Sunday, May 31, 2009

Detection of asset bubbles

One of the great struggles in the culture wars within the finance industry is the issue of what to do about asset bubbles. Greenspan and Bernanke (and others) have always argued that you simply cannot detect asset bubbles in advance and the best you can do is focus on how to clean up after them. Others vociferously argue that we can and must detect and prevent asset bubbles. A related issue is whether asset prices, particularly bubbles, should be included in inflation. The standard argument is that since asset prices are frequently volatile (falling sharply eventually even if they do rise sharply), it is best to simply exclude them. Most asset bubbles do not significantly affect the core financial system, the banks, so ignoring them has not traditionally been a problem, but in the most recent financial crisis the real estate bubble with its attendent bubble of mortgage-backed securities held by banks shows that even if most asset bubbles can be ignored, they cannot be completely ignored when they involve assets held by banks and other core components of the financial system. Nonetheless, the question of how to detect bubbles is still outstanding, not to mention the second question of what to do when they have been detected.

Many of the proponents of early treatment of asset bubbles are also proponents of the gold standard and opponents of fiat currency and simply believe that loose money is the cause of most asset bubbles and that the cure is simply to get back to a non-fiat currency. Obviously that is not going to happen. The net result is that most of the proponents of early detection and control are simply not offering any realistic proposal for early detection.

So, we remain without a credible proposal for detection (and then mediation) of asset bubbles.

Even if we cannot in general detect arbitrary asset bubbles, it seems quite clear that we really do need to prevent them in the core of the financial system.

One harsh alternative is to dramatically restrict the form of assets that banks can hold, so that asset price inflation becomes a non-issue for banks.

Banks traditionally held mortgages and loans, which gave banks an incentive to assure that the valuation of those assets was "safe". The advent of mortgage-backed securities and bulk rating and tranching of assets and availability of derivatives to "insure" against default allowed banks to lay off risk to the point where nobody thought they were responsible for the risk of the inflated asset prices. This enabled the development of an asset bubble in housing prices and cheap loans. The theory is that without all of these "innovations", banks would have simply ceased issuing mortgages as housing prices made the risks unacceptable, possibly simply raising rates incrementally as risk increased, so that eventually people could no longer afford them.

That still begs the question of how banks would have properly detected that housing prices were excessive.

Ultimately we need a mechanism for determining the value of an asset, as distinct from its market price.

One possibility would have been for banks or the rating agencies to simply look at a projected long-term value trend for the asset and raise yellow and red flags when the asset price rose too far above the long-term trend. I think this would in fact work for "real" assets such as housing.

Alas, even if such an approach worked for real assets, it would be quite problematic for non-real assets such as stock and bond prices, or even for hybrid assets such as futures and options for commodities. The classic case is a hot new company (ala Google) who has great but unproven future potential even if a short track record. How does one determine current value and project it into the future without resorting to unproven "innovations" in valuation? And for commodities, how does one distinguish the demand from speculators from the demand from real consumers of the actual commodities?

In summary, detection of asset bubbles in non-real assets such as securities and derivatives may be very problematic, but something does need to be done for the assets held by banks. Absent some better solution, the fallback should be that banks either cannot hold assets whose value (as opposed to price) cannot be determined, or to value those assets at a harcut to market price based on a projection of stable traditional prices, a surrogate for current "rational value."

For general asset bubbles, I would suggest that we develop models of realistic and acceptable asset price increases and then slap the "possible asset bubble" label on any asset that exceeds some standard rational price increase. Option pricing models might provide a model for how to calculate price changes which are outside of the range of believability. So, investors, traders, and speculators, and their management would suddenly see all of those flags starting to pop up when any market started to get too frothy. Risk management rules would then kick in for most organizations, cutting back on speculative demand. What we really need to do is look at the risk-adjusted price of an asset rather than the nominal market price. Show people their risk up front, in their faces, on each transaction and maybe then we might see some genuine behavioral change. Showing people book value would also help to give people visibility into their risk. Force traders to report their real risk and management would pay a little more attention. Force management to report real risk to regulators, and suddenly risk will start to become managed.

-- Jack Krupansky

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