Saturday, December 15, 2007

Home Values, Manias, Panics, and Crashes

Last night I dusted off my copy of Charles P. Kindleberger's classic Manias, Panics and Crashes (I have the 2000 edition which leaves off at the East Asian Financial Crisis in 1997; the link is to the 2005 edition which no doubt has something to say about dot-coms). Kindleberger outlines the life cycle of a bubble, and summarizes 40+ events dating from 1618. My edition has a blurb on the cover from Paul Samuelson which says, "Sometime in the next five years you may kick yourself for not reading and re-reading Kindleberger's Manias, Panics, and Crashes." This was good advice for residential real estate and RMBS investors.

Our current situation fits Kindleberger's taxonomy perfectly:

Object(s) of Speculation: Previous bubbles have related to tulip bulbs, canals, cotton, railroads, coffee, Argentine securities, bank stocks, and many other commodities and financial instruments. In the current case, it's homes and residential mortgage backed securities (RMBS) financing homes.

Exogenous Shock Setting off the Mania: Subject to argument, but my belief is the trigger was the rapid decline and extended period of very low short term interest rates between July, 2000 and July, 2004 compounded by flawed securitization models which did not appropriately price risk and investor misinterpretation of the risks underlying the securities.

Scandals and Defalcations: Subprime fraud revelations.

Turning Point: Week of June 18, 2007, collapse of Bear Stearns hedge funds.

Domestic Propagation: Falling home prices, mortgage securities indices.

Crisis Management Devices: SIV Superfund, Joint Term Auction Facility, Paulson Modification Plan.

To a certain extent it's comforting that current events fit a well established pattern.