Wednesday, Nov 04, 2009
Short explanation of how falling loan-to-value ratios cause bubbles
Wall Street Journal: Crisis Compels Economists To Reach for New Paradigm
When banks set margins very low, lending more against a given amount of collateral, they have a powerful effect. Using large amounts of borrowed money, or leverage, buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances. [There's a nice graph in the article too.]
Posted by drewster @ 11:49 PM (386 views) Add Comment
4 Comments
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1. quiet guy said...
Good post Drewster.
Top marks for relevance and yet I cannot stifle my scepticisim.
When the next bubble approaches, where would you place your bet:
Economic theoretical dampeners (subject to political vagaries) vs Free Market creativity to slip free of restrictions?
I apologise in advance for saying this but the only real solution looks like honest money i.e. based on precious metals. The next best thing is to try to recognise the market booms and busts to play them (but be very careful.) It's virtually impossible to legislate against greed.
2. drewster said...
quiet guy,
I'm not sure about a currency based on precious metals. I'm increasingly under the impression that the fault lies with fractional reserve banking, not with fiat money. It's something of a pointless debate though, the status quo is unlikely to change in the foreseeable future.
Personally I think loan-to-value limits on all borrowing would fix things. The idea that you can buy a car or a sofa with no money down seems foolish; the idea of buying houses or shares with nothing but the tiniest of deposits is just stupid.
It's probably far too simplistic, but why can't we just have a 20% minimum down payment on all leveraged asset purchases?
3. mark wadsworth said...
"falling loan-to-value ratios" shouldn't that be "rising"?
QG and D, you can have a gold-based currency and fractional reserve banking at the same time, that is what we had for centuries. Read up a nice basic textbook, the gimmick was that the bank/goldsmith/moneylender took deposits of 100 gold coins (initially charging them a fee for putting stuff in the vault, later on paying them interest) and lend 90 of them out again. The expression "fractional reserve" means that they kept a fraction (one-tenth in this example) for day to day redemptions.
Of course, when the borrower spent those 90 gold coins, they came straight back into the vault for safekeeping. So after a while, the "bank" realised it would always have the physical 100 coins, so he ends up with loans worth 900 gold coins and 100 physical coins (assets) and total deposis, i.e. liabilties to repay, 1,000 gold coins.
Quite where do you put the dividing line between "metal" currency and "fiat" currency? Answer, there isn't an absolute dividing line. The big argument is over the fraction.
4. Dunkindogdo said...
In reply to Drewster@2,
Banks are already insisting on large deposits, despite such stipulations, people are able to circumvent this by borrowing the deposit money from another lender via an unsecured personal loan (this is also why banning interest only mortgages will not make any difference).
I know several people that have done this, despite the credit crisis, rising unemployment, and falling prices (what was particularly worring was that the people in which I observed such behaviour, are supposedly intelligent, as well as holding down responsible, skilled jobs).
The masses seem to have taken leave of their senses with regard to property, and when considering the costs of mortgage payments not a second thought seems to be given to quality of life, insurance, possible unemployment, serious illness, children, property maintenance, falling prices, etc., it's absolute tunnel vision, and rather frightening + confusing to observe.
In the absence of a method by which to instill, in the masses, a reasoned sense of responsibility with regard to credit, I personally think that at the very least, secured loans should come with mandatory contributions to life, critical illness & pension insurance plans. I know that this in no way a foolproof fix for avoiding future bubbles, but it may certainly dampen the enthusiam of those with abjectly wreckless intentions.