Bubble Expectations
The banks that survived the holocaust of the early thirties probably differed from those that went under. In addition, and very much likely more important, they undoubtedly drew from their experience lessons that affected their future behavior. For both reasons, the banks that survived understandably placed far greater weight on liquidity than the banks in existence in 1929.
The shift in the liquidity preferences of banks was destined to be temporary. To judge by the experience of earlier episodes, the passage of time without any extensive series of bank failures would have dulled the fears of bank managers.…
—Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960
AN ECONOMIST DEFINES A “BUBBLE” as any situation in which the price of an asset exceeds its “fundamental” value.1 Therefore, bubbles pose a puzzle for standard economic theory. Why would investors continue to purchase assets at prices for which they are certain to lose money when the asset’s price returns to normal? Why wouldn’t the market be flooded by offers to sell the asset at the inflated price?
The “no-duh” answer is simple: investors believe that the fundamental value of the asset has increased. But where do such beliefs come from, and how are they propagated? How do the beliefs become so widespread that buyers continue to buy and sellers won’t sell as asset prices spike?
Economists are divided on the answers to these questions.2 Behavioral economists like Richard Thaler, George Akerlof, and Robert Shiller have stressed the psychology of decision making. They argue that most investors are only boundedly rational.3 In particular, they are not very good at distinguishing between fluctuations in prices and changes in underlying values. So if they see the price of an asset increase, they are likely to assume that its value has increased. Contrary to economic theory, they may buy more and sell less as the price increases. If most investors respond this way, asset prices may greatly exceed the underlying values—that is, until the price starts to drop and the same psychology leads to plummeting values.
Other economists are less likely to stress the irrational aspects of the bubble. After all, because the value of an asset is what someone is willing to pay for it, it is not irrational to pay the market price for an asset whose price has risen. One only needs to expect to be able to sell later for a higher price. As former Citigroup chair Chuck Prince put it, “when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”4 But the musical chairs explanation just moves the question back one level: why do investors believe that other investors believe that the fundamentals have changed?
So, regardless of whether one views a bubble as a reflection of rational or irrational behavior, the driving force is overoptimistic beliefs about the value of assets. The consequences of such exuberance are far reaching. First, investors overinvest in the bubble asset, diverting resources from assets whose price-to-true-value ratio may be lower. Just as market capitalizations for Internet start-ups skyrocketed during the dot-com tech boom, there were huge increases in residential real estate investment that could not be justified by an increasing demand for housing. Second, investors borrow additional funds to buy more of the bubble asset, using the asset as collateral. Investors also borrow to take cash out to finance consumption. Because the asset prices are inflated, these loans are naturally highly leveraged (the ratio of the loan to the true value of the asset is very high). But the belief that the price of the bubble asset will rise even further leads to even laxer lending standards, magnifying leverage and risk even further.
What happens when the bubble pops? The economy survived the pop of the dot-com bubble without a great recession. The pop of the housing bubble was different. When the residential real estate bubble popped, falling prices led to increased expectations that underwater borrowers would not pay the basic mortgages. This led to a fall in the price of securitized mortgage loans. Financial institutions became less willing to accept these securities as collateral. Highly leveraged owners of these assets were forced to seek liquidity by selling other assets, spreading the crisis throughout the economy. The crisis is worse if optimism is replaced by pessimism and asset prices fall below fundamental values.
Because beliefs and expectations are crucial, the most obvious government intervention would be to cool down these expectations or to counteract their effects. But that is much easier said than done. The biggest hurdle is that key government officials and regulators often share the beliefs on which the bubble is sustained.5 For example, one of the principal beliefs that sustained the recent housing bubble is that innovations for securitizing mortgage debt could be used to package together bits and pieces of the very risky subprime mortgages into almost riskless securities that could be sold to investors in exchange for a reasonable rate of interest. Consequently, lending standards could be lowered, more buyers would be brought into the market, and rising home prices would be the natural response to this shift in the way that risk was “spread out.” This innovation made it appear that high-risk securities were “diluted” by being poured into an “ocean” of low-risk securities.
Did this view justify the complex and far from transparent instruments that were created in the bubble? On the one hand, there are sharply diminishing returns to risk management by diversification. In his famous book A Random Walk Down Wall Street, Burton Malkiel makes the point that one gets almost as much diversification by owning twenty stocks as by owning two thousand.6 On the other hand, massive defaults of purportedly “dilutable” no-income-verification loans are economically harmful—perhaps even more so when risk management strategies carve up the original loan into pieces owned by a multitude of owners.
Nonetheless, there was, in the expression of Warren Buffett, a “mass delusion” about the benefits of financial innovation in the mortgage market.7 Market actors were by no means the only ones who believed that securitization of subprime mortgages could sustain large growth in the housing sector.
Politicians of all stripes shared the industry’s enthusiasm for financial innovation. Upon signing the Gramm-Leach-Bliley Act that repealed the Glass-Steagall firewall between commercial and investment banking, President Bill Clinton declared, “This historic legislation will modernize our financial services laws, stimulating greater innovation and competition in the financial services industry. America’s consumers, our communities, and the economy will reap the benefits of this act.… Removal of barriers to competition will enhance the stability of our financial services system. Financial services firms will be able to diversify their product offerings and thus their sources of revenue. They will also be better equipped to compete in global financial markets.”8 Alan Greenspan told a Federal Reserve Conference in 2005, “Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country.… The mortgage-backed security helped create a national and even an international market for mortgages, and market support for a wider variety of home mortgage loan products became commonplace.”9
Put simply, when the policy makers share the bubble beliefs, they must also believe there is no rationale for intervention. Willem Buiter, now the chief economist at Citigroup, has dubbed this phenomenon the “cognitive capture” of financial regulators: “It can be called cognitive regulatory capture (or cognitive state capture), because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, or some important regulator, like the Fed, but instead through those in charge of the relevant state entity internalizing, as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest instead.”10 That private investors and policy makers share beliefs is not terribly surprising. There are tight social and professional links between the regulators and the regulated. In many cases, today’s regulator is tomorrow’s regulated. Moreover, government officials are influenced by the same economic research and financial journalism that informs market actors.
Even if government officials did not share the enthusiasm of the market participants, it would have been politically difficult to intervene given that the bubble euphoria extended well beyond Wall Street to the general public. According to the Gallup Organization, in May 2005, 70 percent of Americans believed that the average price of houses in their area would increase over the coming year.11 This follows a decade in which housing prices grew at astronomical rates.12 Even at the top of the market in 2006, 60 percent still believed that prices would push higher.13 Given such beliefs, it is little wonder that millions of Americans bought new homes and refinanced existing mortgages in the hope of profiting from increasing home values.
As we now know all too well, the consequences for popping the bubble were traumatic: defaults, foreclosures, and huge financial losses. Yes, these losses would have been mitigated if the government had intervened in 2005, 2004, or 2003. But in a democracy, one can hardly expect elected officials to take direct responsibility for costly actions running so counter to public opinion. To paraphrase Abraham Lincoln, most people fool themselves most of the time. Career politicians, even if they know better, have to go along. They want to be reelected. There are not enough “profiles in courage.” Most are loath to “take away the punch bowl during the party.” It is much better for them politically to let the bubble run its course.
Governments are often themselves the cause of bubble beliefs. Asset values may inflate simply because market participants believe that government will step in to offset the losses if things go bad. For example, during the bubble, many market participants believed that their downside risk was hedged by the “Greenspan put.” In other words, there was a widespread belief among investors that if financial markets were in trouble, the Federal Reserve would use its various policy tools to calm the markets and prevent losses. Thus, government policy worked exactly like a put option in which the investor has the right to unload a security at a prespecified price if its value declines too far. Such beliefs clearly promote risk taking by investors. Another example of policy beliefs inflating a bubble was the widely believed, but never explicit, government guarantee of the debt of Fannie Mae and Freddie Mac. This belief substantially lowered the government-sponsored enterprises’ cost of borrowing and allowed them to dramatically ratchet up their holdings of mortgage-backed securities. It is hard to count on government to counter bubble beliefs when it is often the underlying source of them.
When the bubble pops, there will be greater divergence in beliefs between the financial services industry and government officials. Policy makers and their constituents are naturally going to be more suspicious of information and analysis coming from the industry. Similar to investors whose pessimism deepens, policy makers and voters may become overskeptical of the benefits of unregulated financial markets and practices. As we discuss in chapter 8, busts often lead to populist backlashes against financial services firms.
A prime example is the firestorm that erupted over the payments of retention bonuses to many American International Group (AIG) employees after the government bailed out the firm following its losses on credit default swaps. Government-selected CEO Edward Liddy argued that the retention bonuses were necessary to keep key personnel in place to liquidate AIG’s positions at minimal cost to the taxpayer.14 But voters and their representatives in Congress were outraged that bonuses would be paid by a firm that had received a bailout of well over $100 billion of taxpayer money. They believed that the bonus payments were essentially a looting of the U.S. Treasury; they did not accept that the bonuses were a business necessity given the compensation practices in the financial services industry and the need to retain expertise in a company now owned by the taxpayers. The House quickly passed legislation (of dubious constitutionality) taxing the bonuses at a 90 percent rate. The House engaged in cheap populist theater, knowing the Senate would never go along. And the Senate did not.
Although the malleable and procyclical expectations of investors and politicians play a very important role in generating financial crises, we argue that they are far from the only beliefs that matter. As we discuss in chapter 2, the rigid and inflexible beliefs emanating from political ideologies are perhaps even more important in generating and sustaining the political bubble.