Minsky, mortgages and you
Posted on July 16, 2009 by Richard Beddard
Filed Under Markets |
In practice:
Minksy’s protracted moment
If you follow this blog, you’ll recognise these names: Jeremy Grantham, Nouriel Roubini, Robert Shiller, and James Montier. I’ve quoted them many times, and they anticipated the financial crisis.
They have something else in common, they’re all followers of economist Hyman Minsky. Grantham describes himself as a Minsky maven. Roubini feared we were at the top of Minsky credit cycle in July 2007. There’s an intellectual genealogy linking John Maynard Keynes to Robert Shiller via Charles Kindleberger, Shiller’s teacher, and Minsky, who influenced Shiller. James Montier describes himself as a proponent of the Kindleberger/Minsky framework for analysing bubbles.
Montier recently left Soc Gen, for GMO, Jeremy Grantham’s company. It’s a small, Minskyish club of financial crisis Cassandras.
Here’s Montier’s Kindleberger/Minsky crib-sheet showing the phases of bubbles and crises current and past (click on it for the full sized version):
There are at least five phases, and no prizes for spotting we’re in either phase four or phase five now:
- Displacement: A new development, the Internet say, or low interest rates, creates investment opportunities.
- Credit creation: Banks create credit to fund the boom, new banks form, and invent new ways of lending and borrowing.
- Euphoria: As stockmarket prices rise, overconfident investors ignore risks, abandon safeguards, and make bad investments.
- Distress: Insiders cash out, the prices of investments start to fall and some prove to be fraudulent.
- Revulsion: Investors can no longer bring themselves to participate in the market. Investments are cheap again.
Minsky, who died in 1996, explained the credit cycle which fuels booms and busts. In his Financial Instability Hypothesis (for a nutshell explanation see CXO Advisory Blog) he said the economies are not self-correcting, or equilibrium-seeking, as is commonly supposed, but, depending on the nature of borrowing and lending, can be wild and unstable.
According to the FIH there doesn’t need to be any reason for a recession, or a depression, beyond a long period of prosperity, which lulls borrowers, investors and regulators into complacency, a situation which seems to describe the year 2007.
As confidence in the status quo grows the kind of debt used to finance investment and consumption changes from:
- Hedge financing where the borrower can repay the debt out of income and has a high equity stake, to…
- Speculative financing where the borrower can repay interest but not the loan, which must be refinanced when it’s due, to…
- Ponzi financing: where the borrower cannot repay interest or the loan but must sell assets or borrow more to meet its commitments.
When hedge financing dominates, the economy is stable. When the other two categories dominate, it’s not. Ever-riskier borrowing leads to financial bubbles, and when confidence bursts Ponzi and speculative borrowers are unable to refinance. Instead they must sell assets to stay afloat, driving markets downwards and squeezing more borrowers.
In a recent paper Paul McCulley, managing director of Pimco the giant American asset manager, explains how this time a shadow banking system, unregulated investment banks, hedge funds and the now notorious structured investment vehicles, created explosive growth in debt which ratings agencies and regulators were ill equipped to deal with because they simply hadn’t seen this kind of debt before (and the rating agencies were in the pockets of the shadow bankers).
Since Minsky first published his theory in 1986, McCulley says:
…the first thing we do when we discuss Prof. Minsky is show reverence.
Chalk up another acolyte, who warned that interest-only and subprime mortgages are textbook examples of speculative and Ponzi finance in March 2007.
For a graphic, and somewhat easier to absorb illustration, you only had to watch Freefall on BBC 2 on Tuesday night (you still can on iplayer), and judging by the reviews on Amazon.com, Robert Barbera has written an excellent explanation in his book The Cost of Capitalism.
Freefall dramatised the human side of what McCulley calls the Minsky Moment, or the bursting of the bubble.
He coined the term to describe the Asian credit crisis of 1997, when it was Asian corporations doing the risky borrowing, but the pattern repeats itself through history, as Montier’s crib-sheet shows.
It’s apparent now that nearly everybody’s carried away by these credit fuelled business cycles, from the commanders of the economy, like Alan Greenspan and Gordon Brown, to the family that borrows more than it can afford, reassured by rising house prices.
But this chart, which accompanied an article in Der Spiegel about another economist, William White, who also warned of the impending crisis, makes me wonder whether we have reached revulsion, the final phase of the cycle, yet.
Although it refers to America, the UK’s had nigh-on thirty years of falling interest rates too, which probably makes us very complacent.
Figures from the Council of Mortgage Lenders show that the number of new and probably speculative interest only mortgages have declined from a high of about 34% of house purchases in 2007 to 19% in May, but 26% of remortgages are interest only.
More worrying, I think, is borrowers’ predilection for short-term fixed-rate deals and lenders’ willingness to supply them. The CML doesn’t have statistics for the relative popularity of short and long-term fixes but says that one to three year deals are by far the most popular.
The nation’s gambling that interest rates when we come off those rates will remain low. I’m not sure where these deals sit in Minsky’s scheme, but they look speculative.
Add in more risks; house prices falling further, lenders unwilling or unable to refinance loans on similar terms, unemployment, and mortgage holders enjoying low rates now on mortgages that aren’t fixed for the long-term face an incalculable future.
Borrowers haven’t yet learned Minsky’s lesson. Don’t even get me started on bankers!
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Have asset prices further to fall? The economy is distressed, but there’s a big difference between phase four of the cycle (distress) and phase five (revulsion). In phase four asset prices are still falling and in phase five they’re cheap.
My modest contribution to the study of asset prices, measuring the long-term price earnings ratio of UK shares, shows they are cheapish but not necessarily revoltingly so.
And just to add even more ambiguity to that statement, Robert Shiller, who believes that lower long-term price earnings ratios do predict higher returns, says the precarious state of the economy means stockmarket predictions are even more unreliable than usual.
In theory:
Vampire Squid is a buy
Some more economists who know what they are talking about. This time Alphaville highlights research by Dirk J Bezemer, including a list of analysts ‘who saw it coming’. Contrary to main stream economists, these analysts paid a great deal of attention to the role of finance and property in the economy.
Another one, Nassim Nicholas Taleb, says instead of inflating assets, banks need to deflate debt by offering homeowners lower interest rates for part ownership of their property.
Pimco’s Paul McCulley, pulls out Ben Bernanke’s roadmap, and sees Washington cutting taxes and printing money like never before.
Meanwhile, the Federal Reserve Bank of New York has published two timelines showing what governments have done so far.
Jeremy Siegel: “Stocks always win in the long run”. Barry Ritholz says “No!”
Meredith Whitney, an analyst that was bearish on banks before the financial crisis, issued a buy note on Goldman Sachs, aka ‘The Great Vampire Squid’.
Ric Traynor, of restructuring specialists Begbies Traynor, says corporate insolvencies could exceed peak levels at the height of the last recession in 1992. They’re up 43% year-on-year.
Graeme defines a value trap.
If financial comment isn’t free, it isn’t influential says Felix Salmon.
Bernard Madoff is transferred to the same prison Charles Ponzi was jailed in.
Comments
6 Responses to “Minsky, mortgages and you”
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Great write-up! Just discovered your site from a link on The Big Picture (another great site). Will make sure to hit your site regularly!
Many thanks,
Rick
Thanks Rick
What makes people like Roubini interesting is not that they saw that things would go wrong - for one thing the obvious bubble in housing had to burst sooner or later.
What was remarkable is that they realized how bad it would be. I remember reading Roubini before it all fell apart and thinking “he is right, except that it is not going to be that bad” - now of course it is clear that it is “that bad”.
Hi Graeme, I agree. The interesting thing about Roubini in particular is that he didn’t just say property prices would crash, but that it would destabalise the finanicial system and how. Here are the speeches: http://www.rgemonitor.com/roubini-monitor/253448/2006_and_2007_imf_speeches_by_roubini_predicting_the_recession_and_the_financial_crisisand_the_five_stages_of_grief . I don’t know how you do that, but it’s either very lucky, or very impressive!
Great post, thank you. I shall spend some weeks scouring the links…
Thanks Pragmatist, let me know if you have any observations beyond mine when you have! I’d like to spend more time on the FIT too.