This theory is pretty cool (and accurate i think)...
Quote
In the latest CFA Institute Conference Proceedings, Paul McCulley's article ("The Liquidity Conundrum") has a superlatively readable discussion of economist Hyman Minsky's work on financial instability. Minsky's theory goes a long way toward explaining the housing bubble, in particular the creative mortgage products that blew it up.
Minsky’s core thesis is known as the “financial
instability hypothesis.†Translated very simply, the
hypothesis states that stability is inherently destabi-
lizing because stability leads to the extrapolation of
stability into infinity, which encourages more risk-
seeking financial structures, particularly with debt.
Therefore, the more stability a market has and the
longer it lasts, the more unstable the foundation of
the stability becomes. Stability is destabilizing
because it begets more unstable debt structures.
Minsky broke down the process of stability
producing instability into three steps that are char-
acterized by three types of debt unitsâ€"hedge units,
speculative units, and Ponzi units. In a financial
cycle, a long period of stability leads to more mar-
ginal units of debt creation, and the economy shifts
from hedge units to speculative units to Ponzi units.
Once the economy reaches Ponzi units, it slows,
and it is set up for a reverse Minsky journey. As I
define the three units in the following, the process
that led to the mortgage market crisis in 2007 will
become clear.
Hedge Unit. In Minsky’s framework, the hedge
unit describes a borrower who obtains a loan to buy
an asset, and the asset plus other income generates
sufficient income to pay the interest and amortize the
principal on the loan. The debt is self-liquidating,
and it is hedged because the income stream can pay
the interest and amortize the principal. It is a very
stable unit, and in the mortgage market, a hedge unit
would be a conventional 30-year fixed amortizing
mortgage. In the past, debt was perceived as a bad
thing, and therefore, trying to pay off one’s mortgage
as quickly as possible was part of the culture. If the
marginal debt creation in the economy is a hedge
unit as described by Minsky, it is a stabilizing factor.
Speculative Unit. A speculative unit is a step
farther out on the risk spectrum. It is characterized
by a borrower who buys an asset, and the income
generated by the asset plus other income is suffi-
cient to pay the interest on the note but not to
amortize the principal. In the mortgage market, a
speculative unit would be an interest-only loan with
a balloon paymentâ€"at the set maturity date, a bal-
loon payment is due that is equal to the amount
originally borrowed. The speculative type of debt
unit is less stabilizing than a hedge unit because the
borrower is speculating on at least three things: The
interest rate is not going to rise, the terms and con-
ditions will not change, and the value of the collat-
eral will not decline.
If the marginal unit of debt creation is specula-
tive, then the system is becoming less stable. But the
paradox is that the longer an economy is stable, the
more likely borrowers are to engage in such specu-
lation. Doing so produces the immediately favor-
able effect of lowering the monthly payment
because the principal is not being amortized.
Ponzi Unit. Minsky’s third step is called the
“Ponzi unit,†which is typified by a borrower who
buys an asset, but the income generated by the asset
plus other income is insufficient for amortizing the
principal or even paying all the interest. In the mort-
gage market, a Ponzi unit would be a negative amor-
tization loanâ€"at the maturity date, the borrower
has a balloon payment, but it is bigger than the
original amount borrowed because of the unpaid
interest. Like the speculative unit, the Ponzi unit is
also speculating on the interest rate as well as the
terms and conditions of the loan not changing. But
it is taking a fundamentally different position with
respect to the value of the collateral. In a Ponzi unit,
the borrower is betting that the value of the collat-
eral will go up. Borrowers who take on a Ponzi debt
unit are betting that if they buy an overvalued asset,
when the balloon payment comes due, another bor-
rower will pay a higher overvalued price for the
collateral. The collateral cannot just hold its value;
it has to go up in value.
Minsky and the U.S. Property Market.
Minsky’s three steps precisely describe what
unfolded in the U.S. property market over the last
seven years. By 2006, the preponderance of debt
creation at the margin was Ponzi unit finance. A
classic example is the 2/28 subprime adjustable-rate
mortgage in which borrowers put no money down,
get a teaser rate for two years, and can opt to pay
less than the full amount of interest. The borrowers
choose how much interest to pay, and the rest is put
toward principal. After two years, though, the inter-
est rate goes up by about 500 bps. The majority of
the marginal borrowers for the years 2004 through
2006 made use of this mortgage structure.
Minsky’s hypothesis explains why the down-
turn occurred. Property prices had been rising at a
steady and stable pace for a long period, so borrow-
ers walked the path from hedge units to speculative
units and, finally, to Ponzi units. In the midst of the
exuberance, the rising prices were a self-fulfilling
prophecy. As more people walked down the Min-
sky path, they drove up the value of the collateral.
Very few defaults were occurring because borrow-
ers do not default when they are making money.
One should realize that what was happening, in
effect, was that by 2006, the mortgage industry was
granting to marginal borrowers a free at-the-money
call option on the value of their property. As the
property market continued to go up, the default rate
on the mortgages was low because borrowers’ free
at-the-money call options were going in the money.
If they defaulted on their mortgage, they gave up
the in-the-money portion. So, the default rate is
initially low in the last stage of the Minsky journey
from speculative to Ponzi.
The rating agencies assumed that this default
experience would continue. But by the first quarter
of 2007, the subprime mortgages issued in 2006 had
a surge of early payment defaults. The percentage
of borrowers not making the first payment on their
mortgages rose quickly, which signaled that the
property market had reached the Ponzi stage. For
borrowers, the rationale behind not making the first
mortgage payment can be explained by the call
option effect. If the value of the property goes down,
then borrowers’ call options are worth nothing, so
why should the borrower continue to pay for it?
Once affordability is stretched beyond any rational
sense relative to rent values, borrowers stop seeking
loans. The Minsky journey is over, and the economy
starts heading in the other direction.
http://optionarmageddon.blogspot.com/2008/04/minskyin-brief.html?ref=patrick.net
I agree with the theory. On the margins, that is clearly what happened. But, with the price declines, interest rate declines and wages continuing to rise, things may be getting better as seen on this chart:
(http://bp0.blogger.com/_otfwl2zc6Qc/R-wYyeFFtXI/AAAAAAAAEGg/rSSyEZRuAAk/s400/nar1.bmp)
According to this blog by a Michigan econ professor, housing is now cheaper than at any time since 2004:
QuoteUpdate: The chart above shows the National Association of Realtors' Housing Affordability Index (HAI) from 2005 to Feburary 2008 (annual averages for 2005 and 2006, monthly in 2007 and 2008), based on the national median-priced home, median family income, and the 30-year fixed mortgage rate.
The HAI has gone from 103.6 in July 2007 to 135.6 in February 2008. A composite HAI of 135.6 means that a family earning the median family income ($59,967) in February had 135.6% of the income necessary to qualify for a conventional loan (at 5.94%) covering 80% of a median-priced existing single-family home in February ($193,900). This increase of more than 31.6 points in the HAI in just seven months, from both falling home prices and falling mortgage rates, is already starting to have a positive effect on the housing market (February sales increased) and could continue to play an important role in the recovery process for the slumping real estate market.
Housing affordability is higher today than at any time since early 2004. For the perspective of homebuyers, aren't we now in a real estate boom, since affordability is the highest level in four years?
http://mjperry.blogspot.com/
RG - clearly you know that anything from the NAR is tainted. come on man! i know that you know this. that is like asking the Red Raiders' cheerleaders "Who is the best team!?!?"
"RED RAIDERS!!!! YAY!!!"
actually, though...i would guess that they are close to correct...i would estimate that housing here is not as affordable as it was in early 2004, but probably in early 2005...i still think we have 15% to fall.
predicting a bottom is just as hard as predicting the top though.
This is also a good piece on the issue. As you can see, the average appreciation has historically been 4% per year and the market is now bringing prices back into line after much higher than normal returns. We have a little farther to go down according to this analysis but it isnt the end of the world:
QuoteHome Price Reversion to Trend
People are wondering how far home prices have to fall before hitting bottom, or some sustainable level. One way is to look at what a price reversion to trend would entail.
From 1982 to 2001, median existing home prices grew at a 4 percent per year trend rate. We select 2001 as a cut-off, because the Fed dropped the funds rate to 1.75 percent and home sales took off in the subsequent years.
(http://bp2.blogger.com/_gL4N3uYQG50/R_Y_O5MfnvI/AAAAAAAAAnU/6YIZbICvGGs/s400/JP1.GIF)
Home prices also surged; until they peaked in 2006, home prices grew at an 8 percent per year pace, double the 1982-2001 trend pace. Home prices have started to correct, with a 2 ½ percent drop in 2007 and 7 percent drop so far this year.
Comparing actual home prices with what the 1982-2001 trend projected, we see that prices in 2006 were almost 40 percent above trend. Current prices are still 16 percent above the trend projection.
If prices are to revert to the trend by next year, they still need to fall another 12 percent from current levels. Reversion to the trend by 2010 would require a 10 percent decline from current levels.
Obviously, prices still have a way to go. However, this also means that homes are becoming more affordable. The home affordability index is now at the highest level since early-2004. (Thanks to Mark Perry at the Carpe Diem blogsite for highlighting this).
(http://bp1.blogger.com/_gL4N3uYQG50/R_Y--pMfnuI/AAAAAAAAAnM/G3XczGOk1IA/s320/JP3.GIF)
Falling home prices aren’t pleasant, but they are part of the market’s self-correction process. It’s also worth noting that even if prices revert to the trend growth rate, a home purchased more than five years ago would still have appreciated in value.
http://www.kudlowsmoneypolitics.blogspot.com/
Quote from: Driven1 on April 07, 2008, 11:32:11 PM
RG - clearly you know that anything from the NAR is tainted. come on man! i know that you know this. that is like asking the Red Raiders' cheerleaders "Who is the best team!?!?"
"RED RAIDERS!!!! YAY!!!"
actually, though...i would guess that they are close to correct...i would estimate that housing here is not as affordable as it was in early 2004, but probably in early 2005...i still think we have 15% to fall.
predicting a bottom is just as hard as predicting the top though.
The NAR analysis may be tainted but the raw numbers, as seen through the index, speak for themselves. In this case, they do appear to show that we are close to getting out of the weeds. We will see. As you said, it is hard to know the precise moment when the bottom has been hit except in hindsight.
I have no idea as to the total number but foreclosures are a part of the cleansing of the system. Do you have a source for the 2 million figure?
duh!!!! almost no one knew what a short sale was up until 4 months ago. i tried one about two years ago and the bank would not even BUDGE!!! i mean...the balance on the house was like $132k and i was asking them to take $125k (it was in foreclosure proceedings) and they would not budge a bit. now, the honest word from sources around town is that the banks are taking 50-60 cents on the dollar on these homes. my, my how the times have changed.
truly, truly i say unto you though...it is the bottom-fishers who WILL allow the market to put in a bottom.