Asset Price Bubbles: Housing Bubble and The Subprime Meltdown

After 3 days of tremendous work pressure, today (probably this half hour/hour) is like a breather and so I just thought of coming back here and recollecting my thoughts. Actually, in yesterday’s session of presentations, the topic of discussion was “Global Action and Local Reaction to it”… so of course sub prime meltdown was THE major issue.. That whole discussion reminded me actually of what I had promised to myself and hence this post.

When I say asset price bubble, what do I mean? Basic economics dictates that “Asset” is something from which I get SOME return. This is the first criterion.In this sense, even the breakfast that I had in the morning, the newspaper that I bought to read enroute to office will become asset then. Because I am getting something in return of their consumption. Okay. So I am saying that whatever I am consuming becomes an asset.(assuming that I am a rational being and consume only when there is a “rational” reason to need/demand it – i.e my “Demand” is as per economic concept: rational demand). The next logical question is related to price bubble. In a free market economy, the price discovery mechanism is fully in the hands of demand and supply factors. Term “normal”, “reasonable” or “justified” price though relative to each one’s purchasing power, is still arrived at only on the forces of supply and demand is a free economy. So assuming that this is a free market economy and there arent any factors like the government intervention etc, the concept of “reasonable” price is one that both the demand and supply factors can justify as per my understanding. In that case, most logical explanation of “asset price bubble” is the asset price which is unjustified given the above line of thought. Okay, so we’ve got cement shortages due to hoarding etc, was that a cement price bubble? It seems to me that in a way it was. But now I have to differentiate “Assets” in a deeper sense. As I said, my breakfast has been an asset in a very basic sense, but now I have to make differentiation between the “nature of returns”. So whether my gratification from consumption is instant or not is the criteria. Thus I have now two categories: A basket of assets meant for current consumption and a basket of assets which once owned will give me return over a period of time. Pricing of “consumables” or the things that I consume in short term are easier to price than such assets like say houses/ stocks and shares from which I shall receive returns for years and years. No one can extrapolate too long into future with accuracy and hence pricing of “Real” (houses etc) and “Financial” (stocks etc) assets becomes difficult. It is these assets that we refer to when we say “ASSETS ” normally, because one important factor apart from receiving returns from consumption is that these returns are received over a period of time. This was the second criterion. So when I refer to an asset, I imply such consumption that grants me returns over a period of time.  Pricing anomaly therefore is more likely to happen in case of assets than the consumables.

Anyways, coming back to the sub prime crisis, here is my understanding of the situation:

US economy is “Consumption Driven” (India is getting there – atleast has begun ) . In a consumption driven economy investment happens as a reaction. US doesnt totally confirm to this logic, but thats a topic for a seperate post. So, the consumption driven economy… people take loans and credit to buy things, and they do it regularly, daily in fact. Most of the transactions out there happen on the basis of plastic money, the credit cards.  Its been Fed habit of having a liberal monetary policy so as to stimulate economic growth. Which means lower interest regimes. Which means more loan offtakes. More and more people opting to take loan and buy things they otherwise couldnt have afforded. Primarily this loan-taking happens for assets which one wouldnt have otherwise even dreamt of buying. So suddenly there’s demand for housing. This demand leads to steady price appreciation. Since rates are low and its now or never situation, people opt to buy these highly priced houses at any cost and have their interest payments pegged to some floating rate, because it was a regime of falling interest rates. These loans are then off loaded by housing banks via mortgage backed securities(securitization) to various other financial organizations. Subsequent trading leads to some major financial organizations in Europe and Japan buying the MBS portfolio of the US bases loans. Many funds from world over take an exposure in these securities.Now even Fed cannot be generalized. They realise that a housing bubble is developing. Time to curb inflation and rising prices. They start tightening monetary policy. Interest rate increases. This happened around Aug-Sep 2006. Due to floating rate, suddenly people have to pay a lot of interest. Demand for houses goes down. Now many people cant even afford to pay interest on their existing loans. They go bankerrupt and their mortgages lead to closures. The banks/parties who lent these people for houses have now to sell these houses to recover their money. But who will now buy at a price which these institutions want to recover in order to cover losses. But soon we know that its not just the major US mortgage banks themselves filing for Bankruptcy. Some major firms from all over the world too have suffered.The funds’ portfolios have suffered. The risk premium has increased and everywhere things are looking like an advent of a slowdown.

The reason it didnt affect India much is that we hadnt taken any exposure on these kind of securities. We were quite safe. However, due to global outlook’s change on the risk, our markets too suffered and there was a pull out of money from our economy to some extent. The markets fell at that time, not due to domestic reasons, but the sub prime crisis. Anyways, time to sign off now. Work begins!!

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About pradsword

My posts will reveal the most about my nature and my thoughts...all in all, this is an attempt to figure out my thoughts!

Posted on September 27, 2007, in BSE Realty, Interest Rates, Irrational Exuberance, Macroeconomics, Real Assets, Real Estate, Robert J Shiller, Stock Markets, Sub Prime Crisis and tagged , , , , , , . Bookmark the permalink. Leave a comment.

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