Ron Hiebert
Sun, October 19, 2008
A brief guide to busts, manias and greed
By RON HIEBERT
Einstein once said that the difference between genius and stupidity is that there is a limit to genius.
Stupidity, it seems, has once again trumped the geniuses on Wall Street.
They designed complex algorithms to protect the world from the effects of all the toxic financial instruments they were concocting. Instead, they created two bubbles, one financial, the other real estate.
Both are bursting at the same time, punishing both the greedy and indifferent alike with the financial consequences of a global recession.
Why is it that we never seem to learn the vital lessons? Booms that drive asset values grotesquely upwards are ALWAYS followed by busts, which vaporize the previous gains.
The aftermath in all cases is devastating, yet we seem to learn nothing.
Manias are created when three conditions exist.
The first catalyst is called the game changer. It can be a significant technological advance like the development of the Internet or a major financial innovation.
New products like collateralized debt obligations, credit default swaps and special investment vehicles caused the current bubble. This fancy terminology hypnotized people into believing that the risk of giving people loans that they don't have the ability to repay could be eliminated.
The estimates of how much Wall Street Fat Cats generated in fees from mortgage-related investment banking since 2003 range as high as $2 trillion. When it began to leak out how obscene the profits were from playing this financial shell game, everybody wanted in. Big profits can make a believer out of almost anyone.
Bubbles also need the easy credit that is caused by too much liquidity. American households today have $7.4 trillion in bank accounts and money market funds and another $4.1 trillion stashed in U.S. treasuries and other types of short-term bonds. That totals $11.5 trillion in accessible cash that is sitting in low-paying interest bearing accounts looking for a more profitable home.
This isn't just an American phenomenon. The rest of the world is also awash in money. Massive liquidity prompts the lax lending required to fuel a mania.
The final catalyst in bubble formation is the abandonment of long-term metrics for valuing assets. Sir John Templeton said "The four most dangerous words in investing are 'It's different this time.' " When the old benchmarks are tossed aside by investors who believe that they are living in a new paradigm, the sky becomes the limit as to how high valuations can be pushed.
When these three conditions come together to create a boom/bust cycle, it always blindsides investors.
Humans, it seems, are very good at learning specific lessons but lousy at transferring that experience to the bigger picture. We gathered from the Internet bubble that tech stocks were risky and should be avoided. We didn't grasp the broader principle that to escape financial ruin, we should avoid overpriced and overhyped assets of all kinds.
This inability to transfer the lessons from past bubbles to future ones means that we seem destined to keep repeating the same economic folly over and over again.
Sad! I actually was beginning to think we were smarter than this.
Ron Hiebert is a portfolio manager and director, wealth management at ScotiaMcLeod. He can be reached at ronald_hiebert@scotiamcleod.com
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