12/04/2016 Bubble Markets 1 Bubbles • Despite the wide range of assets that have witnesses bouts of irrational exuberance (tulips, sugar, coins, bonds, cotton, wheat), bubbles follow a similar pattern • As Marx noted, history repeats itself, first as a tragedy, second as a farce. © 2 1 12/04/2016 3 © 4 2 12/04/2016 Anatomy of a Bubble © 5 Anatomy of of a a Bubble Bubble • Time after time we see the same sentiment and the same fundamental mechanics at work. • In each case, we see massive supply/demand imbalances. • The supply build leading up to the bubble persists for years and sometimes decades as irrationality grips markets. © 6 3 12/04/2016 © 7 Anatomy of of a a Bubble Bubble • Despite the disparate nature of assets on which bubbles have formed, there is an uncanny similarity about the phases through which each moves. We identify five stages of a bubble © 8 4 12/04/2016 Five Stages Five Stages • Displacement • Credit Creation • Euphoria • Financial Distress • Revulsion • “Kindleberger/Minsky” model © 9 © 10 5 12/04/2016 Example 1 Irish Property Bubble 11 Example 1 Irish Property Bubble 12 6 12/04/2016 Example 1 Irish Property Bubble 13 Example 1 Irish Property Bubble 14 7 12/04/2016 Example – Shewsbury Road • In 2005, houses on Shrewsbury Road were among the most expensive in Europe after 12 years of almost uninterrupted nationwide rises. • For example, in 2005, a 4,000 sq ft (372 sq m) house on Shrewsbury Road (Dublin 4) set an Irish record when a buyer paid more than €58m for a home with extensive land to the rear that remains undeveloped. • Despite having a guide price of €35 million, the house eventually reached €58 million due to a rumoured six potential buyers vying to purchase the property. • Example – Shewsbury Road • In 2005, houses on Shrewsbury Road were among the most expensive in Europe after 12 years of almost uninterrupted nationwide rises. • For example, in 2005, a 4,000 sq ft (372 sq m) house on Shrewsbury Road (Dublin 4) set an Irish record when a buyer paid more than €58m for a home with extensive land to the rear that remains undeveloped. • Despite having a guide price of €35 million, the house eventually reached €58 million due to a rumoured six potential buyers vying to purchase the property. • In September 2011 the house went on the market again for a price of €15 million, down €43 million from its sale value in 2005, but was withdrawn presumably because it never met the guide price 8 12/04/2016 Example: Walford Shrewsbury Road Dublin Second-hand House Prices €800,000 €700,000 €600,000 €500,000 €400,000 €300,000 €200,000 €100,000 €0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: Sherry Fitzgerald Research (2007) 9 12/04/2016 Residential Real Estate Prices, Rents & Income Ireland 600 500 400 nominal house prices 300 price/income price/rent 200 100 0 . 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source OECD Property Lending and GDP 250000 200000 150000 total property lending 100000 nominal GDP 50000 0 2000 2001 2002 2003 2004 2005 2006 2007 Source: Irish Central Statistics Office, Annual Statistical Summary 20 10 12/04/2016 Proportion of Total Bank Lending attributable to Property- related Lending 65 60 55 50 45 40 35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 Source: Irish Central Statistics Office, Annual 21 Statistical Summary Sectoral Decomposition of Increase in of Bank Lending 2000-2007 900 800 700 600 construction 500 real estate personal mortgages 400 total lending nominal GDP 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 2007 Source: Irish Central Statistics Office, Annual Statistical Summary 22 11 12/04/2016 ECB Interest Rates and Interest Rates on House Purchase Loans 2000-2013 7 6 5 4 ECB - marginal lending rate 3 House purchase loans - average interest rate 2 1 Source: Department of the Environment 0 . and Local 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Government 23 Property – related Tax Revenues as a Proportion of Total Government Income 2000-2010 20 18 16 14 12 10 % of total tax revenue 8 6 4 Source: European 2 Commission and Goodbody Stockbrokers 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 24 12 12/04/2016 Performance of Irish Share Indices 2000-2014 18000 16000 14000 12000 10000 ISEQ General 8000 ISEQ Financial 6000 4000 2000 Source: Irish 0 Stock Exchange 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 25 Quotes • “While short-term economic prospects for AIB’s main markets are somewhat mixed, the medium outlook is more positive. • Irish GDP is forecast to slow to 2.5% this year, reflecting the slowdown in the housing sector and a weaker global economy. • However, economic fundamentals remain solid and growth is expected to pick up again in 2009 and beyond” (AIB annual report, 2007) 26 13 12/04/2016 Quotes • “Economic fundamentals remain firm- demographics, job creation, income growth and the government’s fiscal position all remain positive while the interest rate environment is now more supportive. • These fundamentals support ongoing demand for housing” (Anglo Irish Annual report, 2007) 27 Quotes • “Economic fundamentals remain firm- demographics, job creation, income growth and the government’s fiscal position all remain positive while the interest rate environment is now more supportive. These fundamentals support ongoing demand for housing” (Anglo Irish Annual report, 2007) • • ”The banks performance in 2008 demonstrates the resilience and strength of our business model. “The bank has no exposure to US or other sub- prime sectors and does not sponsor any off-balance sheet activities. ” (Anglo Irish Bank, Interim Report, September 2008) 28 14 12/04/2016 • The following extract reported in McDonald and Sheridan (2010) about a circuit court repossession case in February 2009 illustrates: • .. a Dublin father of three on an Air Corps pilot’s (Irish airforce) salary of around €53000 a year had managed to build up a twelve- house property portfolio, with loans of €8 million from nine separate financial institutions 29 Sunday Business Post, Nov 2006 • Free boat with special price house. – Close to Lough Allen, a select development of 20 homes offering a 17- foot Star craft with every purchase 30 15 12/04/2016 Example 2 Dot Com Bubble 31 Dot Com Bubble 16 12/04/2016 Question • Why did USA stock markets reach such high levels by March 2000? 33 Displacement Displacement • Displacement – Displacement is a shock that triggers the creation of profit opportunities in some sectors © 34 17 12/04/2016 Displacement Displacement • Displacement – Displacement is a shock that triggers the creation of profit opportunities in some sectors – Investment and production pick up to exploit new opportunities © 35 Credit Creation Credit Creation – Monetary expansion/Credit Creation: (new credit instruments; expansion of personal credit) – Sooner or later the demand for the asset will outstrip the supply; resulting in price increases – These price increases will give rise to further investment – A positive feedback loop ensues © 36 18 12/04/2016 Euphoria Euphoria Euphoria The virtuous circle: risings assets, rising Leverage © 37 Euphoria Euphoria Euphoria • The virtuous circle: risings assets, rising Leverage – Adam Smith referred to such developments as “overtrading.” – Kindleberger, “An over estimate of prospective returns or excessive gearing.” © 38 19 12/04/2016 Financial DistressFinancial Distress Firm may not meet its liabilities ‘Financial fragility’ grows – 1. Meet liabilities from reliable earnings (‘hedge finance’, because hedged against changes in credit market) – 2. Meet liabilities by rolling over debt (‘speculative finance’) – 3. Meet liabilities by increasing debt (Ponzi finance) © 39 Revulsion Revulsion • Revulsion – Doom: the big unwinding – Speculative and Ponzi financiers have to liquidate – Fisher: debt deflation © 40 20 12/04/2016 The Magic ofThe Leverage magic of leverage • Case 1: Spend $1 on asset, goes up 10% => My return is $.10, or 10% • Case 2: Spend .10 of my own money and .90 of borrowed money on asset, goes up 10% => my return is $.10, or 100% © 41 The Magic ofThe Leverage magic of leverage • Case 1: Spend $1 on asset, goes up 10% => My return is $.10, or 10% • Case 2: Spend .10 of my own money and .90 of borrowed money on asset, goes up 10% => my return is $.10, or 100% • Case 3: Spend $1 on asset, goes down 10% => my loss is 10% • Case 4: Spend .10 own and .90 borrowed, asset goes down 10% => my loss is 100%, & I still owe .90: may have to sell this or other assets to get my leverage down © 42 21 12/04/2016 Balance Sheets Balance Sheets Assets Liabilities Stock shares Bank loans Real estate Bonds Equity = Assets minus liabilities © 43 Hyman Minsky’s theory of financial crises • A theory on how changes in balance sheets drive phases of boom-bust cycle • Displacement: External event touches off investment wave • Boom: expectations of a sustained rise in asset prices become entrenched • Liquidity (availability of credit) increases • Leverage increases (debt-equity ratio increases) © 44 22 12/04/2016 Leverage on Leverage on the way up the way down Leverage on the way up © 45 The virtuous circle • The virtuous circle: risings assets, rising Leverage “Excess” Borrow more money to collateral buy stocks Stock Price rise (liquidity increases) 46 23 12/04/2016 • Buying stocks ‘on margin’: Value of Collateral required depends on size of loan. • Must keep ‘rolling over’ loans to stay in market © 47 The virtuous circle • The vicious circle: falling assets, falling leverage (“deleveraging”) Insufficient Sell stocks to Stock collateral pay back loans) prices fall © 48 24 12/04/2016 The virtuous circle • ‘Debt deflation’ (Irving Fisher) ‘Fire sale’ Prices fall Deflation to pay (deflation) makes debts business fail © 49 50 25 12/04/2016 IPOs • Initial under-pricing • Long-term underperformance • “Hot Issue” markets when IPO demand is especially high © 51 Case Study 1: Boston Chicken Inc.