Thursday, September 24, 2009

A Word on Financial Bubbles and How They Burst
Joe El Rady

As the Financial Instability Hypothesis states, speculative investment bubbles are endogenous to financial markets. In prosperous times, a speculative euphoria develops due to increasing asset values. This encourages increasing amounts of speculation using borrowed money, which, in turn, results in debt levels that exceed serviceability by the investors’/borrowers’ revenues. When investors/borrowers lose the ability to service the spiraling debt they have incurred in order to finance their speculative investments, they rush to sell. As more and more investors face this same situation, the selloff grows larger and larger. Due to both the ballooning supply, which severely outpaces demand, and the similarly dire cash flow position faced by a large number of the market’s participants (they all need to sell), bids tremendously undercut asks, leading to precipitous collapse in market clearing asset prices and a sudden evaporation of market liquidity. This shapes a virtual death-spiral as losses on levered assets decimate equity and coerce the increasingly rapid sale of assets to reduce liabilities. The fire sale itself forces an increasingly intense devaluation of assets. The resulting devaluation of assets accelerates the need for asset sales, which accelerates the decline of asset prices, which, of course, decelerates the extinguishment of the matching liabilities, leaving large amounts of un-payable leverage in the market. The cycle continues, causing losses to beget losses and so on… The resulting liquidity crisis forces banks and lenders to tighten credit availability, even to borrowers that can afford loans. This type of financial crisis proves damaging enough without the magnification effects of structured credit instruments and portfolios that can turn a storm into a hurricane, the disaster that occurred during the financial crisis of 2008. More on that in a later post…