this type of euphoria state that precedes a collapse in asset prices, withdrawal of credit, and significant damage to bank balance sheets.
The lending cycle, as outlined by Minsky, grows slowly at first, developing gradually as increased borrowing by businesses and households continues to be supported by rising asset prices, incomes, and expanding balance sheets. This he called “hedge finance.” As the cycle continues banks are seduced into expanding their lending business by the rising values on the collateral side (houses are collateral) and the very low level of defaults. Borrowers are comforted by their ability to borrow more and more, often borrowing enough in new loans to pay off previous loans and the interest on those loans too. This second phase he called “speculative finance.” As long as borrowers have sufficient cash flow to pay off the interest and qualify for new loans when it comes time to rollover existing loans, the cycle continues. Often governments and central banks contribute to the growth and add to complacency by relaxing the standards for bank loans and leverage ratios for banks. Financial innovation becomes rampant with clever participants finding ways around any rules that put limits on the amount of borrowing.
The irony is that the longer the lending cycle and the related boom in asset prices continue the more comfortable, complacent, and confident the participants become. Individuals who were originally reluctant to borrow large amounts become willing to take on larger loans; the ease with which the interest payments are covered, and the loans are rolled over into new loans, convince them that there is no danger. Lenders, who should know better, are also lulled into complacency by the feeling that there is a permanent upward trend in asset prices. This last phase, when eventually receipts are insufficient to cover interest payments, he called “Ponzi finance.”
Minsky called his ideas the “financial instability hypothesis.” In lay terms, his theory suggests that the financial system swings between robustness and fragility – swings that are in tune with the business cycle and the credit cycle. Instead of trending towards equilibrium, the system swings between boom and bust. His theory did not gain a large following in the beginning, as he was in the shadow of more famous economists and defenders of free market ideology (such as Milton Friedman) who argued that markets, if left alone, would tend to equilibrium.
Minsky pointed out that the longer a trend continues without interruption and without a significant negative shock the more convinced people become that it will continue forever. In the current period in Canada, which extends back to the early 1990s without a major crisis, real estate speculators, foreign investors, and most Canadians have come to believe that house and condominium prices will continue on an upward trajectory indefinitely. This belief, as odd as it seems to some of us, is widespread among speculators, homeowners, and especially young adults. I can imagine asking a hundred people on a busy downtown street in Toronto or Edmonton a question like, “Is housing a good investment?” Alternatively, how about this: “In the long run do you think house prices will rise?” or “Is it a good time to borrow money to buy a house?” The answers, I am sure, would be: “Yes,” “Yes,” and “Yes.” A similar survey taken in the United States after the housing crash of 2007–09, or in Canada after the real estate crisis of the early 1990s would get responses with a more mixed outlook, including some very negative views on the future of real estate.
An unqualified belief in housing as an investment (which really means a belief that house prices will rise indefinitely) causes many people to take out bigger and bigger loans, which invariably means larger risks. However, Minsky would point out that, as the credit cycle extends in time, the system is also becoming more and more fragile while complacency grows, leading to the inevitable crisis.
The term, “Minsky moment,” started to gain popularity when, in the summer of 2007, two New York–based hedge funds collapsed. The funds specialized in subprime mortgage-backed derivatives and were run by Bear Stearns, a global investment bank and brokerage firm based in Manhattan. Bear Stearns had been named “most admired” firm in the securities division of a Fortune magazine survey for two of the previous three years prior to 2007. The start of the global financial crisis, can be traced back to the collapse of these funds, named the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leverage Fund. Both funds were based on subprime loans to highly indebted people with poor credit histories that were acquiring residential real estate at elevated prices, although you couldn’t tell that by their exotic names. The funds specialized in a type of derivative called a collateralized debt obligation (CDO).
Bear Stearns, the sponsor of the funds, folded on March 14, 2008, after eighty-five years as one of the top U.S. financial institutions. The assets of the firm were bought for pennies on the dollar by JP Morgan Chase & Co. and with the help of a government guarantee. Minsky couldn’t have foreseen the collapse of those Bear Stearns hedge funds and the worldwide mayhem that ensued, but he would not have been surprised.
The term Minsky moment describes nicely the ultimate crisis that follows a period that starts with complacency, leads to rising indebtedness, and grows to include rampant speculation on borrowed money. At some point, the debt levels become too large and the cash flow from the assets purchased is not large enough to cover the interest costs. However, the lenders realize belatedly that some of the borrowers are unable to cover the interest on their loans and they demand repayment of the loans. But the only assets borrowers have to sell are ones that they have purchased with borrowed money, and once they start to sell them, the value of their assets fall, and more loans get into trouble and the situation spirals out of control. As borrowers declare bankruptcy, the banks seize the assets that were used as collateral, and try to minimize their losses by selling those assets. But if the number of speculators was large and the asset class they were buying was illiquid, the banks will have huge difficulty selling the assets. In the process of selling, the banks will push asset prices even lower — forcing more borrowers into trouble. Eventually, even cautious borrowers who were careful not to stretch their borrowing to the maximum amount find that they are under-collateralized for their loans. At this point, the banks are in trouble since leverage ratios in banks don’t allow for losses of 30 percent or greater in the value of collateral. Once the banks are in trouble, the government must step in to stabilize the situation. This happened in the United States, Ireland, Iceland, Spain, Portugal, Greece, and other countries within the last six years, as a result of situations that were often triggered by excessive borrowing to buy illiquid real estate assets.
In Canada, if a Minsky moment were to arrive in the next couple of years, the government would be heavily involved. More than 60 percent of all mortgages outstanding carry some form of mortgage insurance guaranteed by the Canadian government. As of December 2013 the CMHC had outstanding insurance coverage valued at close to $600 billion (the limit set by government). Genworth Canada, a private mortgage insurance company (56 percent-owned by Virginia-based Genworth Financial), carries up to $250 billion (90 percent government guaranteed) of outstanding insurance obligations, bringing the total of those two close to $900 billion. Obviously, if housing values were to collapse due to a Minsky moment, both of these organizations would run into difficulty. The government would have to step in to fill the gap and cover the losses. If the government didn’t step in, the impact on Canadian banks and the financial system would make the collapse of Bear Stearns and Lehman Brothers seem like a Sunday picnic on a sunny day by comparison. After all, the gross domestic product (GDP) of Canada is only $1.8 trillion annually and there are more than $1.2 trillion in mortgages outstanding plus hundreds of billions of other debt.
The credit cycle, fuelled by the availability of cheap and easy credit, allowed Canadian housing prices to soar and residential construction activity to reach record high levels. Excesses such as these are normal at the peak of a real estate cycle, and reversion to the mean is the rule. Reversion to the mean is a statistical term meaning that observations well above average tend to move back to average and similarly for observations well below average. Every bubble in real estate and property prices that has ever formed has subsequently reverted to the long-term average (mean), and most over-correct well beyond (below) the long-term trend line due to the excessive pessimism that participants develop during the correction.
