Financial Bubbles Then and Now: Does Another Burst Mean Yet Another Bailout?
Sharon L. Secor
December 03, 2007
While the fallout from the latest speculative market mania is still spreading its contagion throughout American financial markets and those of many countries with which we do business, the media coverage of these events might lead the public to believe that the current crisis is an unprecedented event, a temporary and unforeseeable series of events perpetrated by a few bad actors. However, this sort of activity is hardly an anomaly in the world of business and finance. Checking back through past financial headlines might give one a distinct feeling of entering a time warp, as the pattern that gave rise to the current economic crisis has been played out time and time again throughout American history. Unfortunately, most often the taxpayers are left to foot the bill of the inevitable bailout, while those responsible for the mess are never truly held to account, free to begin yet another round.
The current economic crisis, with its roots in the sub-prime mortgage and real estate markets is just the latest example of an old classic, the speculative market bubble. These two industries, sub prime lending and housing, rose together in recent years, with climbing real estate prices driving higher demand in sub-prime mortgage lending. This led to more creative loans, both in the sub-prime market and in a market that came to be referred to as exotic loan products, as skyrocketing housing prices pushed consumers into ever higher levels of borrowing, exceeding what they could possible get in the prime lending zone. This is the point that speculation became rampant.
House-flipping is one example of the type of speculation that came into being, where the house was sold before teaser rates expired. No down payment loans, with closing costs financed in, meant that buyers really had little invested and less to lose. However, while housing prices continued to climb, they had a lot to gain, providing a great deal of incentive for speculators to enter that market. This, in turn, contributed to the inflation of housing prices, shooting them so high that it was difficult for the average American to enter the market without taking on a much higher amount of debt than had been customary in the purchase of homes in pre-bubble decades.
The next level of speculation came as these mortgages were packaged into investment vehicles and financial instruments. Mortgage backed securities were once very solid investments relied upon by conservative investors to balance portfolios, offsetting the risk of more volatile investments. As sub-prime loans began to make up a higher percentage of the mortgage market, they began to play a greater role in the make-up of a variety of mortgage backed financial instruments. Retirement funds and hedge funds have long made use of such investments, however awareness of the rising risk of these traditionally safe instruments did not increase at the same rate as did the inclusion of more and more subprime mortgage backed debt in these investment packages.
As investors continued to buy subprime loans, thereby relieving their originators of risk, mortgage brokers and lenders had little incentive for caution, when recklessness was so handsomely rewarded. And, thus, the bubble continued to grow, with financial markets being permeated with these subprime risk riddled investments. The deflation of the bubble began with rising interest rates, which affected adjustable rate mortgages at reset time, sometimes resulting in dramatic increases of the monthly payment due. A wave of defaults followed, which in turn caused a bit of a panic that pushed home prices down, as a greater number of homes hit the market, their owners selling ahead of foreclosure. As defaults progressed into the foreclosure crisis, with numbers approaching Great Depression Era levels, investors in mortgage backed investment vehicles saw the value of these investments decline. Write downs in the millions suddenly flooded the headlines, with billions soon to follow. Like the Confederate dollar of old, many mortgage backed securities were no longer worth the paper they were written on.
If all of this sounds rather familiar to you, rest assured, it is not a case of deja vu. We have seen this pattern before, with the rise and fall of junk bonds, and the subsequent savings and loan crisis, which was attributed to a significant degree to their holdings in what similarly became a speculative investment bubble. Like subprime loans, junk bonds started out as a slightly more risky investment than mainstream bond products. As the investment market for these bonds heated up, again speculation drove more risk into the market. As demand rose for these bonds and profits soared, rather than just limiting themselves to the best of the junk bonds, brokers began to dig deeper into the risk pool, in a pattern similar to the mortgage brokers of today, as they courted high risk borrowers with increasingly “creative” products.
Taxpayers footed the bill for the massive savings and loan bail-out, to the tune of an estimated $1.62 billion. Already there are whispers, murmurs, and even demands, for a government bailout of the current mortgage and lending crisis. That, of course, means that the tab would be presented to the taxpayers yet again. Another interesting 'yet again' to be found in this situation is that many of the same speculators that were involved in the junk bond debacle rode the housing bubble to the top, as well, with such financial institutions as CitiCorp playing essential roles in both speculative cycles. There's little incentive to learn from your mistakes when someone else pays the price.
Without any real incentive for caution, the bubble and burst cycle of speculation will continue, as it has time and time again, going back to the stock market crash that launched the Great Depression and beyond. While in the past such cycles were somewhat tempered by the fact that the federal government did not step in to bail out the major players the way it does today, meaning that they had to take their losses, those cycles did have the power to rock the nation's financial base. In today's era of tax-payer funded bailouts, not only does the economic foundation of the nation shudder in response to the burst of a big bubble, but the average American is forced to foot the bill to shore up the foundation upon which the next bubble will be built.
The current economic crisis, with its roots in the sub-prime mortgage and real estate markets is just the latest example of an old classic, the speculative market bubble. These two industries, sub prime lending and housing, rose together in recent years, with climbing real estate prices driving higher demand in sub-prime mortgage lending. This led to more creative loans, both in the sub-prime market and in a market that came to be referred to as exotic loan products, as skyrocketing housing prices pushed consumers into ever higher levels of borrowing, exceeding what they could possible get in the prime lending zone. This is the point that speculation became rampant.
House-flipping is one example of the type of speculation that came into being, where the house was sold before teaser rates expired. No down payment loans, with closing costs financed in, meant that buyers really had little invested and less to lose. However, while housing prices continued to climb, they had a lot to gain, providing a great deal of incentive for speculators to enter that market. This, in turn, contributed to the inflation of housing prices, shooting them so high that it was difficult for the average American to enter the market without taking on a much higher amount of debt than had been customary in the purchase of homes in pre-bubble decades.
The next level of speculation came as these mortgages were packaged into investment vehicles and financial instruments. Mortgage backed securities were once very solid investments relied upon by conservative investors to balance portfolios, offsetting the risk of more volatile investments. As sub-prime loans began to make up a higher percentage of the mortgage market, they began to play a greater role in the make-up of a variety of mortgage backed financial instruments. Retirement funds and hedge funds have long made use of such investments, however awareness of the rising risk of these traditionally safe instruments did not increase at the same rate as did the inclusion of more and more subprime mortgage backed debt in these investment packages.
As investors continued to buy subprime loans, thereby relieving their originators of risk, mortgage brokers and lenders had little incentive for caution, when recklessness was so handsomely rewarded. And, thus, the bubble continued to grow, with financial markets being permeated with these subprime risk riddled investments. The deflation of the bubble began with rising interest rates, which affected adjustable rate mortgages at reset time, sometimes resulting in dramatic increases of the monthly payment due. A wave of defaults followed, which in turn caused a bit of a panic that pushed home prices down, as a greater number of homes hit the market, their owners selling ahead of foreclosure. As defaults progressed into the foreclosure crisis, with numbers approaching Great Depression Era levels, investors in mortgage backed investment vehicles saw the value of these investments decline. Write downs in the millions suddenly flooded the headlines, with billions soon to follow. Like the Confederate dollar of old, many mortgage backed securities were no longer worth the paper they were written on.
If all of this sounds rather familiar to you, rest assured, it is not a case of deja vu. We have seen this pattern before, with the rise and fall of junk bonds, and the subsequent savings and loan crisis, which was attributed to a significant degree to their holdings in what similarly became a speculative investment bubble. Like subprime loans, junk bonds started out as a slightly more risky investment than mainstream bond products. As the investment market for these bonds heated up, again speculation drove more risk into the market. As demand rose for these bonds and profits soared, rather than just limiting themselves to the best of the junk bonds, brokers began to dig deeper into the risk pool, in a pattern similar to the mortgage brokers of today, as they courted high risk borrowers with increasingly “creative” products.
Taxpayers footed the bill for the massive savings and loan bail-out, to the tune of an estimated $1.62 billion. Already there are whispers, murmurs, and even demands, for a government bailout of the current mortgage and lending crisis. That, of course, means that the tab would be presented to the taxpayers yet again. Another interesting 'yet again' to be found in this situation is that many of the same speculators that were involved in the junk bond debacle rode the housing bubble to the top, as well, with such financial institutions as CitiCorp playing essential roles in both speculative cycles. There's little incentive to learn from your mistakes when someone else pays the price.
Without any real incentive for caution, the bubble and burst cycle of speculation will continue, as it has time and time again, going back to the stock market crash that launched the Great Depression and beyond. While in the past such cycles were somewhat tempered by the fact that the federal government did not step in to bail out the major players the way it does today, meaning that they had to take their losses, those cycles did have the power to rock the nation's financial base. In today's era of tax-payer funded bailouts, not only does the economic foundation of the nation shudder in response to the burst of a big bubble, but the average American is forced to foot the bill to shore up the foundation upon which the next bubble will be built.
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