Wednesday, August 16, 2006

The 5 Stages of Bubbles

Billmon points out about bubbles:

Working from a schematic first developed by the late financial economist Hyman Minsky, Kindleberger described the idealized bubble thusly:

* Displacement: Some sort of exogenous shock -- such as the huge drop in interest rates in the early '00s -- gets the speculative juices flowing.

* Credit expansion: Lenders hustle to get in on the action, feeding more liquidity into the market, creating a self-sustaining loop of price increases, which leads to:

* Euphoria: (Minsky, following Adam Smith, called it "overtrading.") Since expectations are adaptive, not rational, a prolonged period of rising prices creates a growing consensus that the boom will never end. Clever writers and hack economists like Jim Glassman and Kevin Hassett, hustle to develop new wave theories showing why this must be true.

* Distress: As price gains slow or plateau (there are only so many fools in the world with money to wager) it begins to dawn on the crowd -- always slowly, never at once -- that the boom will NOT last forever.

* Revulsion: (Minsky also used the term "discredit") The conviction sets in that the one thing you do not want to own, under any circumstances, is the asset in question -- the same one the Glassmans and Hassets of the world were recently predicting would grow to the sky.

When we apply this to the current housing situation (Billmon again):
It goes something like this:

1.) We're not in a bubble. Prices are just recovering from years of underappreciation.

2.) It's a bubble, but it's a sustainable bubble because the fundamentals of the market have changed in the past decade. People need to recognize this. (Note: this stage is usually recognizable by an explosion in popularity of increasingly desperate and bizarre financing options.)

3.) Yes, growth is slowing, but we think we'll navigate a soft landing. It's absurd to think that housing in [fill in area where you live] will actually lose value.

4.) This is a disaster! Somebody better step in and do something! People are losing their life savings!

5.) Buyers have learned a permanent lesson this time. Homeowners need to accept the reality that the bubble of the past five years was a one-time fluke and we'll never see it happen again.

Sounds familiar? Read the rest.

Personally, I know of areas that have *tripled* in price since 1995. A "10-20%" drop is being very optimistic, in my opinion. Heck, if you have a fixed-rate mortgage and your house *tripled* in value in 10 years and "only" dropped 10-20% you still have every reason to be *thrilled*.

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