On January 13, 2010, the chief executives of four top Wall Street institutions gathered together in Washington to testify on what went wrong in the years leading up to the great recession. Jamie Dimon, the CEO of JPMorgan Chase, noted that:
In mortgage underwriting, we somehow missed that home prices don’t go up forever.
Lloyd Blankfein, the CEO of Goldman Sachs, added:
Whatever we did, it didn’t work out well. We were going to bed every night with more risk than any responsible manager would want to have.
In hindsight, this was all painstakingly obvious and the solution was simple – don’t take on more risk than you can handle. Going forward, all regulators needed to do was make sure that financial institutions don’t overextend themselves. Just like that, the business cycle would come to a halt and recessions would become a thing of the past.
But this wasn’t the first time we learned this lesson. There was the programmatic trading crash of 1987, the Asian financial crash of 1997, the Russian currency crash of 1998, the tech bubble crash of 2000. After 2008, there was the Greek debt crash of 2011 and the Chinese market crash of 2015. This stuff wasn’t new. Jamie Dimon, in that same testimony, noted:
Not to be funny about it, but my daughter asked me when she came home from school ‘what’s the financial crisis,’ and I said, ‘Well it’s something that happens every five to seven years.’
So the questions becomes: If everyone knows that market crashes happen frequently, and that the best way to survive them is not to be overextended, why then does everyone get caught overextended when the next one arrives? The work of Hyman Minsky helps us answer that question.
Stability Breeds Instability
Minsky was a child of the Great Depression and spent his life trying to understand why financial crises occurred. Towards the later half of the 20th century, when other economists were satisfied with the efficient market hypothesis, Minsky was putting the finishing touches on his financial instability hypothesis.
At its core, the financial instability hypothesis argues that long periods of prosperity set the foundation for the next crisis. To reach that conclusion, we have to turn to the world of finance where Minsky drew most of his insights. Finance can be summarized as the exchange of money today for money tomorrow. In Minsky’s words:
The present money pays for resources that go into the production of investment output, whereas the future money is the “profits” which will accrue to the capital asset owning firms (as the capital assets are used in production). As a result of the process by which investment is financed, the control over items in the capital stock by producing units is financed by liabilities–these are commitments to pay money at dates specified or as conditions arise.
For Minsky, the difference between future profits and liability payments was the main factor that contributed to financial crises. Minsky defined three categories: 1) Hedge financing – where cash flows cover both interest and principle payments on obligations, 2) Speculative financing – where cash flows only cover interest payments and the principle needs to be rolled over, and 3) Ponzi financing – where cash flows cover neither interest nor principle payments and the asset must appreciate in value to remain solvent.
Economies dominated by hedge financing are stable, and economies dominated by either speculative or ponzi financing are fragile. Why then don’t all firms restrict themselves to hedge financing? Minsky explains:
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.
Basically, stability breeds instability. After a crisis, everyone is in bunker down mode. Firms raise capital and lower their leverage. Hedge financing dominates. As years pass, and things start to go better, firms start to become more optimistic about the future. If earnings are going to continue to rise, why not borrow more? If no one is defaulting, why not lend more? This cycle feeds in on itself, pulling the economy further and further away from the equilibrium state that, according the efficient market hypothesis, an economy should gravitate towards.
The longer this cycle of speculation goes on, the worse the subsequent crisis will be. The longer the bull market, the worse the bear market. The tipping point between the two is known as a Minsky moment.
When ponzi borrowers realize they were too optimistic about the future, they start to sell everything – good assets and bad assets – to cover their liabilities. However, in a panic there is no one to buy. Liquidity vanishes and asset prices collapse. The correlation of everything goes to 1. If something drastic isn’t done, this cycle will feed in on itself and lead to a depression.
Great Recession Case Study
Returning to the housing crisis, let’s look at it through the lens of the financial instability hypothesis.
In 1992, real estate investing was highly out of favor. Home prices had just fallen as much as 50% in some areas and banks would only extend mortgages if borrowers met strict lending criteria. By 1997, house prices had recovered and people began to forget about the crash. Or maybe they thought this time would be different. Since prices were now going up, lenders could lower their standards and still be covered in the case of a default.
The first loans where to hedge borrowers, traditional loans where the borrower is paying back both interest and principle. Then came the speculative borrowers, interest-only loans that needed to be rolled over. Lastly came the ponzi borrowers, negative amortization loans where the principle was actually increasing. Lenders would only provide loans to ponzi borrowers if they believed that house prices would increase.
Higher house prices led to more loans which lead to even higher house prices. Then the Minsky moment came. There were no buyers left and house prices began to fall. Ponzi borrowers were bankrupt, speculative borrowers had to sell at fire-sale prices, and hedge borrowers saw the value of their homes collapse along with everyone else. Suddenly, the early 1990’s was fresh in everyone’s memories again.
Today, Minsky’s idea are front and center on the world stage. Central bankers quote him frequently and businesses are fortifying their balance sheets in preparation for the next Minsky moment. But Minsky’s own theory suggests that this will be short lived. The world will get better and doomsayers will fall out of fashion. We will forget what a down cycle looks like and start overextending again.