ECON 2105 Assignment 2015

| December 3, 2017

An asset price bubble can be defined as ‘that part of asset
price movement that is unexplainable based on what we call fundamentals’
(Garber,2000), where a fundamental is ‘usually argued to be along-run
equilibrium consistent with a general equilibrium’ (Rosser,2000). Asset price
bubbles are often difficult to identify until the inflated prices are either
supported by subsequent cash flows (Siegel,2003) or until the bubble ‘bursts’
and the price of the asset plummets down to, or below, the fundamental value.
Bubbles can form in various ways, but often occur as a result of inconsistency
in the expectations of the market and through disagreement in the value of a
large economic development (WSJ).Speculation and expectations are a major
contributor in the formation of an economic bubble, as this is the catalyst of
spiralling price increases which occur until the bubble eventually bursts
(book). Price bubbles are often bred when interest rates are low, funds are
easily accessible and optimistic investors are willing to borrow them. The
formation and implosion of asset price bubbles has been observed in some of the
world’s earliest economies and have caused steep declines in economic activity
for some of the world’s largest economies more recently. In this report, the
cause and effect of the ‘dotcom’ bubble, the US housing market bubble of 2007
and the EU price bubble are deconstructed. As is highlighted by these cases,
when an asset price bubble crashes, detrimental follow-on effects can include
‘economic activity reduction, financial instability and, in some cases,
significant budgetary costs from banks altering their capital structure’
(IMF).Potential monetary policy response mechanisms are explored, and their
effectiveness in mitigating the repercussions of a burst asset bubble

Asset Bubbles in the
Australian Market – MARCEL TRIPOLONE 20971214

In terms of determining
whether any bubbles exist within any Australian markets, a number of
assumptions must be satisfied. As of March 2015, the Australian Banking
Association (ABA) determined that despite unprecedented growth in the
Australian Property market, there was in fact no bubble observed. This
conclusion was justified by a number of factors, firstly, they argued it was
volatility of housing prices had increase post-GFC, which had contributed to
the overall increase in price rise but had seen prices fall in specific markets
eg. Adelaide and Hobart. Secondly, recalling data from December Quarter 2014,
suggests that the rate of growth in housing prices nationwide had already
peaked. Finally, historical factors support the notion that property price
appreciation has been a key driver for wealth creation for Australian’s since
late 1980’s, stating that natural confidence and expectations of growth is the
driver of high property prices Australia wide.
Despite these
justifications by the ABA, a number of economic commentators have been critical
of the report, adamantly believing in the existence of a property bubble.
Firstly, the reports comparison of growth rates of property markets globally
puts Australia in good stand, but this is only concerning data post-GFC, and is
ignorant of Australia’s record-breaking housing growth of the early 2000’s
second only to Norway. Of course, the counter argument, stating that income
growth was proportional is valid, but overall the price-to-income ratio for
housing has been ever increasing (Figure 1), indicating household prices rising
faster than personal income. So if it isn’t the domestic market driving these
exorbitant prices, who is?
significant periods, the risk free return has beenhigher
than the rental yields on housing. Under this scenario it would only make
financial sense to purchase dwellings as an investment to rent if there were
expectations of capital gains on housing…” ABA Economic Report, March 11th,
This quote from the ABA
report, identifies the concept of negative gearing, which involves supports
investors as governments make up the difference if investment is less than the
cost of owning and managing the investment. Arguably, this has allowed wealthy,
overseas investors to purchase property in the Australian market at a
marginally lower risk, as any losses on investment will be directly returned in
Tax deductions. This could be argued as one of the primary reasons for
continued growth in the property market, post-GFC, as despite low consumer
confidence, support by the Australian Government made reward outweigh the risk
in many instances.

One of the central causes of the Global
Financial Crisis (GFC) in 2008 was the bursting of a bubble that had been
growing over for a number of years. House prices rose by approximately 8.3%
between the first quarter of 1990 and the first quarter of 1997 (according to
the S&P/Case-Shiller Index). Following this, house prices experienced a
swift increase and peaked in the second quarter of 2006 more than 132% higher
than the first quarter of 1997. There were four main causes of the housing
bubble: overexuberance without rationality, low short-term interest rates,
lower standards for mortgage loans, and low mortgage interest rates (2).
Mortgage Interest Rates
During the period of
the housing bubble, there was an excess of savings in the US over investment.
In addition to this, countries such as China, Japan, Brazil and major oil exporting
countries were sending savings to the US, pushing mortgage interest rates down
(2). Net foreign savings inflows to the US increased from approximately 1.5% of
GDP in 1995 to 6% in 2006 (Bernanke, 2009). Investors from the countries
sending money to the US were seeking investments holding good returns and low
risk. The original focus was on US government securities, before a quest for
higher returns led them to mortgage-backed securities. Following this,
investors venture into the market for mortgage-backed securities issued by Wall
Street firms. These securities appeared to carry low risk due to favourable
credit ratings granted to them by respected credit agencies such as Standard
and Poor’s, and Moody’s. The contribution of the low mortgage interest rates to
the housing bubble was that they allowed monthly mortgage payments to remain
affordable even while house prices were rising (2).
Short-term Interest
An attempt by the
Federal Reserve between 2002 and 2004 to help boost recovery from the 2001
recession led to the federal funds rate reaching a historical low. These low
short-term interest rates were important in the formation of the housing bubble
for two reasons. Firstly, they encouraged the use of adjustable rate mortgages
(ARMs), as potential home buyers could afford the lower short-term monthly
payments as opposed to the longer-term rates provided by fixed rates. The
resulting demand for housing increased prices, but when after two years the
interest rates increased, the home buyers found it impossible to keep up with
the higher mortgage payments.
Secondly, short-term
interest rates encouraged leveraging (investment using borrowed money).
Investors looked to increase returns by borrowing at the low short-term rates
and using the money to invest in long-term investments with higher yields, such
as mortgage-backed securities. Leveraging boosted the available financing for
mortgage lending and as a result contributed to the rise in house prices. When
the housing bubble finally burst, effects were amplified by the amount of
leverage in the economy (2).
Mortgage Standards
In 1995, banks were
pressured into increasing mortgage lending to lower-income households due to an
alteration to the Community Reinvestment Act. The resulting relaxation of mortgage
lending standards was also increased by the greater securitisation of home
mortgage debt. In the securitisation process, a mortgage’s originator sells it
to another party, usually an investment bank. The bank then buys thousands of
mortgages and pools them, before these “securities” are sold to investors. The
securities are divided into tranches with differing risk and return qualities
and rated by credit agencies. However, improper evaluations based on historical
mortgage default rates for similar mortgage pools occurred, later causing
problems. An increase in subprime mortgages (home loans for people with higher
credit risk) also contributed to relaxed standards in mortgage lending (2).
Irrational Exuberance
Speculation caused by the housing bubble led to parties involved in its
creation believing that house prices would continue to rise. The unhealthy
trends continued, leading to the bursting of the housing bubble.
The peak in house prices was reached in the second quarter of 2006, but
did not immediately fall significantly following this. However, an increase in
foreclosure start rates between the second and fourth quarters of 2006 by 43%
and increase by 75% in 2007 compared to 2006 (Liebowitz, 2008) signified that default
rates on mortgages began rising as soon as house prices began falling. People
began walking away from properties, and negative equity for people with ARMs
could no longer make monthly payments once their rate increased. Falling home
prices proved reinforcement for already falling house prices. Foreclosures led
to more houses available for sale, gain leading to further foreclosures. They
also lowered the value of mortgage- backed securities, increasing the
difficulty of lending more of them by the investment banks, removing a large
source of financings for new mortgage loans and so continuing the downward
trend in house prices.
Huge losses were incurred by the bursting of the housing bubble.
Homeowners, in particular those who had bought homes or taken out credit from
home equity lines against the value of their homes too close to the peak were
heavily affected. Since the bursting of the bubble, a third of the top 30
mortgage lenders have either filed for bankruptcy, been liquidated or been
acquired (Zandi, 2009). Likewise, the largest five US investment banks have
either been acquired, filed for bankruptcy or become commercial banks
controlled by greater legislation. Foreign investors and insurance companies
were also greatly affected. The entire financial system felt the effects of the
burst, with the perceived credit risk increasing. Financing for corporations,
commercial real estate investors and home buyers became much more difficult to
access. The credit crisis meant that spending on real investment decreased
between the third quarter of 2007 and the second quarter of 2009 by 32%.

Prior to the housing
crisis, the US experienced the effects of the “dotcom bubble”. The “dotcom
bubble” saw the share prices of early internet companies rise due to
significant speculation. This speculation was fuelled by the booms in the
economy and stock markets in the late 1990’s, leading some economists to
believe that inflation had become non-existent, and recessions a remnant of the
past. In the period from 1996 to 2000, the NASDAQ stock index surged from 600
points to 5000. The “dotcom companies” were being run by young people with no
clear business plans and even some others who were not earning at the time.
Despite this, their companies were going public, and hundreds of millions of
dollars’ worth of capital were being made in the process. At the height of the
bubble, it was even said that every 60 seconds in Silicon Valley a new
millionaire was being produced (Colombo 2012).
Near the beginning of
2000, investors began to come to the realisation that a speculative bubble had
been formed. In a matter of months, the NASDAQ stock index plummeted from 5000
points to 2000. Companies that had rapidly become multibillionaire corporations
disappeared as quickly as they had arrived, with panic setting in, as by 2002
the NASDAQ reached 800. Combined with this, scandals were brought into the open
concerning tech companies artificially inflating their earnings. The bubble led
to the US experiencing a recession in 2001, forcing the Federal Reserve to cut
interest rates repeatedly to try to stem the problems resulting. Large numbers
of technology professionals saw both their jobs and life savings disappear
(Colombo 2012).

bubbles in Europe

Similar to the United
States, the financial crisis that Europe faced gradually lead to a housing
bubble. Due to the crisis, it was difficult for many European nations to
re-finance their debt without the help of third parties.

The European financial
crisis is said to have began in October in 2009, which coincided with the
formation of the new Greek government. This crisis is said to have been
initiated through the globalization of finance, international trade imbalances,
many real estate bubbles bursting, easy credit, fiscal policies, slowed
economic growth and bailout policies.
The following month after the new government announced its plan to
reduce it’s level of deficit, wages in the public sector were frozen. This was
when the EU Commission stepped in and urged Greece to cut the wage bill and the
International Monetary Fund (IMF) were sent to assess the finances. Following on from all of this, taxes were
increased, wages were cut, public sector bonuses were reduced and state-funded
pensions were frozen.

Although there had been
progress, a month later a bailout plan was created for Greece by the European
Monetary Union and their debt rating was downgraded to junk bonds. With Greece
not being the only country to have their debt rating downgraded, concerns began
to heighten throughout Europe. These concerns lead to a domino effect, starting
with a major selloff and a 1000-point intra-day drop in the Dow Jones
Industrial Average followed by a fall in the euro and further debt. By June
2010, the euro had fallen to its lowest in four years and another bailout was
approved in September.

There was a substantial
rise in debt in only a few countries, but the crisis became a perceived problem
for all of Europe. Although Greece, Portugal and Ireland was greatly affected
by this, the currency for Europe was able to remain at a stable rate even with
these countries’ accounting for approximately 5% of the Eurozone’s GDP.

Due to investors
seeking for yields greater than what bonds from the US Treasury were offering, there was an increase in available savings for
investment between 2000 and 2007. Because of this, policy and regulatory
controls were overwhelmed and lead to bubbles bursting that caused asset prices
in the property market to fall. The amount international investors were owed
remained at their full price and raised questions about the banking and
government systems solvency abilities.

All the countries
within Europe generated bubbles to different extents due to money being
invested to different degrees. For example, a huge housing bubble was generated
in Ireland due to their banks loaning money to property developers and there is
speculation of a bubble in the Sweden property market as their prices have more
than trebled since 1996 and household debt is 174% of after-tax income.
However, concern is not limited to these countries alone as the IMF requested
policymakers to work on constraining housing prices all around the world.

Within the European
property market, countries were separated into two categories; the countries
that experienced sharp drops and the countries where there was a dip followed
by a rebound (Figure 1). As they take on larger mortgages, household debt
levels are hitting record levels and have overtaken America’s debt to after tax
income percentage. Urban Backstorm, a former governor of Sweden’s central bank
says, “You cannot know you’re in a bubble, but you can know that debt has moved
too far.” But prices are still set to increase due to expectations that
borrowing will stay cheap and not enough supply of housing.

Figure 1

As the economies in the
euro zone remain in such bad condition, central banks are unable to use
interest rates to try deflate the housing bubble. The use of monetary policy was attempted in
Sweden in 2010 to try control the market but resulted in the country heading
towards deflation.

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