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.