Financial reform legislation is in its endgame in Washington. But the reinvention of the global financial system is just beginning. Where are we headed?
Email Tweet This Post to Facebook Share on LinkedIn Print Featured Products Guide to Persuasive Presentations Buy it now » Guide to Better Business Writing Buy it now » Guide to Getting a Job Buy it now »(Editor's note: This post forms part of the HBR Debate, "Finance: The Way Forward.")
Asset price bubbles are obvious in hindsight. US housing prices in 2006 were 50% above their long-term historic trend. Similarly, ten years ago, some dot-com companies were fetching as much sixty times earnings without turning in any reported profits. But although these disconnects seem so clear in retrospect, they are hard to predict in advance. For every asset bubble that burst, there are several alleged asset bubbles that never blew up. For instance, is China now in a housing bubble that will explode, or just in a high-riding trend that will wind down? In other words, how many null cases are there in which someone predicted a bubble burst, but it did not — or did not in a really destructive way?
It is difficult to predict asset bubbles for several reasons. First, there is often disagreement about how to perform the underlying analysis. What is the correct measure of price earnings, or the proper baseline for housing trends?
Second, there are technological and other changes that do alter historic relationships. Of course, the Harvard economist Kenneth Rogoff may be right that this time it may not be different. But we have seen permanent changes in certain well-established concepts. For instance, we no longer believe that unemployment rates below 4% must be associated with high inflation.
Third, momentum is a powerful force that drives financial markets. Contrary to the normal laws of supply and demand, investors often want to buy more shares of a company after they have zoomed up in price. Following the herd can be an effective investment strategy — until, of course, the herd runs off the cliff.
Finally, even if you accurately diagnose the situation as an asset-price bubble, you cannot know exactly when it will burst. In 2003, Yale Professor Robert Shiller persuasively showed that the US was in the midst of a housing bubble. Yet if you had sold all your US houses in 2003, you would have missed out on three years of big price increases.
For all these reasons, asset-price bubbles are probably going to continue to arise from time to time. So what can we do to reduce the fallout? In my view, we should follow four rules.
1) Don't let financial leverage get too high in heady times. When a bubble bursts, institutions with high leverage all race to the exits at the same time. Even a small loss at an institution with a 30 to 1 leverage ratio will force it to sell assets equal to 30 times the loss in order to maintain this leverage ratio. This means fire sales at bad prices for this institution and downward price pressures on all asset sales at this time.
2) Don't let the mismatches between assets and liabilities get too wide. When bubbles burst, institutions with large mismatches are very vulnerable to liquidity problems. In the current financial crisis, the bank sponsors of special purpose entities issuing asset-backed securities financed long-term mortgages with 60-day commercial paper. When questions arose about the quality of the mortgages, they could not roll over the commercial paper.
3) Watch out for foreign lenders. Although Japan has a high ratio of public debt to GDP, 95% of its debt is held by Japanese lenders who tend to be quite stable. By contrast, foreign lenders to Ireland and Spain pulled the plug quickly once problems arose. In these situations, a national government should adopt measures to cool off its real estate sector as China has recently done.
4) Beware of suddenly popular financial innovations. In the initial stages, new instruments may not pose a material risk to the financial system. However, at high volumes, they can help create a bubble; for example, the notional value of credit default swaps rose from $1 trillion in 1999 to over $50 trillion by 2007. If a new financial instrument scales up, a government agency should re-examine its potential impact on the system and take appropriate action.
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var disqus_identifier = 'http://blogs.hbr.org/finance-the-way-forward/2010/06/how-to-survive-a-bubble.html'; Comments How to Survive a Bubble (Editor's note: This post forms part of the HBR Debate, "Finance: The Way Forward.") Asset price bubbles are obvious in hindsight. US housing prices in 2006 were 50% above their long-term historic trend. Similarly, ten years ago, some dot-com companies were fetching as much sixty times earnings without turning in any reported profits. But although these disconnects seem so clear in retrospect, they are hard to predict in advance. For every asset bubble that burst, there are several alleged asset bubbles that never blew up. For instance, is China now in a housing bubble that will explode, or just in a high-riding trend that will wind down? In other words, how many null cases are there in which someone predicted a bubble burst, but it did not — or did not in a really destructive way? It is difficult to predict asset bubbles for several reasons. First, there is often disagreement about how to perform the underlying analysis. What is the correct measure of price earnings, or the proper baseline for housing trends? Second, there are technological and other changes that do alter historic relationships. Of course, the Harvard economist Kenneth Rogoff may be right that this time it may not be different. But we have seen permanent changes in certain well-established concepts. For instance, we no longer believe that unemployment rates below 4% must be associated with high inflation. Third, momentum is a powerful force that drives financial markets. Contrary to the normal laws of supply and demand, investors often want to buy more shares of a company after they have zoomed up in price. Following the herd can be an effective investment strategy — until, of course, the herd runs off the cliff. Finally, even if you accurately diagnose the situation as an asset-price bubble, you cannot know exactly when it will burst. In 2003, Yale Professor Robert Shiller persuasively showed that the US was in the midst of a housing bubble. Yet if you had sold all your US houses in 2003, you would have missed out on three years of big price increases. For all these reasons, asset-price bubbles are probably going to continue to arise from time to time. So what can we do to reduce the fallout? In my view, we should follow four rules. 1) Don't let financial leverage get too high in heady times. When a bubble bursts, institutions with high leverage all race to the exits at the same time. Even a small loss at an institution with a 30 to 1 leverage ratio will force it to sell assets equal to 30 times the loss in order to maintain this leverage ratio. This means fire sales at bad prices for this institution and downward price pressures on all asset sales at this time. 2) Don't let the mismatches between assets and liabilities get too wide. When bubbles burst, institutions with large mismatches are very vulnerable to liquidity problems. In the current financial crisis, the bank sponsors of special purpose entities issuing asset-backed securities financed long-term mortgages with 60-day commercial paper. When questions arose about the quality of the mortgages, they could not roll over the commercial paper. 3) Watch out for foreign lenders. Although Japan has a high ratio of public debt to GDP, 95% of its debt is held by Japanese lenders who tend to be quite stable. By contrast, foreign lenders to Ireland and Spain pulled the plug quickly once problems arose. In these situations, a national government should adopt measures to cool off its real estate sector as China has recently done. 4) Beware of suddenly popular financial innovations. In the initial stages, new instruments may not pose a material risk to the financial system. However, at high volumes, they can help create a bubble; for example, the notional value of credit default swaps rose from $1 trillion in 1999 to over $50 trillion by 2007. If a new financial instrument scales up, a government agency should re-examine its potential impact on the system and take appropriate action. var disqus_url = 'http://blogs.hbr.org/finance-the-way-forward/2010/06/how-to-survive-a-bubble.html'; var disqus_title = document.getElementById('disqus_post_title').innerHTML; var disqus_message = document.getElementById('disqus_post_message').innerHTML; Please enable JavaScript to view the comments powered by Disqus.Posting Guidelines We hope the conversations that take place on HarvardBusiness.org will be energetic, constructive, free-wheeling, and provocative. To make sure we all stay on-topic, all posts will be reviewed by our editors and may be edited for clarity, length, and relevance. We ask that you adhere to the following guidelines.
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var zflag_nid="675"; var zflag_cid="424/414/391"; var zflag_sid="5"; var zflag_width="300"; var zflag_height="250"; var zflag_sz="9"; div#blogContributors h4{background-color: #fff; color: #000 !important; float: left; font: normal 11px/8px Arial, Helvetica, sans-serif; margin: 0; overflow: hidden; padding: 1px 5px 0 0; text-transform: uppercase;} div#blogContributors div.blogContributorsContent{background-color: #fff; clear: both; line-height:14px; margin: 0 3px 0 0; padding: 8px 10px 10px 0; overflow: hidden;} div#blogContributors div.blogContributorsContent p{color: #585556; font-size: 11px; margin: 0; padding: 0 0 10px 0;} ContributorsPhilip Augar was Group Managing Director, Securities, at Schroders in London before turning to writing. He is the author of several books including Reckless: the Rise and Fall of the City.
Amar Bhidé is a Visiting Scholar at the Harvard Kennedy School. His new book, A Call for Judgment: Sensible Finance for a Dynamic Economy (Oxford University Press) will be published this October.
Matthew Bishop is the U.S. Business Editor and New York Bureau Chief of The Economist. His new book, The Road from Ruin: How to Revive Capitalism and Put America Back on Top, with Michael Green, was published by Crown in February 2010.
Margaret Blair, a professor at the Vanderbilt University Law School, is an economist who focuses on management law. She is the author of Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century.
Nicholas Dunbar is a financial journalist and the former technical editor of Risk magazine. He is the author of Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It. His second book, entitled The Devil's Derivatives (Harvard Business Review Press) is scheduled for publication in February, 2011.
Justin Fox is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.
Martin Fridson is chief credit strategist for BNP IP Global Credit and the author of Unwarranted Intrusions: The Case against Government Intervention in the Marketplace.
