The next financial bubble

Attendee at a seminar: “There are bubbles in the market every now and then. What are the indicators of the next bubble?”

Expert speaker: “The day you stop thinking of this question, that is an indication of the next bubble.”

When everyone is hundred percent sure that the markets can only rise up, that is the time to be cautious.

Sir John Templeton has said, “Bull markets are born on pessimism, gorw on skepticism, mature on optimism and die on euphoria.”

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The seeds of the crash are planted in times of the boom and vice versa

The proximate causes of these successive crisis are very different – emerging market debt problems, the new economy bubble, default on asset-backed securities, the political strains within Eurozone – yet the basic mechanism of all these crises is the same. They originate in some genuine change in the economic environment: the success of emerging economies, the development of the internet, innovation in financial instruments, the adoption of a common currency across Europe. Early spotters of these trends make profits. A herd mentality among traders attracts more and more people and money into the asset class concerned. Asset misplacing becomes acute, but prices are going up and traders are mostly making money.  …

… Yet reality cannot be deferred forever. the misplacing is corrected, leaving investors and institutions with large losses. Central banks and governments intervene, to protect the financial sector and to minimise the damage done to the non-financial economy. that cash and liquidity then provide the fuel for the next crisis in some different area of activity. successive crises have tended to be of increasing severity.

The above paragraphs have been taken from John Kay’s book “Other People’s Money – Masters of the Universe os Servants of the People”.

Different market cycles appear different, but there is a lot of similarity in each. I have written about the anatomy of a market cycle in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget” that echoes the above words to a great extent. If you observe, the parallels are often staring you in the eye. However, very often, we choose to ignore the signals.

The seeds of the crash are planted in times of the boom and vice versa. As Lord Krishna tells Arjun in the Bhagvad Geeta

Bhagvad geeta 2-27

#RidingTheRollerCoaster – 174

Can the Governments and regulators prevent the next crisis?

Recently I came across an article from Knowledge@Wharton. The article quotes two  professors: Wharton’s Peter Conti-Brown and Carnegie Mellon’s Allan Meltzer. I would like to highlight one point in particular that Prof. Meltzer talked about..

Meltzer noted that regulators failed to anticipate the 1929-1932 financial crisis and others that followed over the decades. “The whole idea that the government, the Federal Reserve or any other agency — clever, intelligent [and] smart people that they are — will anticipate the next crisis is very small,” he said. “It will come from a direction in which they are not looking. That is why crises blow up, because they aren’t looking in the direction where the crisis is coming from.”

Meltzer argued that regulation alone will not solve financial crises, and called for banks to have higher equity as a proportion of their total capital. “We can regulate the mistakes of the past; we can’t foresee the mistakes of the future …”

At the same time, they discussed that the only way is to increase the bank’s own capital. The skin was not in the game for the banks. Many banks were hugely leveraged. Though the banks are required to maintain a capital adequacy ratio, many banks took off-shore routes to register their SPVs (Special Purpose Vehicles) and heavily used derivatives. Lehman Brothers, the famous failure of the 2008-09 crisis had more than 50 times leverage.

There are so many instances referred in the book:

  • Benjamin Graham later said that the mistake was that he owed money.
  • The leverage at LTCM was way too high. At some point, it was more than 50 times the capital. Leverage can enhance returns when the cost of borrowing is lower than the return on investment. However, when the returns are poor, the cost and the liability of repayment can be detrimental.
  • Easy availability of cash (foreign capital, easy credit, leverage – in whatever form) is one of the common factors among all the market frenzies.
  • Leverage used to invest in illiquid assets also poses a risk. Once again, if you do not have an alternative cash flow and the asset is illiquid, repayment of borrowed capital becomes difficult.

I have just highlighted a few from the book.

Two important points here: Every crisis looks very different in the beginning. This happens since we keep looking at the events that happened without understanding the lessons. We keep looking for the old crisis to happen again from the same place. Government and the regulators are no different.

The crisis is not new. It just crops up from somewhere else.

#RidingTheRollerCoaster – 171