RateWatch #371 – Borrowed Money Bubble
August 30, 2003 by Dick Lepre

What's Happening

Some data Friday: Personal Income +0.2%, Personal Consumption +0.8% (still loving to spend), Disposable Income +1.5%, U Michigan Consumer Sentiment 89.3. Greenspan addressed Kansas City Fed Bank Conference rejecting the use of an inflation target in policy-making.

Once Congress gets back and the summer season is officially over look for most talk out of Washington to be about jobs. It is going to be as if nothing else matters.  A prelude/parallel to this will occur in California in the recall election.

Bubbles: Some Comments, Some Concerns

When you were a kid, bubbles were those wonderful things your mom blew. She stuck a funny looking plastic thingy into a bottle of soapy water and blew air through a nearly invisible film which expanded into a spherical soap ball. The bubbles were somehow magical. They were no color and every color. They went up and they went down for no apparent reason. When you grabbed them they no longer existed. When they hit the floor they broke and nothing was inside.

Economic Bubbles

An economic bubble is a short-to-medium term increase in prices that is neither sustainable
nor justified. It is not justified because it is caused by unreasonable speculative investment.

There are, I believe, two very different "colors" of economic bubbles. The "borrowed money" bubble and the "non-borrowed money bubble."

The dot-com thing was a bubble. No one was "investing" in these stocks for long term growth.
People invested in them because the prices of  those stocks could go up by more than 10% in a
single day.

The bubble busted because there was no other possibility.
There was one important thing about the equities run-up. In general, people did this with their own money.  This is the "non-borrowed money bubble."

The Borrowed Money Bubble

On April 22, 1999 Federal Reserve Governor Laurence Meyer in a speech in Annendale-on-the-Hudson, NY pointed out that asset price bubbles in real property were much more dangerous to the economy than inflated equity prices. To quote Meyer:

"There are two kinds of asset price bubbles. There is one which is centered on financial assets and equity markets. The other is when it stretches the real property market, and it is infinitely more dangerous. The U.S. economy can handle surely an equity kind of correction well. But when you
have the kind of correction going on in Japan in property markets, you undermine the collateral
of the banking system and you crush the value of  banks."

The Near Term Future of Real Estate Values

Meyer's point then is that real estate price run-ups represent risks to banks. His point may be accurate but there is a difference between the relationship of banks and real estate values now then there was many years ago. FHLMC & FNMA have spread out the risk on conforming loans. This risk is spread very thin. Pools of mortgages are owned by investors all over the world. If property values in Podunk fall 40% banks in Podunk may get hurt for concomitant reasons but the citizens of Podunk might own only 1% of 1% of the mortgage backed securities for the
properties in Podunk.

This is not the same for commercial loans. Losses on such loans are more likely to hurt individual banks. Homebuilding has been very strong lately. Another demographic factor is just starting to play. The baby-boomers had babies. These baby-boomer babies are just now somewhere between entering college or, having already gone thru college, entering the job and housing market.  This is likely to create increased demand in the housing market for, perhaps, the next
10 years.

Meyer's concerns were expressed 4 years ago.  There has been almost no evidence of repercussions from a "borrowed money bubble."  Housing prices are up sharply this year.  We keep reading about a "housing bubble" but I do not think that it really exists. Meyer's words point out that the consequences go beyond the damage to the equity that individuals have
in their homes and that if there really were a bubble in real estate there would be serious consequence impacting the banking system.

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