The Financial and Asset Bubble – Since the official start of our six (6) yearlong “Credit Crisis”, we have all seen the various wide-ranging extremes of the financial and asset cycles with both busts and booms. During the past several years, our economy has experienced deflation, inflation, and potentially hyperinflation partly due to a weakening U.S. Dollar, declining job numbers and investor demand, and various financial strategies and bailouts.
In spite of numerous analysts alleging that the “Sub-Prime Mortgage” implosion was the cause of the “Credit Crisis” (or near absolute implosion of the world’s financial markets), it is related more to the freezing, or the near implosion, of the world’s Derivatives Markets. As a comparison, the combined value of all outstanding sub-prime mortgages at the start of the Credit Crisis was something like less than 1% when compared with the size of the derivatives markets at the time.
What is a Derivative?
The primary cause of the “Credit Crisis” is related to the alleged near implosion of the world’s Derivatives markets as I have noted before over the years. Derivatives are akin to a hybrid of financial and insurance instruments such as Credit Default Swaps or Interest Rate Options.
Derivatives may be considered as similar to a glorified financial bet in which various parties bet on the future directions of interest rates such as the LIBOR Rate (London Interbank Offered Rate). In some cases, there may be a big winner who may win upwards of twenty (20) to fifty (50) + times their original investment amount. In other cases, however, there may be a big loser who may lose upwards of fifty (50) + times their original investment amount.
Some financial analysts suggest that the world’s combined Derivatives market may be larger than $1,500 trillion. If true, then this dwarfs the size of all assets on Earth combined by a multitude of times.
If derivatives may be visualized as potential “falling dominoes” since so many large financial institutions are tied to the same financial “bet”, then one falling “domino” (or bank) may, in turn, knock over several other adjacent “dominos” or banks as they all may implode. Another game to visualize is the game of “Hot Potato” in which financial institutions try to pass off their riskiest investments to other banks or investment banks so that they are not stuck holding the “Hot Potato” when the music finally stops playing.
After the near implosion of the world’s financial system as also confirmed by Federal Reserve Chairman Ben Bernanke back in March 2009 as he made this same statement in front of a Congressional Sub-committee, the Fed provided various Big Banks, Investment Banks, and Insurance Companies with supposedly upwards of trillions of dollars of both anonymous and not so anonymous bailouts. These funds were used to try to better stabilize these financial institutions so that they did not collapse as well along with AIG, Bear Stearns, Washington Mutual, Bear Stearns, and other large financial entities which have collapse since 2007, sadly.
Supposedly, the bulk of these bailout funds were used to first stabilize the financial institutions so that they did not run out of cash or credits as they were originally intended. However, then many of these same financial institutions used the bailout funds to invest more money in derivatives as opposed to making more loans to their banking customers such as mortgage loans, credit card loans, small business loans, and automobile loans.
At present, many of the largest U.S. banks may have more funds invested in the Derivatives market than even prior to the start of the Credit Crisis in dollar amounts which may far exceed their current combined stock value today. If true, this means that some of the largest financial institutions in the USA currently may have more funds invested in risky derivatives (a glorified “bet”) than their entire bank’s combined net worth.
This is akin to betting more than one’s combined personal net worth at their local casino that the color red will show up on the roulette table as opposed to black or green. If I win, then I will be very happy. If I lose, then I am financially wiped out, tragically.
Bubbles to the Rescue
Between the summer of 2007 and 2011, real estate prices (both residential and commercial) dropped dramatically throughout the USA. In many regions, home prices fell between 30% and 50% plus in just a few years. Numerous large retail shopping center values imploded significantly as well after many of their tenants filed for bankruptcy and moved out. Land deals were particularly hard hit with many land values falling 500% – 700%+ in value on many deals which I worked on personally.
For most Americans, the bulk of their net worth comes from the equity in their primary home. A homeowner who is “upside down” (mortgage debt exceeds their current market value) is more likely to walk away from their home than a homeowner who has a large portion of equity to protect. The worsening unemployment numbers in recent years and the declining income for a high percentage of Americans have created financial problems for so many people as well.
The Fed acted or reacted a few years ago to the deflationary asset cycle by implementing “Quantitative Easing” (QE) financial policies. QE is effectively the increased purchasing by the Fed of much larger amounts of stocks, bonds, and mortgages in order to try to drive up asset prices.
The antidote to asset deflation is inflation by artificially increasing demand for assets in order to try to increase asset values. For example, the Dow Jones index reached a low of 6,443 on March 6, 2009. Today, the Dow hovers near 15,000 primarily because of the Fed’s QE policies. In spite of a very sluggish U.S. economy, how does it make any sense that the Dow Jones today is near all-time record high levels?
Additionally, the Fed is supposedly purchasing upwards of $85 Billion of Treasury Bonds and Mortgages per month in order to attempt to drive down interest rates. The more investors for Treasury Bonds such as 10 Year Treasuries, then the better the price and the lower the 10 Year Treasury Yield. Since thirty (30) year fixed mortgage rates are tied to the directions of 10 Year Treasuries, then we have all seen record and near record mortgage rate lows over the past year.
Booming Real Estate Prices
Thanks to financial bailouts and creative, nonsensical, and potentially very risky financial strategies such as Quantitative Easing and “Operation Twist”, real estate prices have begun to increase quite well over the past year or two in many U.S. regions. Operation Twist is when the Fed buys and sells short and long term bonds simultaneously in order to drive down long term fixed mortgage rates.
The combination of a declining supply of homes for sale nationally, and the record and near record low mortgage rates are two of the primary reasons for massive price improvements in many parts of the USA. The declining home inventory numbers is related partly to a larger number of all cash buyers from investment banks and Hedge Funds which are buying hundreds or tens of thousands of homes at a time from banks and mortgage loan servicing companies even before they are ever listed on the MLS (Multiple Listing Service) for sale to the General Public.
How long will the financial and asset bubble continue to grow? Or, will it pop soon as suggested by some financial analysts and economists. Who knows the true answer to those questions since there is no historical precedence for these same financial strategies used by the Fed in order to try to better stimulate the financial markets.
All we can do is hope that our economy and job market improve so that the Fed doesn’t have to continue using financial shenanigans for too many more years in order to try to continue improving financial and asset prices.