Fannie Mae and Freddie Mac; still-increasing mortgage delinquencies, defaults, and foreclosures; and a discontinuous global financial freezeup. It is now a little hard to remember the former political enthusiasm that accompanied rising home ownership rates and the former economic enthusiasm that arose with complex financial structures built out of subprime mortgages.

Why was the financial market reaction so severe? The short answer is leverage and the short-term financing of risky long-term assets. If the price of an asset is always rising, more debt leverage always seems better. Thus, the credit experience of loans financing the asset will be good, with low delinquencies and defaults, so that the risk of the loans seems to be decreasing even though the risk is in fact increasing. Minsky called this process the "endogenous build-up of financial fragility." He described the central behavioral elements as follows:

Acceptable financing techniques. . . depend upon the subjective preferences and views of bankers. . . Success breeds a disregard of the possibility of failure; the absence of financial difficulties over a substantial period leads to the development of a euphoric economy in which short-term financing of long positions becomes a normal way of life. [4]

It becomes normal, that is, until the shortterm financing is no longer available. When the price of the underlying asset begins to fall, with credit defaults and losses rising, overconfidence is replaced by fear. Everybody becomes conservative all at once, and the short-term lenders withdraw, creating a panic in the process. Velleius Paterculus nicely summed up the overall pattern in his history of Rome (c. 30 AD): "The most common beginning of disaster was a sense of security."

During the subprime mortgage expansion, sophisticated, computerized models created a sense of security. But the reality of subprime credit defaults and losses turned out far worse than the models predicted, and the market value of mortgage-backed securities has dropped far more than the models expected they could. This recalls Moore's Law of Finance: "The model works until it doesn't."[5]

It is useful to consider that in the first half of 2007, the financial world was being treated to pontifications such as "abundant liquidity" or even "a flood of liquidity," which would guarantee a firm market bid for risky assets and narrow spreads. In August, a "liquidity crisis" began that has continued until now.

At a discussion of the mortgage bust last fall, a senior economist from an international institution intoned, "What we have learned from this crisis is the importance of liquidity risk." "Yes," I replied, "that's what we learn from every crisis." The tendency of financial markets to re-learn the same lessons every decade or so is one of the most intriguing things about them.

Bubbles never last forever, and neither will the bust, although it may seem like forever to many people caught in it. Will the lessons of the first 21st century bubble and bust last more than five or ten years? The evidence of history is that they will not.

Alex J. Pollock is a resident fellow at AEI.

Notes

1. Walter Bagehot, Lombard Street, 1873; Charles P. Kindleberger, Manias, Panics, and Crashes, 1978 (see also 5th edition, revised by Robert Z. Aliber, 2005); Hyman P. Minsky, Stabilizing an Unstable Economy, Chapter 9, "Financial Commitments and Instability," 1986.
2. Bagehot, Hyperion Press edition, 1962, p. 78.
3. Ibid., p.77.
4. Minsky, p. 213.
5. Named after my friend and bond market colleague, Mike Moore of Hillebrand Partners.