and the Way Back
April 14, 2009
The late economist Hyman Minsky is widely known for his observation that, over the long-term, “stability leads to instability.” Less recognized is Minsky’s explanation for the phenomenon – stable economic systems break down because they encourage increasingly risky debt financing.
In a talk on April 4 at the Altegris Strategic Investment Conference, Paul McCulley, a Managing Director with PIMCO, discussed the application of Minsky’s research to the current financial crisis, its implications for identifying future asset “bubbles,” and his prescription for restoring order to the world’s financial markets.
“Bubbles can be identified by the nature of the marginal source of finance,” McCulley said, as he explained the course of financing within the housing market and the shadow banking system.
Home financing followed Minsky’s progression, beginning with the “hedge” unit, followed by the “speculative” unit, and ultimately ending with the “Ponzi” unit. With a hedge unit, the borrower has adequate cash flow to pay interest and principal, unlike the speculative unit, where the borrower can make interest but not principal payments. In the housing market, the transition from hedge to speculative financing coincided with the spread of interest-only loans.
Use of the speculative financing unit increases leverage throughout the system, pushing up asset prices which, in the housing market, began to rise at an accelerated pace in the late 1990s.
Investors, or in this case homeowners, eventually got bored with the speculative unit, McCulley said, and they moved on to the Ponzi unit. With a Ponzi unit, borrowers cannot fund either interest or the principal payments, and they are merely betting that the value of the collateral will not go down. In 2006, the housing market’s version of the Ponzi unit became popular – the “pay option loan with no money down.”
“When you have Ponzi units, you are in a bubble,” McCulley said. He added that there is no mystery to identifying bubbles – you merely need to understand the structures used to finance asset purchases.
McCulley said these pay option loans were really just “at the money call and put options.” If home values went up, homeowners would exercise their call option and refinance or, if they went down – as was the case – they mailed in the keys, defaulting on their mortgage and exercising their put option.
Each Minsky journey has a Minsky moment – the point at which excess leverage cannot be sustained and the system unravels. For the housing markets, the Minsky moment came in August of 2007, when BNP Paribas “raised the gate” on two of its structured investment vehicles (SIVs), informing investors it had insufficient liquidity to meet its cash flow requirements.
An avalanche of de-leveraging commenced, otherwise known as the reverse Minsky journey, and it proceeded at a far more rapid pace than had the forward Minsky journey.Display article as PDF for printing.
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