How to Spot an Ongoing Asset Bubble

As 2007 draws to a close, the notion of price has been resurrected in the financial markets. Less than a year ago, it seemed that prices for some asset classes simply didn’t matter any more. Disregarding price is tantamount to suspending belief in markets. There were a lot of nonbelievers for a while. Witness the apostasies.

Real Estate. The subprime mess and mortgage crisis can be traced to one fundamental problem: buyers paid too much for real estate. This insensitivity to price was enabled by a flood of easy credit, which often was extended in looney loans that for many borrowers were impossible to repay. The resulting rapid rise in prices was used as a justification for paying even higher prices, on the theory that a rising market would allow anyone, however lacking in creditworthiness, to sell or refinance. This recklessness soon became foolishness, and fools and their money are (and were) soon parted.

Derivatives. Vast numbers of mortgages were financed through mortgage-backed securities that were then engineered into derivatives contracts sold to investors. Many of these derivatives purported to construct AAA-rated investments from subprime loans. This alchemistic feat of turning lead into gold involved Wall Street using computer models to assign valuations to the derivatives (while chanting incantations, we now suspect). When things got ugly and investors tried to sell the derivatives, they found that there was a bit of a chasm between the computer valuations and the cash prices real human beings were willing to pay. Ultimately, all financial assets are measured by the amount of cash they command. Computer models don’t buy food, clothing, rent, college educations or retirements. When push comes to shove (and eventually it will), derivatives contracts have value only to the extent they can be transformed into cash. Since these investments are largely unregulated, caveat investor.

Risk. The summer and fall of 2007 will be remembered as the Great Repricing of Risk. Recall that previously, risk was viewed as something that could be whisked away by clever financial engineering. We now understand that risk never dies. Even if banished to distant lands, it has a way of wending its way back, across great oceans if need be, to pop unexpectedly out of closets and cellars, and work its evil. The financial markets now price risk as if it were real, which is a good thing since it is real.

Market dysfunctions always end in an ugly way. But Alan Greenspan notwithstanding, asset bubbles can be spotted while they’re happening. When price becomes increasingly insignificant to purchasers, you have an asset bubble in the making. Maybe it’s hard to precisely identify when an asset bubble begins. But the limitations of statistical methodology shouldn’t be used as an excuse to refrain from seeing what’s right in front of you. Price insensitivity in the real estate and mortgage markets was hard to miss in 2005 and 2006. Wall Street executives and the regulators could have spotted this one in the offing. Indeed, a few did but could make no headway toward action against the Panglossian self-satisfaction of the conventional wisdom. Next time (and there will be a next time) remember that when price sensitivity diminishes, economic insanity will soon follow.

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