Tuesday, June 19, 2007

What Makes a Bubble?

Here is an excellent description of the present:

"Shares rose faster than at any time during the century. House prices were also climbing sharply, producing a boom in the construction of suburban mansions. The Republic lost some of its Calvinist austerity as its people became a nation of consumers, mixing their love of display with an avidly speculative pursuit of wealth."

The present it describes is Holland in 1635, at the height of the Tulip Mania. With some very minor editing, this is a quote from Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor, an excellent book recently recommended here by reader/analyst U. Doran.

The key context for manias, bubbles, crashes and financial panics is of course the human mind. To quote again from this book:

"Speculators were, in Vega's words, "full of instability, insanity, pride and foolishness. They will sell without knowing the motive; they will buy without reason." Vega's speculators exhibit many of the features associated with the full range of manic-depressive behavior. A manic-depressive experiences violent and uncontrollable mood swings. As his expectations grow increasingly unrealistic, the manic becomes careless and this precipitates his downfall. Unable to see the broader picture, he becomes fixated on insignificant details."

That's a very good description of the psychology of greed and fear--emotions shared by all humans. But what other characteristics of previous bubbles might provide context for our own stock and asset bubbles? Here are three which seem under-reported:

An expansion of easy credit allows companies to borrow off their assets, and then spend the borrowed money buying their own stock, thereby boosting their assets as share prices rise, enabling the company to borrow even more for future buy-backs.

The use of margin debt (buying an asset with only a percentage of cash, the balance being borrowed from the broker). In the tulip mania, 20% cash was all that was required to buy a tulip future (the bulb itself was still in the ground) worth ten times the annual average salary (200-400 florins). In the 1929 mania, margin requirement was 10%. Today, it is 50%.

The purchase of derivatives and credit swaps without having to deliver the underlying good or shares. As fantastic sums were borrowed and traded for rights to various bulbs, the derivatives/futures outstripped the actual supply of highly valued bulbs; when it came time to actually deliver the goods--by this time, the bulb had a mountain of trades piled on it--there weren't enough bulbs to go around. All the trades and swaps made on non-existent bulbs blew up, and after months of lawsuits, "a government commission declared that tulip contracts could be annulled on payment of 3.5% of the agreed price."

Speaking of insignificant details: Does anyone remember the book-to-bill ratio? During the 1990s tech boom, the semiconductor industry's book-to-bill (orders/shipments) ratio could trigger massive movements in the NASDAQ each month; the report was awaited with breathless anticipation. Now it's merely an artifact of that bubble.

Our current insignificant details include phony, manipulated measures of inflation and GDP growth. The initial number is inevitably wide of reality, more a wild guess than truth, yet the invaribaly inflated number moves the market ever higher, even as later downward revisions are utterly ignored.

Let's hear a cheer for stock buy-backs! The South Seas bubble of 1720 was based on a variation of the current private-equity/stock buy-back bubble. In our present bubble, it works like this: you borrow $1 billion based on company assets--the value of its outstanding shares--and then you buy $1 billion of shares back and retire them, effectively reducing the float (supply) of stock. This reduced supply means any demand moves the price of the shares up, boosting the value of the company, which can then support another $1 billion loan. Rinse and repeat.

Do you see the circularity of this "Bull market"? Rising prices feed more borrowing which raises values even higher which enables more borrowing which... hmm, is this "value investing"? It's more like crass manipulation by insiders--all perfectly legal and even hyped as a "good thing for current stockholders."

As for mountains of derivatives and credit swaps built on tulips which can't be delivered--how about all those CDOs and other mortgage-backed securities? All those instruments are based on the delivery of income and/or principle from tranches of pooled mortgages. If the homeowners stop paying the mortgages, then there's nothing to deliver, and the house of trading cards falls. The same also holds true if the homes are foreclosed and sold "as is" for a mere slice of the mortgage; the promised principle comes up short, and all the promises made to holders of CDOs melt like an icecube dropped in the Sahara.

In other words, the "value promised"--the interest and principle--become undeliverable. This triggers demands for payment on holders of upstream contracts (CDOs, credit swaps, you name it) who can't deliver, either. As the bottom layer defaults--the homeowners--so too does the next layer, and the next layer and so on to the very pinnacle of the derivative mountain.

This is how you get a crash. All the same machinations were in play in 1635 and 1720. Global trade was extraordinarily vigorous and profitable then, too. "Prosperity" was just as limitless as it is now. But the endgame wasn't decades more of wealth-creating machinations; it was financial ruin for everyone who played until the end.

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