Tuesday, July 12, 2011

A Simple Cobweb Model of Speculative Housing Bubbles

[Author: P. Ben Chou, New Jersey Institute of Technology]

This research develops a simple Cobweb model that characterizes how a housing bubble forms and bursts. In particular, the model shows that the combination of the entry of a sufficiently large number of speculators and their expected price increase can reinforce each other and sustain a housing bubble at a new steady state in the short run as a self-fulfilling prophecy. The entry of speculators can also lower the fluctuations of the housing price, while the exit of the speculators will increase the volatility of the housing price. After the bubble bursts, it will be the re-entry of non-speculators that stabilizes the housing price. However the time frame for re-entry may be lengthy because potential homebuyers may be expecting price to fall even further. In addition, if banks are reluctant to begin lending again, government support as a lender of last resort may be required to speed up the process.

Click here to download the complete paper.

Friday, July 1, 2011

The Kindleberger-Aliber-Minsky Paradigm and the Global Subprime Mortgage Meltdown

[Author: William V. Rapp, New Jersey Institute of Technology]

This paper analyzes the current global financial crisis that originated in the US subprime mortgage market through the lens of the Kindleberger-Aliber-Minsky [KAM] paradigm as set forth in Manias, Panics and Crashes (Kindleberger and Aliber, 2005) to first examine the bubble’s origins in the displacement caused by the Internet collapse, the subsequent US recession, and the aggressive lowering of US interest rates. It shows how these events combined with other technological and regulatory factors resulted in a US housing bubble fueled by the aggressive securitization of mortgages by many large financial institutions, a reduction in their credit standards, and a lack of regulatory oversight. In this way it assesses the prime players in the process in terms motivation and performance.

It then explores how the process peaked and began to unravel as cash flows at the base of the financial pyramid built through securitization slowed. Once the supporting cash flow came under pressure and was questioned several major players went bankrupt or took tremendous losses. It became apparent risk and innovation had been improperly balanced, a prime characteristic of the KAM paradigm. Indeed, greed, innovation, and technology had combined to substantially reduce credit quality and increase leverage, vastly expanding the likelihood of a liquidity crisis and a substantial drop in the value of asset-backed securities. The analysis then examines why this effect had significant global dimensions unlike for example the Japanese real estate and stock market collapse or the US Internet boom and bust. The analysis also shows how market reactions have been in line with what might be expected under the KAM paradigm. It also conforms to what Robert Shiller and Edward Gramlich anticipated and to normal bank behavior in a credit crisis. See Irrational Exuberance (Shiller, 2005) and Subprime Mortgages (Gramlich, 2007).

Finally the paper assesses the policy responses to the crisis and their likely success under a KAM paradigm analysis. The proposed remedies already include the aggressive fiscal and lender of last resort monetary responses typical of the KAM paradigm but regulatory measures too. Further, as KAM notes almost all booms and crashes involve scandals and scams. So not surprisingly there has been growing recourse to the courts seeking criminal and civil remedies. Also typical of such a dramatic boom and bust governments are examining regulatory and legislative actions to address the current difficult economic and credit situation and to make sure similar things do not occur in the future. But politics and a US presidential election are driving significant differences in approach. Under these circumstances what can the lens of KAM paradigm tell us about the actions taken or proposed and what is or is not likely to work.

Thursday, June 30, 2011

Clash of Titans. The Barclays - Bear Stearns Case and the Current Financial Crisis

[Author: William V. Rapp, New Jersey Institute of Technology]

This paper is a focused analysis on the legal recourse investors in subprime mortgage vehicles might have against integrated originators, packagers and investment vehicle organizers in the mortgage process based on the resulting bubble and the economic aftermath of its collapse. It does this through the lens of a major civil case involving two financial giants, Barclay’s Bank and JP Morgan Chase the current owner of Bear Stearns. This approach is used because if a large well-financed plaintiff investor with a credible claim cannot make a good legal case against a participant controlling all aspects of the mortgage origination to investment chain it will be even more difficult with respect to smaller participants or those that worked with different or multiple participants in the chain on an arms-length-basis. In addition, the case offers an excellent perspective on the origins of the current crisis and how even sophisticated investors to their regret got caught up in the intricacies and complexities of the global mortgage backed securities market and related financial products.

Wednesday, June 29, 2011

The Global Mortgage Crisis Litigation Fallout

[Author: William V. Rapp, New Jersey Institute of Technology]

In the aftermath of most bubble collapses a proliferation of scams and legal controversies emerge as investors realize their greed or naivete has been exploited legally and illegally (Kindleberger and Aliber 2005)¹. This naturally results in a surge in lawsuits as such investors try to recover some of their money from everyone involved in promoting and exploiting the rapid rise in asset prices. The current global financial crisis resulting from the Mortgage Meltdown has been no exception. This chapter will review some of these legal controversies by examining the recourse to the courts of two types of investors: one, investors in subprime mortgage vehicles and two, investors in banks and other lenders that lent and promoted such loans and securities and whose stock prices subsequently declined dramatically or became worthless. The analysis includes an assessment of which suits appear to have the best chance of success and those that have ended in frustration. This review is also an excellent way to understand how the bubble developed and how some investors became involved directly or indirectly in the Bubble’s evolution and ultimate collapse.

Click here to download the complete paper.

¹ See Kindleberger, C. and Aliber, R. (2005), Manias, Panics, and Crashes. John Wiley. Chapter 9, “Frauds, Swindles and the Credit Cycle”, 143-175.

Tuesday, June 28, 2011

The Diagnosis and Analysis of Asset Bubbles: A Behavioral Science Perspective

[Author: Mark John Somers, New Jersey Institute of Technology & Rutgers Business School]

Bubbles occur when market factors distort the value of a financial asset such that it greatly exceeds its intrinsic value. At least some of the theory and research in this area has operated from the perspective that asset bubbles are inevitable; that is, bubbles are a characteristic of markets, and under the right conditions, will develop, grow and ultimately burst (cf., Kindleberger & Aliber, 2005). Not surprisingly, a great deal of interest has been expressed in identifying the stages (e.g., life cycles) of asset bubbles not to prevent them, but rather to avoid or mitigate the consequences of crisis and collapse when bubbles deflate.

Information from financial markets generated in vivo as a natural consequence of the formation, growth and unraveling of asset bubbles has provided a rich source of data to model the stages of asset bubbles. Scholars in working in the areas of finance and financial economics have built complex quantitative models designed to assess market risk and the degree to which any given asset might be dangerously overvalued (cf., West, 2002). These models are typically built retrodictively and then used predictively to identify potential and emerging asset bubbles.

This objective is accomplished by identifying extreme levels of market indicators that have been predictive of future steep declines in asset values. As these models are based on underlying financial theory, it is a mistake to consider them “black box” or atheoretical because hypotheses (either implicit or explicit) about the nature of markets are being tested empirically. Further, as data are collected and predictive models are refined, the underlying financial theory is modified accordingly.

Monday, June 27, 2011

Industry Herding and Momentum

[Authors: Zhipeng Yan, School of Management, New Jersey Institute of Technology; Yan Zhao, Economics Department, City College of New York-CUNY]

Theoretical models on herd behavior predict that under different assumptions, herding can bring prices away (or towards) fundamentals and reduce (or enhance) market efficiency. In this article, we study the joint effect of herding and momentum at the industry level. We find that the momentum effect is magnified when there is a low level of investor herding. Herd behavior in investors help move asset prices towards fundamentals and enhance market efficiency. A trading strategy taking a long position in winner industries and a short position in loser industries when the herding level is low can generate significant returns.

Click here to download the complete paper.

Sunday, June 26, 2011

2007-2009 Financial Meltdown

[Author: William V. Rapp, New Jersey Institute of Technology]

In the Fall of 2007 the Dow Jones Industrial index reached an all time high over 14,000. By November 2008 it had fallen under 8000. Other stock market indices worldwide including the high growth emerging economies of India and China saw similar or greater drops. Those predicting these economies had developed an Asian regional economy that would prove relatively robust despite problems in US and European financial markets were wrong. Mirroring this change in financial fortune in March 2008 Bear Sterns one of five major US investment banks and a leader in subprime mortgage lending collapsed leading to a rescue merger with JP Morgan Chase engineered by the Federal Reserve. This was followed in September by the failure of another major US investment bank and leader in subprime mortgage financing, Lehman Brothers. It was the largest bankruptcy in US history at over $600 billion. Then came the disappearance of Washington Mutual, the largest bank collapse in US history, and another JP Morgan Chase rescue, this time engineered by the Federal Deposit Insurance Corporation (FDIC). Further during 2008 and later in early 2009 the US government needed to rescue several large financial institutions with billions of dollars in loans and capital injections. These included AIG, Citicorp, and Bank of America. European governments too had to undertake similar actions.

Yet despite its global reach and historically severe adverse economic impact the meltdown reflects all the traditional characteristics of a classic boom and bust fed by excess credit. This is seen in the development of the housing bubble beginning in 2003 through its peak in August 2005 and finally the collapse in 2007 and 2008 of the mortgage and housing markets with their legal, economic and political aftermath. Indeed any reasonable analysis of the boom based on the classic boom and bust scenario should have raised early policy warnings about the housing bubble and its inherent risks. What was not fully appreciated even by those predicting a collapse was the scale and worldwide scope that magnified the financial and economic impact of the housing market’s collapse so as to trigger a global decline in credit availability even to large corporations and financial institutions resulting in a global recession.

However, to grasp how the subprime and US housing bubbles and their crash triggered the 2007-2009 Financial Meltdown and its current aftershocks, one must understand key changes that have occurred in the markets for US mortgage related securities and their legal underpinnings along with how computerization and the Internet provided global scale, while changes in US banking and security laws have complicated finding a solution.