Basically, just the “explain like I’m five” version of Minsky’s idea of inherent instability of the market…plus, and this might be Great Debate…but was he even right?
Shameless bump…
Well, after read this… Hyman Minsky - Wikipedia
I can simplify it by saying:
When the economy is going along well and businesses are making good profits, they feel secure in taking out loans to expand their business.
So, if they’re making profit, why take on debt? Because they think they can use the extra money from a loan to make very profitable investments either in Research & Development, or expansion, or acquisition, or investment in the markets (which, BTW, are doing very well in this general growth phase of the economy). And since they’re making a profit now, they think they’ll always be making a profit, because, you know… once things start growing, it will grow forever! Right? Right!!?? (The answer is: no.)
On top of taking on debt instead of just using their profits, Minsky noted that many business often take on the bad sort of debt, namely, too much. And they try to finance it through shady practices like borrowing even more (speculation) or ponzi schemes of getting more investors help you chase profits that may never materialize promising to pay them back… with money from even more investors.
And so, when the natural business cycle declines, or, when the bad over-borrowing catches up to businesses, things start to crash, like dominoes.
Eventually, after all the bankruptcies and losses and recession is over, things start picking up again. And with things picking up, you need to get a jump on competitors, so, better borrow some extra money while you have the profits to cover the debt…
I can give one interpretation of the Financial Instability Hypothesis, but with the caveat that I’ve only read indirectly about it from various sources, not directly from the man himself, so I’m likely to be coloring the original with my own thoughts. But here is how I would describe it:
We start by noting that most of the modern money supply is not currency, not the little pieces of paper or the jingling coins that we carry around in our pockets. Most of the stock of money that exists is debt. Money is debt. (In an accounting sense, even those little pieces of paper in our wallets are debt, too, since they represent liabilities of the central bank.) But it goes even beyond that. Not only is the majority of money debt, but the majority of money is private debt.
I have bank accounts: savings, checking. I think of these accounts as if they’re “cash”, but really, they’re not. They’re just numbers that exist in my banks’ ledgers. Specifically, they’re numbers that exist in the LIABILITIES column of the bank. My bank account balances aren’t really cash, but rather a promise by the bank (a debt) to pay me cash whenever I show up to claim that cash. I might write a check to my landlord, when my landlord uses exactly the same bank that I do. My landlord will deposit the check, but what happens in an accounting sense? No actually currency changes hands. What the bank does is look at my deposit balance and say, “Sure enough, we owe Hellestal money. But Hellestal wants to give that cash to his landlord. So let’s decrease the amount of money that we owe to Hellestal (debit his account) and increase the amount of money that we owe to the landlord (credit his account).” Everyone is satisfied with this arrangement. My account balance is lower, and my landlord’s account balance is higher, and the bank still owes exactly the same amount of debt… it just owes the debt to a different person.
The real world obviously has many different banks, but in a certain sense, we can look at the whole banking system as a whole in the same way. When I swipe my check card, it’s not always necessary for any government money to change hands. The whole series of transactions can be changes in private debt only. We think of it as “real money”, when in fact, the only changes that are made might be in the financial statements of private banks.
This means debt is vitally important to the money supply. Money is a kind of debt, so new loans can create new money. When a bank issues a new loan, the very act of creating the loan will create new money in the system. If I want to buy a house, I’m not going to get into debt directly with the contractor. The contractor isn’t in the business of knowing who is credit worthy, and who not, so the bank bridges the gap between us. I get into debt with the bank, in the form of a 30-year mortgage. Simultaneously, the bank gets into debt with the contractor by creating a brand new account and crediting that account for the purchase price of the house. The bank is an intermediary, both a borrower and a lender simultaneously. The bank owes money (the new deposit account created), and the bank is owed money (the amount of the loan). Profit comes from the difference in interest rates. The banks “earn a spread”. This has nothing to do with impressing a date, but refers to the interest-rate spread between what the bank is paying in interest to its deposits and what it is receiving in interest from its mortgages and other loans.
Okay, with that background out of the way, we get to Minsky and the business cycle.
During good times, good businesses wish to expand. But they need money to do so. Where does this money come from? Successful businesses will be profitable, but still, the profits from the business will almost always be insufficient to finance expansion. Businesses need more “purchasing power” to finance productive investments. That purchasing power comes in the form of loans. The private banks create new money and new debt, and the business can expand. The better businesses should ideally be profitable enough to meet the interest payments on the loan, and over time even pay back the principal. This is the story of productive loans and investment.
But the creation of this new debt-based money also tends to push up asset prices. Naturally. If there is more money out there buying stuff up, then prices will tend to increase. Now the rest of the world is looking at these higher asset prices – for example, housing prices in the naughties – and they see “investment” opportunities, too. So they might take out loans, but for speculation. They’re making a market gamble that prices will continue upward. Their profits from their investments should be enough to meet their interest payments. They’re borrowing for investment, but they pay the interest on the loans from their profits, even if they’re not able to pay back the principal. But we can already see the beginnings of troubles. It’s the debt that’s fueling the increase in asset prices.
So we have one more set of people enter the story, the Ponzi financiers who take out loans for massive speculative bets that don’t end up panning out. These people are not able to meet their interest payments, so what do they do? They take even more debt, in order to pay the interest on previous debt. Banks trust them. They’ve never missed an interest payment, have they? That must mean they’re responsible! But of course, it is utterly impossible for this trend to continue indefinitely.
And now we have a proper debt-fueled bubble in asset prices.
Eventually, one or more of those Ponzi-financiers will bust. They’ll be forced to liquidate assets by the court. The massive liquidation will drive down asset prices, finally… but lower prices will put the squeeze on other borrowers, who will then have to sell to meet their margin calls. But this round of liquidation will drive asset prices down further, which will cause another round of tension in the markets. Asset prices can plummet. This is the “Minsky moment” where the debt-fueled bubble finally bursts and asset prices come back down.
But all of that debt? It doesn’t come down. So people are still stuck with the same $450,000 mortgage, when the price of their house has dropped to $350,000. If they keep their job, well, then maybe they’ll be able to ride out the bad times. But what happens if they lose their job? In that case, they’re stuck paying very high monthly payments for a $450,000 mortgage, when the house isn’t worth nearly that much anymore. That isn’t worth it. They walk away. The house is liquidated, put on the market, and so house prices drop even further. It’s a viciously self-reinforcing cycle.
Now we look at the banks’ perspective. They have all of these loans on their books that people can’t pay back. The banks can foreclose on the house, but that only recoups part of the value of the loan, not the whole value, because asset prices have fallen so far. So the banks get a huge hole blown into their balance sheets. They make huge losses, and this means they’re not able to make as many loans. This is the key point: Banks can no longer make even the productive loans that drive the economy during good times. It’s the debt/money system that allows good businesses to expand, and when that financial system breaks down, even good businesses are in trouble. The resulting downturn destroys good businesses along with the bad. A bunch of people are thrown out of work for no good reason.
Stability can last a long time, and the longer the stability lasts, the more people forget the dangers of making bad loans. So an extended period of stability can set up the complacency and lack of caution that eventually leads to the fall.
This is how I would characterize Minsky.
Minsky’s description of the bubble economy seems simple and obvious: prosperity leads to speculation; speculation drives the use of debt to acquire assets. Minsky identified three kinds of investor-debtors, hedge borrowers, speculative borrowers, and Ponzi borrowers. Hedge borrowers rely on the cash flow from their investments to pay down their debt; any increase in asset value is profit to be realized later. This has its risks, but is a fairly sensible strategy, and common in successful businesses.
Speculative borrowers can maintain interest payments (and avoid default) out of cash flow, but rely on the underlying asset’s value to cover the principal, and only some future increase in value will provide any profit. This is a typical strategy in financial investing, but in times of prosperity, loads of amateurs come out of the woodwork hoping to make their pile and get out while the getting’s good. In the meantime, they pay their interest and roll over the principal, reassuring lenders with the soundness of the underlying assets.
Ponzi borrowers can’t expect cash flow to cover anything – the entire strategy is to flip the asset before the payments come due. During times of prosperity, they convince lenders to “let it ride,” rolling over debt and allowing interest charges to pile up in anticipation of a huge payday.
It’s these last two types who characterize “speculative euphoria,” the irrational conviction that the assets will always cover the debts. When they can’t – when the bubble pops, when the remaining buyers can’t sustain the demand – Ponzi borrowers lose their shirts, their lenders lose confidence, speculative borrowers can no longer roll over their debts, and assets are rapidly liquidated at prices that go lower and lower. When the crash is bad enough, the lenders are so spooked that even sensible hedge borrowers can’t get loans: sound assets can’t find buyers, successful businesses can’t expand, and economic growth falls below what’s actually sustainable.
Eventually, a bottom is reached when investors start to believe that it can’t go any lower, and that they’d better get back in the game while it’s cheap. Money changes hands, assets regain some of their value, economic growth recovers, and confidence returns. Ten years later, everyone forgets what happened, and it all starts over again.
The heart of Misky’s theory is this: that at some point, Ponzi debt causes the crash – at some point, there’s so much money tied up in assets that no one can pay for them, or lend enough money to pay for them. Demand collapses, followed by everything else.
Never really heard of this so I read the wiki too and I was a puzzled by the ponzi part of the theory. It says that the ponzi borrower assumes that the value of the underlying asset will continue to appreciate and can therefore refinance. OK, I guess that works for the borrower, but what about the lender.
Interest rates would at least have to be stable if not declining right? Otherwise everyone who owned all of the paper at the old interest rate would take a loss on it since if rates are going up, bond prices go down. In that situation, if lenders have to take losses to free up capital for more loans, shouldn’t that have the opposite effect?
Also, as rates go up, this tends to have a negative impact on demand for debt. So this should be another limiting factor. Did the theory consider this?
Why did so many lenders approve loans to people who could not afford them during the housing bubble? The only possible way for many of the loans to have been paid back would have been for house prices to continue to rise. Even prices just leveling off would have lead to a lot of defaults, never mind the damage that the drop in prices did. I’m fairly sure this is the sort of thing that falls under the “Ponzi” rubric, in Minsky’s terminology.
The lapse in lender judgment which caused irresponsible mortgage lending likely has strong parallels in other bubbles.
Probably yes.
I think this is one of the proposed triggers for the “Minsky moment”.
I think I can answer this one. The banks immediately turned these mortgages into securities, got the rating agencies to rate them AAA and sold them to investors. At a profit, of course. Although the ratings agencies weren’t doing their jobs (and maybe had to give good ratings in order to keep the increased business–were in effect being bribed by the banks) what they were doing was not without a certain logic. If you think that there is a 5% chance that any given loan will default and you put 20 of them together, you would expect that only one will actually default. The chances that 10 of them is negligible. You think. But that computation is based on the assumption that the chances of default of different ones are independent events. But they are not. Assuming there is a housing bubble, one default makes others likelier. And then the bubble bursts and they all (or mostly all) default and then you are in trouble. The ratings agencies appear to have ignored this possibility. Read Nate Silver’s The Signal and the Noise for a longer explanation.
Now I have a question. Every Ponzi scheme eventually crashes. It must. Ponzi went to jail, Madoff went to jail. They mostly all do (unless they move some place with no extradition). Why do they do it? Are they too stupid to know where it must end?
Absolutely yes, that happened, and the rest of your explanation is right, too, but that just pushes the question back a step or two.
Why did the investors not look at where their money was going? They can be considered “lenders” as well. My own bank accounts are me lending money to my bank, and these larger forms of investment are essentially the same thing, just on a grander scale. I trust the bank because it’s federally insured. I don’t trust the email that tells me of the great opportunity to be found in Nigeria. What causes the massive breakdown of basic precaution that leads people to trust such large sums of their money to others, without any due diligence about the real nature of the risk? All of those buzzwords about diversification and financial engineering, large pools of mortgages mathematically spreading the risk, these are just empty stories if you don’t know what sorts of shit mortgages are being diarrheally dumped into the pools.
The answer has something to do with how people form expectations of the future. We see asset prices increasing for four or five years, with some people truly making godawful sums of money, and some idiot switch flips in our minds that causes a big fraction of us to believe that the trend is permanent, or at least, that everyone else is a sucker but we can pull out in time. This is how “lender” standards break down, along every single link in the chain. This is how we get the “Ponzi finance” of mortgages whose repayment is entirely dependent on higher house prices.
It’s this shift of expectations into sheer fantasy along the entire chain of finance that I find the most interesting part of the story.
One problem for businesses is that they often have to borrow to cover the gap between paying their costs (suppliers, wages, etc) and getting the cash from their customers.
Those people or organisations with large amounts of cash/credit have to put it somewhere. If you keep it as transferrable paper (cash under the mattress) then its value will decline with inflation. Even if you lend it to the bank as a supposedly ‘safe’ investment, it will lose value because the bank pays interest at a lower rate than inflation.
So they look for better returns - This seems to be where the dodgy dealers in financial houses create a Gordian Knot of financial instruments and investment ‘opportunities’ that sometimes seem more risky that the previously mentioned West African with a couple of mill he wants to get out of his country.
Once the mortgages were being bundled by the thousands and tens of thousands into single securities with multiple, graded tranches, even the institutional investors were out of their league. How do you analyze that? I’ve worked in mortgage banking. Trying to pull the docs together for just one loan can sometimes be an issue and that was when everything was on paper.
How would you have done that 15 years ago with each bank having it’s own origination system, with everything being recorded in MERS, with the real problem loans not even having critical docs?
There was no diligence, “due” or otherwise to be done in many cases, especially the really toxic stuff which was the problem of course. And certainly this doesn’t excuse places like S&P for pimping themselves out and essentially selling triple A ratings, but if they had tried to check, it wouldn’t have been possible.
But the market was so hot, this shit was getting sold one way or the other. It just didn’t matter.
I absolutely wouldn’t argue against the point that going to the original mortgages would’ve been nearly impossible, but in many cases, they wouldn’t have had to do that. An institutional investor could have easily looked up the prospectuses for the bonds, then looked at the aggregate information for the mortgages.
We know this was possible, because some people actually did it.
First one thing, people should know immediately that a negative-amortizing interest-only adjustable-rate loan is likely to be fishy. A no-doc loan is likely to be fishy. If the prospectus indicates that these kinds of loans take up a big chunk of the pool, then that’s already a red flag, a huge reason to be suspicious of the aggregate. And if you keep looking, and the new bonds later in the year tend to have an even higher percentage of these kinds of loans, then you can easily see the trend in lending is becoming worse and worse. This is the kind of basic diligence one might expect, given the large sums involved.
But when they see others making money hand over fist, for years, that kind of caution just can’t be sustained. Their expectations are shaped by the crowd, not by the aggregate info in the prospectuses.
Very easily. All you need to know is that if a deal is too complicated for you to understand, then it’s probably a bad deal.
Except the things you mention would then be inconsistent with a AAA rating wouldn’t they? And the fact of the matter is that investors believed, with some justification, that these ratings could be relied upon.
Further, I’m not intimately familiar with the MBS market as it existed at that time, or now for that matter, but I would be very surprised if the issuing institutions were essentially saying in the prospectuses, ‘well, you know, the loans in these securities are really shit so, you’ve been warned.’
That was exactly my point. I’m sure how that wasn’t clear. Although ‘complicated’ isn’t the right word. ‘Obfuscated’ is probably better.
No. Not at the time.
The things I mentioned were not inconsistent with AAA rating, since the upper tranches actually did receive AAA ratings.
I’m not following your point here.
What I said was that the prospectuses had information on the general types of loans inside the pools. That was true, but it still takes an interested human mind to actually decipher the legalese and realize that negative-amortizing loans are not likely to be paid back.
You’re wrong. Neg. am. and interest only had the highest underwriting standards in the 80’s when I worked in the field and risk assessment tends to be constant. Obviously no doc. loans don’t even warrant a response.
But don’t take my word for it. Think about it. For neg. am., any initial equity in the home will be eaten away at every month. That equity is the lender’s security. Ego, every month the lender is less secure.
As for the prospectuses, I’m saying flat out that I find it hard to believe that they would break out the percentage of neg. am., interest only, etc. types of loans if they constituted a high percentage of the securities in the MBS. That’s incomprehensible. It’s laughable as to things like NINJA loans - which we know for a fact were a big part of the problem.
So unless you have some cites to backup your assertions, I can’t take you seriously.
“He offered very good insights in the '60s and '70s when linkages between the financial markets and the economy were not as well understood as they are now,” said Henry Kaufman, a Wall Street money manager and economist. “He showed us that financial markets could move frequently to excess. And he underscored the importance of the Federal Reserve as a lender of last resort.”[4]
A loan is a means to transfer future money to the present. Spending it now instead of later only creates “more money” if the result of that spending is more income.
I don’t think that really helps people understand how things work. From the point of view of a borrower, a loan is certainly a way of tapping into future cash flows - which I think is what you’re getting at. And spending creates more money via the fractional reserve banking system and the money multiplier - spending which is stimulated by borrowing against future cash flows.
The thing is that you need to spell these things out if you mean to help people understand. 
Here (pdf)
Is a paper about the mortgage crisis by Foote and Girardi. It makes the case that people buying and selling MDS had information about what would happen if the housing prices leveled off, they were just wildly optimistic that it would never happen. For example Lehman Bros in 2005 put out some forecasts about what would happen under various scenarios. They labeled one meltdown, and said it had a 5% chance of occuring. They were correct about what would happen to the securities under the scenario, but house pricing reality turned out to be worse than what their meltdown scenario was.
Hereis a non pdf summary of some of the paper.