Saturday, September 3, 2011

Boombustology: Chapter 10

Asset bubbles are frequently popping up, and back down. They are easy to spot in hindsight, but we appear to lack the tools to recognize them ahead of time. Vikram Mansharamani aims to rectify that with his book, Boombustology. He applies a multi-lens approach to understanding bubbles with the aim of giving the reader the ability to identify bubbles, and thereby avoid being caught unaware.

This chapter contains an examination of the US housing bubble boom and bust that took place in the last decade. Because it is recent, and took place in the US, it is likely fresh in the reader's mind. Here's how it appears through the five lenses described in the book:

1) Microeconomics: Demand for real-estate was reflexive, driven by how creditworthiness was measured. Rather than issue loans based on a borrower's ability to pay through earnings and cash flow, they were issued based on asset values. This led to a virtuous cycle where increases in asset values led to increases in credit which led to further increases in asset values.

2) Macroeconomics: After the tech bubble burst, interest rates were lowered to extremely low levels. This increased a borrower's immediate capacity to finance (especially on interest-only loans) a purchase, contributing to sky-high prices

3) Psychology: There was a general feeling that real-estate prices cannot drop. Popular media outlets jumped on the real-estate bandwagon, turning everyone into believers.

4) Regulatory: A number of regulations contributed to the unsustainable boom. For one, government-backed institutions Fannie Mae and Freddie Mac helped securitize home equity loans, decoupling lenders from borrowers, which resulted in mortgage originators who did not have much of an interest in a borrower's ultimate ability to repay a loan.

These government institutions were also pressured to finance lower income and under-served areas as significant portions of their loan portfolios. This increased risk, since such borrowers are likely the least able to repay loans.

The tax deductibility of mortgage interest also played a role. Since interest for car or student loans is not deductible, citizens are encouraged to take home equity loans for the purposes of consumption, thus reducing home equity and increasing risk due to leverage.

5) Biology: By the peak of the boom, citizens were inundated with commercials and programming dedicated to the pursuit of real-estate. The number of real estate agents in the country had doubled in just a few short years. Risky loans (defined as subprime and Alt-A) went from 10% of the mortgage market in 2003 to almost 35% of the market in 2006. From the point of view of the epidemic model, the country had been infected with housing fever, with virtually nobody left to infect.

The final two chapters focus on identifying bubbles through these lenses before they burst.

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