Friday, March 8, 2013

Notes from the 2nd Leir Conference on Bubbles and Government Policies

Leir Retreat - September 14 & 15, 2012

Arthur Hoffman began the Conference by speaking for a few minutes before lunch about the Leir Center’s focus on bubbles and the importance of this research for financial policies. He explained how Mr. Leir left Germany for Luxemburg in 1933 and then left Luxemburg in 1938 for the US where he founded and expanded an international metals business that he sold in 1968. He recognized the markets in the 1960s were experiencing a bubble and thus invested in Treasuries during the 1970s and avoided the collapse in the “nifty fifty”. He recognized this as bad time for investors given the collapse in US financial returns.

He would thus probably have recognized the current financial markets as being challenging since the assumptions concerning housing and stock prices and rates of returns have been undermined. This has created challenges for investors and those considering retirement.

Bill Rapp then began the 2d Leir Conference with a recap of the 2011 Conference and the new issues this conference would address related to bubbles and government policy. 

The Recap ran as follows:

1) Most bubbles have been recognized and analyzed specifically after the fact such as the recent financial crisis. The 2011 Leir Bubble Conference sought to develop metrics and methods to recognize them including the different types and stages for Bubbles. In this regard Bubbles were seen as rapid rises in real prices for an asset above its economic value and so not sustainable.

2) Rapid price increases for an asset relative to the general price level attracts speculator interest that further drives up prices. Signals are herding, more market volatility and high optimism. The initial paper by Dr. Chou argued a period of less volatility if the expected price increase was external (or irrational) but a revised paper shows an increase in the volatility of price action if the expected price increase is endogenously based on the price increase from the previous periods.

3) Speculators will in this case drive out value investors. When some speculators start to leave the market the price deceleration can signal a maturing and measurable loss of momentum. Policy makers are reluctant to act early, however, as they see benefits from the perceived economic prosperity while the Public is optimistic and enjoys the false sense of prosperity. Yet the eventual pain can be extreme when the bubble collapses. So there is a public policy need to manage bubbles. The excess optimism can be measured.

4) Some important Bubble types are Financial Bubbles in Stocks, Emerging Markets, Bonds, Real Estate, Commodities and New Technologies.

5) It is important to differentiate bubbles because disruptive technologies can attract risk capital whereas real estate lending booms financed by bank loans are always bad due to the leverage and credit risk involved. The former can avoid a financial crisis such as the Internet whereas the latter generally cannot as seen in the Great Recession. Government Regulations can initiate, manage and avoid some Bubbles since they require an open market system. A change in government objectives regarding home ownership for example played a role in the recent crisis that could have been avoided with more early action by the Fed.

6) Panics and crashes are usually caused when people have borrowed money to buy inflated assets. Therefore policy debate centers on when funding new ventures poses a risk to the inancial system due to banks’ exposure and leverage that can wipe out their capital base. Strict laws such as margin limits may work better than regulators.

7) The policy objective is keep the financial system especially banks sound while providing the funds needed to support economic growth and new technologies. Given their leverage banks should not provide risk capital. Rather other intermediaries can and should facilitate this such as brokers, insurance companies, VCs, investment banks, and asset managers. One way to test for this is stress tests that look for any spillover effects on the banks.

8) Part of this analytical and regulatory effort should focus on the assumptions of participants and regulators. That is what may make sense on a micro basis may not when it is done in volume through massive herding effects. Combining growth stocks and risk free assets in a portfolio was a sound financial asset management idea based on history but when it was done in volume by many asset managers it resulted in the “nifty fifty” boom & bust. Subprime mortgage lending may have made sense given stable or rising home prices but when it was done in volume it led to the housing boom and bust with foreclosure as a viable exit strategy actually foreclosed because of the number of homes hitting particular markets at the same time with no buyers due to both a reduction in lenders and potential borrowers.

9) Increased prices that attract speculators may make lenders and regulators feel good and in turn will increase prices further attracting more participants through an interactive feedback. But once money becomes less available and some speculators leave the market, price volatility increases leading to more exits and some price decline or deceleration. This decline then at some point creates a panic and with a true price collapse there is a “crash”. Thus price action is the key to understanding a bubble’s evolution.

10) In the real world research indicates that News Stories play little role in creating a crash though they will certainly try to explain it after the fact. Rather prices in terms of market timing describe the bubble’s development where “Financial Innovations” should be suspect, increased leverage should be suspect, complexity should be suspect, concentrated underpriced risk should be suspect, and pro-cyclical regulation should be suspect. 

11) These situations are suspect because they all reflect excessive optimism not only by borrowers but also by lenders and regulators. This three-sided optimism is a bubble cornerstone. But once this over-confidence wanes, the prior greed is overcome by fear, and panic emerges along with loss of confidence, a crash, financial distress, disillusionment and a financial crisis if there is excessive leverage and bank exposure. Ironically this is when the government usually comes in to deal with the aftermath by bailing out the system or prosecuting the inevitable scams and scandals that emerge as the financial tide goes out.

12) Therefore from a policy or regulatory viewpoint there should be a sharp focus on potential banking losses or on other highly leveraged institutions that could impact the national or global financial system. [As discussed elsewhere in these Notes, Dodd-Frank has some of these provisions.] This generally would not include situations where only investor capital is at risk such as the Internet or recent Social Media Bubbles where high margin requirements limit the institutional risk. Conversely one reason the subprime mortgage crisis has been so disastrous is because the asset price risk was borne almost entirely by the banks and this was then extended through low margin derivatives [such as CDS] to the wider global financial system including the foreign exchange markets.

13) Generally regulators must lean against the wind to counter excessive optimism. However due to possible regulatory co-option using strict rules such as margin requirements or exchanges may be more effective than relying on regulators’ discretion. Such black-line rules should seek to control optimistic contracting through simplicity and transparency requirements that limit leverage through installments or balloon payments. In addition regulators need to monitor Aggregation Effects that can lead to concentration of credit risk and counterparty credit issues [Dodd-Frank appears to address some of these issues such as forcing certain transactions through exchanges or limiting single counterparty exposure]. 

14) Finally Ponzi Finance where financial costs are covered by increasing financial exposure must be stopped at an early stage especially when it has adverse foreign exchange and balance of payments effects as explained by Professor Aliber.

15) A more systematic policy approach to managing Bubbles as opposed to the current ad hoc one appears needed because bubbles are based in human behavior and market conditions that incorporate economic risk taking. This risk taking is in turn an important aspect of the growth process. At the same time as Colin Clark has explained and verified statistically and historically capital grows faster than other factors of production and economic activity. Thus at various times there will be an excess supply of capital driving down rates of return. This will lead investors to take on more risk seeking a higher return. New technologies, regulatory changes, etc. can attract this capital leading to bubbles that when they collapse return capital availability and pricing to more normal levels.