Sunday, January 10, 2010

Why Didn't the Tech Bubble Cause a Financial Crisis?

On Friday, Paul Krugman had this to say about why the collapse of the tech stock bubble in 2000 didn't bring about the same sort of financial crisis we just experienced.

The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation’s banks. And banks play a special role in the economy. If they can’t function, the wheels of commerce as a whole grind to a halt.

Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.

Krugman's op-eds are usually infuriating because he writes a lot of false stuff that he knows to be false. In this case, I'm willing to concede that he genuinely doesn't understand what he's talking about.

The true short answer is that the Nasdaq bubble collapse was not an outlier event. It was seen as a reasonably high probability event by everybody throughout the financial system. Options on internet stocks were trading with implied volatility of hundreds of percent per annum, and long-term options on even the boring S&P 500 index were trading at over 20% implied volatility -- extraordinarily high by historical standards. So when the Nasdaq fell over 75% and the S&P fell almost 50% over a period of 18 months, financial professionals were not terribly surprised.

Here's another way to put it. No bank or money manager fund was making non-recourse loans on a stock with a 20% downpayment and no ability to demand variation margin. Yet, that's what a traditional, conservative mortgage on a home is essentially. So when stocks fall 50%, it's not a big shock to the financial system. Few people consider stock market wealth to be as real or as stable as AAA-rated bonds for example.

Homes, on the other hand, had enjoyed low price volatility and had not fallen in nominal price on a nationwide basis since World War II. So when homes across the country fall 35% in nominal price (and over 50% if you look at where most of the mortgage loans were made), this is obviously going to cause a lot of distress throughout the financial system. AAA-rated bonds went from 100 cents on the dollar to 10 cents in some cases. The entities owning AAA-rated bonds did not think they were taking risk. Losses like that simply did not appear on their radar screens. This was very different from the wealth destruction during the tech bubble collapse.

All things considered, I'd have to say that the turmoil caused by the housing fiasco has been pretty mild. The reason is that we have the advantage of a fiat currency system, in which the government can print money at will. The government has made a lot of mistakes which exacerbated the problem, but since the collapse of Lehman in September 2008, the Fed has handled things relatively well (the Treasury less so, but it's done more good than harm).

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