The Kindleberger model of crisis

Kindleberger's argues that there are three phases to a price process that occur during a financial crisis – mania, panic and crash. This is the more traditional view relative to other analogies such as a hangover or grief “model”.

Manias take place during a business cycle expansion when economic agents switch from liquid to real or financial assets. The expansion changes risk perceptions and causes investors to believe that returns will be higher than historical patterns. Over-optimism about a business expansion coupled with cheap credit is the magic elixir for a mania. The asset mania does not have to be in all markets. It can be localized to markets which are going through large changes or where it is difficult to provide clear valuation. In fact, pricing of new technology is more likely to be mis-valued or have a mania. In the current case, there has not been much history on many new mortgages products and the CBO market is still in its infancy.

The panic phase is characterized by a stampede, a race for changing real or financial assets into money. The demand for liquidity and safe assets causes excessive changes in pricing of the risky asset. New buyers for the assets to be sold have to be given a discount to take on the risk associated with the falling market. In many cases, the stampede can come from a single catalyst, an event that changes the perception on the valuation of the risk assets. The change in perception could be as simple as a change in the price momentum. In the case of housing, a slowdown in the ascent of residential real estate was enough to start to have an impact on the ability of some borrowers to pay for their loans.

Crash is the final outcome of the process preceded by panic and mania. The crash comes when there market becomes a one way bet against the asset. Expectations are all negative and there does not seem to be a reversal in negative fortunes in sight.

These stylized descriptions provide more contexts for explaining a financial crisis but also have a problem of not being precise. What is the difference between a panic and crash? What are the visible signs we have made the transition.

Compared to these phases, a focused model can be summarized in five different, yet relatively contemporaneous stages of displacement, boom, overtrading, revulsion, and tranquility. Having five stages may seem a little better, but again there are not precise definitions for these periods. There is no measure to say how long it will take to move from one phase to another. However, with real estate, the time it will take to resolve the crisis will be longer than for assets that have to be market to market. If there is not forced selling, a home-owner can always wait before realizing a loss The problem with this crisis is that the sensitivity of homeowners to changes in the mortgage rate is greater than what we may have seen in past recession where everyone was locked into fixed rate financial. You can provide any number of descriptions for the crisis, but what is needed are a set of policy alternatives. Solution part of crisis is harder to describe.

Market cycles – another morbid view

An interesting perspective on market cycles was presented in cashandburn.com with a chart on grief modeling. Using the stages of grief developed by Elisabeth Kubler-Ross in her book On Death and Dying, we may say that the credit cycle follows a similar form. One more investment analogy but is a variation of some of the behavior models where investors do not want to realize loses.

The credit boom in housing had to die and we have to accept it before the markets can move on. There is a growth cycle in any business. (Note that we have also presented the hangover analogy in our last blog.) The market was in denial that the lending game was up with mortgages. We have been through that initial stage with the housing market peaking over 2 years ago. Some home-owners may still be in a state of denial by keeping their home prices up in the resale market.

Investors have tried to bargain their way out of this problem but that has not proved to be a solution. There is the the view that there is some way to get out of the crisis without paying a penalty.

Many are in a state of depression. There are a host of managers who are asking the question of how did this happen to them.

We are testing the new regime and learning to accept it, so to some degree there are people who have figured out how to move on with their grief. Others are still in the middle of the process. The market will not be ready to move up until this grief process has concluded for the majority of investors.

Hangover theory and credit crisis or just a morality play

An interesting discussion on Brad Delong’s blog posted a comment on the hangover theory of financial crises by Paul Krugman. Worth a look. It makes a good comment on how many often to make a market bust a morality play. Bad things happen to bad people who try and get greedy in financial markets. We party hard during the boom and there is a price that will have to be paid by everyone. We already see this story unfolding in the media.

The consumption portion of the Krugman tale is a little more problematic. Investments creates wealth if the value of the investment goes up. These investments are valued or priced based on their use in the economy. If they are no longer productive, there will be a decline in value associated with this investment which will decrease the wealth of consumers. This wealth effect changes consumption in the bust portion of the cycle. It is not a swtich between consuming or investing.

From Krugman:

Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.... The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand... all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants... reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles.... But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole?... Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods--implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom--which presumably requires a transfer of workers in the opposite direction--also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry--not just the investment sector--normally contracts.... The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives.... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings...

The end of conservation in the Farm Belt

Good story in the NYT on the how conservation land has been placed under the plow as crop prices rise. The Conservation Reserve Program represents 8% of cropland or 35 million acres at a cost of $1.1 billion. http://www.nytimes.com/2008/04/09/business/09conserve.html

Once again, the law of unintended consequences exists. In an effort to save the environment, we have pushed the issue of renewable green fuels like ethanol. This created a growing, consistent and subsidized, demand for corn. The ethanol demand for corm is growing to be above one-fifth of the entire crop. The response should be as expected, higher prices. But once there was a supply shock to the system and a increases demand for grain-feed beef in developed countries, the response of farmers was natural. They wanted to plant more. The only land left was the acreage put aside or conservation. Farmers were made to leave this land alone but at some point the price difference is too great. So much for conservation. Of course, the unintended consequence of leaving cropland fallow as a conservation effort is also having an impact on the cost of bread. The effort for green energy destroys conservation land. Now that is environmental story that we never thought would happen.

New BOJ Governor - more of the same?

Masaaki Shirakawa, the acting head of the Bank of Japan will be announced as the new governor of the central bank. The politics of picking the governor has left uncertainty about what will happen to Japanese monetary policy, but the pick of Shirakawa, a long-time bank veteran is said the be in lock step with the previous governor.

So what can we expect? One simple way is to look at his writing. We get a good view of Bernanke from his academic work, but Shirakawa has not been a prolific writer. There is one BIS piece on monetary policy with a number of authors, “Japan’s deflation, problems in the financial system and monetary policy” Naohiko Baba, Shinichi Nishioka, Nobuyuki Oda, Masaaki Shirakawa, Kazuo Ueda and Hiroshi Ugai of the Bank of Japan. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=861664].

This paper is a reflection on the current state of thinking of central bank action during the zero interest rate policy (ZIRP) and the quantitative easing policy (QEP). This work is interesting reading because it places the focus on asset price deflation not general price declines as the leading problem in Japan during the “Lost Decade”.

Understanding what the BOJ Governor may do is relevant because with Japanese growth declining there is more likely to be a change in policy. Some analysts are currently expecting a cut in rates as early as next month. The good news is that it is unlikely that we will get any change in central bank strategy, so there will be limited policy uncertainty. It also means that we are unlikely to get a strong central bank voice.

Are we afraid of free trade with Colombia?

Editorial from George Will on the Mark Penn firing touches at the heart of the bigger policy issue. The real concern is whether we fall back into protectionism by one or both political parties. Maybe it is time to start listening to some off the simple facts on trade.

From http://www.washingtonpost.com/wp-dyn/content/article/2008/04/07/AR2008040702194.html

Austan Goolsbee, Obama's economic adviser, has said that "60 to 70 percent of the economy faces virtually no international competition." America's 18.5 million government employees, among whom organized labor finds its growth, have almost no vulnerability to foreign competition, and neither do auto mechanics, dentists and countless other professions. Furthermore, Goolsbee, with whom Obama might profitably have a conversation, has said that globalization, meaning free trade and attendant deregulation, is responsible for a "small fraction" of today's widening income disparities.

Under the Andean Trade Preference Act, passed by a Democratic Congress is 1991, the United States imposes tariffs on only 8 percent of imports from Colombia. But more than 90 percent of U.S. exports to Colombia are subjected to tariffs, some as high as 35 percent. The trade agreement would make this "one-way free trade," which now primarily serves Colombia's interests, more mutually beneficial.

Nevertheless, U.S. unions oppose the agreement, probably to preserve the moral clarity of their monomania: Damn the details, full speed ahead in opposing more free-trade agreements, anywhere, anytime.

The financial world is changing, are we ready?

As Wayne Wagner, a market expert, recently stated, “We walk backward into the future, with our minds anchored by the imprinted lessons of the past.” Whether it be monetary policy, the reaction of credit spreads or the link between the US economy with other countries. We are going through a transition and the old ways of looking at the markets.

As John Maynard Keynes put it way back in 1923: “In the long run we are all dead. Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that when the storm is long past the ocean is flat again.” The fact that this credit crisis will be over at some time tell us nothing about how we should deal with the markets today.

So what are the prevailing biases in markets?

As George Soros writes in his book The Alchemy of Finance, “I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also so-called fundamentals that market prices are supposed to reflect.”

So what is the prevailing bias in the market today? There are a number of them and they differ based on the market participant. The prevailing bias in the equity market is that the current credit crisis will be short-lived and that the Fed will be able to bail out the markets. That is a reflection of the reaction whenever the Fed takes action and the fact that the year to date returns are still down only single digits while the rest of the world’s equity markets are showing strong double digit declines. The equity market have punished housing and financial stocks but are willing to believe that a bottom can be reacted quickly as evidenced by the strong turn in the financial stocks earlier in the year. The second bias in the equity markets is that no one wants to fight the Fed. Put differently, the Fed will be effective at getting the economy moving. This is not like Japan during the 1990’s. There will be no liquidity trap and at the worst asset inflation from rising prices will not be bad for stocks.

Fixed income markets are much more negative about the economy and the Fed. Perhaps this is related to the fact that the credit crisis has hit this sector much more that the overall equity markets. Here, interest rates have been pushed down to negative real rates and we have seen a flight to quality that has pushed Treasury bill rates significantly below 1 percent. The front-end expects more easing but the impact of a recession is viewed as more important than inflation at least in the near-term.

The currency markets seem to believe that the US problem can be localized and the rest of the world may be decoupled with the United States. The dollar has taken a beating that suggests growth in the rest of the world can still be strong.

Commodity markets, while off of their highs have been very resilient based on the view that the rest of the world will have high demand from continued growth regardless of what happens in the US.

These biases are embedded in prices so any major change in prices will be based on whether there is a change in the expectations concerning these views. The worsening employment situation only confirms the current biases; consequently, there has not been a strong reaction.

Innovation and Creative Destruction

One of the best books for 2007 was Prophet of Innovation: Joseph Schumpeter and Creative Destruction by Thomas McCraw.

Innovation and entrepreneurship is messy. By its very nature it is unexpected, so it is not easily modeled. While risk is countable, uncertainty is not measurable. Innovation is not measurable. There is no distribution of business creation. You cannot tell when it is going to happen, whether it will be adapted, or if it will be a success. You cannot plan for it. Innovation by its very nature creates new markets and products that did not exist. It is a “Black Swan” event. Yet it happens, and we are poor at forecasting these business prophets. It is this uncertain process of innovation is what drives economies. It takes a person who can see the existing system and envision an improvement or create a market that did not exist before. The very process is destructive because the status quo must change. Trying to explain this process requires not only an understanding of economics but the breath of history, cultural, and institutional structure. Only a remarkable man of intellectual power would be able to describe the environment required for innovation. Joseph Schumpeter was such a man.

His story is a complex one. He was a big ego who clawed his way up the academic world but was also exposed to government service and private banking. His failures coupled with a desire to be a great thinker makes for a fascinating story of a man and an idea. Schumpeter is not often taught in economic classes. The required need for true inter-disciplinary thinking makes him hard to read. The fact that there are no formal models for his thinking makes him out of step with mainstream economics, but he may be one of the most influential thinkers on business.

Even the current credit crisis should be looked at through the process of creative destruction. Innovation has changed the mortgage market forever. We will not go back to fixed 30-year mortgages regardless of how much regulation is imposed on the market. The development o many Asian economies is a result of creative destruction. Innovation allowed for countries to leap-frog the development process.

Thomas McCraw has been writing about innovation for years and he is able to bring the story of Schumpeter together as a lively tale of a man focused on bringing new economic ideas to the world. What McCraw will want you to pick up your dusty copies of Schumpeter’s works and read them for both the insight and enjoyment in a new light.

Credit crisis at half way point

We are already starting to see some historical analysis on the credit crisis and the paper,“Leveraged Losses: Lessons from the Mortgage Market Meltdown”, by David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin; for the US Monetary Policy Forum Conference is one of the best. http://www.brandeis.edu/global/rosenberg_institute/usmpf_2008.pdf

“Leveraged Lessons” provide a good overview as well as a forecast of what may be the loss from this mess. The researchers are forecasting about $400 billion in mortgage loses. We have seen write-downs of about $230 billion. By this measure we are getting to about the half-way point of the problem. I view this as optimistic but as long as firms are taking a write-downs we are moving forward.

The authors look at the housing problem relative to some of the other regional crisis of the last 25 years and find that the foreclosure rates are consistent with the decline in housing. The behavior of housing in this crisis is not out of the ordinary. However, none of these other housing crises had the range of mortgage products that currently exist. This is what makes the crisis unique and provides new level of uncertainty so that any forecasts are suspect.

What is clear is the linkage between credit issues and the overall GDP. The housing problem will have at least a 1.3% or higher drag on GDP which is enough to put us on the cusp of a recession. It is just a matter of trying to predict the extent of the slowdown not whether we are in one.

Why I follow behavioral finance?

I have been following behavior finance for years. It has been an exciting area of finance but also has not always lived up to the hype of being able to identify ways of processing data to find Studying the mistakes that investors may make with decision-making has been helpful, but at the same time much of the behavior finance literature has not had a big impact on exploiting anomalies. Market anomalies exist but they are not frequent and do not always last. More importantly, they may be multiple behavioral explanations for anomalies that may seem inconsistent. I have not found ways to exploit the behavioral finance theories for money-making other than to accept that irrationality exists and can effect markets. So why spend so much time studying the behavior of markets. It is similar to why so much time is spent studying abnormal behavior in psychology. By studying the extremes or abnormalities in behavior we can better understand normal decision-making.

I have to go back to philosophy and the comments of Baruch Spinoza in Tractatus Politicus on studying subjects for the best reason for focusing on behavioral finance, “I have labored carefully not to mock, lament, or denounce human actions, but to understand them.” Study of behavior finance is useful not because we are going to find a rich new method for generating profits but because it provides a framework for observing and accepting the markets not for what they should be but for what they are.

Darwin’s Dictum and Finance

Michael Shermer, the columnist for Scientific American, developed the concept of Darwin’s Dictum to describe how observation should be undertaken. “If observations are to be of any use, they must be tested against some view - a thesis, model, hypothesis, theory or paradigm. Facts do not speak for themselves but must be interpreted.

As noted by the Charles Darwin when told that he spent too much time on theory and should stick with just making observations,
“About thirty years ago there was much talk that geologists ought only to observe and not theorize, and I well remember someone saying that at this rate a man might as well go into a gravel-pit and count pebbles and describe the colours. How odd it is that anyone should not see that all observations must be for or against some view if it is to be of any service!”

Too often in the financial press, there is a premium on observation of some news or some event, but there is little theorizing on what a specific event means other than it must be related to the current behavior of the markets. How is event observation helpful other than pure presentation of facts? There should be a link between the new information and the theory of what describes market behavior. As important, is the news that we are seeing today at all out of the ordinary relative to similar events in the past. Is there truly a relationship between an event and market behavior? Do new facts fit within a theory or are they contrary to our current wisdom. Is the story being told consistent with theory as we know it?

There is a lot of news noise in the markets, reporting and quotes but limited analysis. This is why model are often need to provide a filter to the noise that is bombarding the markets.