Asset Pricing Bubbles

Anna Scherbina UC Davis Bernd Schlusche Federal Reserve Board March 23, 2011

Abstract Why do asset pricing bubbles continue to appear in various markets? What events give rise to bubbles and why do arbitrage forces fail to quickly burst them? Do bubbles have real economic consequences and should governments do more to prevent them? This paper provides an overview of the literature on bubbles. The latest housing bubble in the U.S. is described in the context of this literature.

JEL classication: G00, G01, G10. Keywords: Bubbles, Limits to Arbitrage, Financial Crisis.

Address: Graduate School of Management, University of California, Davis, One Shields Avenue, Davis, CA 95616. ascherbina@ucdavis.edu. Phone: (530) 754-8076.

E-mail:

Address: Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW, Washington, DC 20551. E-mail: bernd.schlusche@frb.gov. Phone: (202) 452-2591. The views expressed in this paper are those of the authors and not necessarily those of the Board of Governors, other members of its staff, or the Federal Reserve System. This work was completed while Scherbina was visiting the IMF Institute.

Electronic copy available at: http://ssrn.com/abstract=1793420

The persistent failure of present-value models to explain price levels set academic research on the path of introducing a concept of asset pricing bubbles as a tool to model price deviations from present-value relations. The early literature was dominated by models in which all agents were assumed to be rational and yet a bubble could exist. In many of the more recent papers, the perfect rationality assumption was relaxed, allowing the models to shift the focus to explaining how a bubble may be initiated, under which conditions it would burst, and why arbitrage forces may fail to ensure that prices reect fundamentals at all times. In light of the recent U.S. housing bubble, the question of why bubbles continue to appear is once again on everyones mind.

1. What is a bubble?
There are a number of ways to dene a bubble. A very straightforward denition is that a bubble is a deviation of the market price from the assets fundamental value. Value investors specialize in nding and investing in undervalued assets. Among the many famous value investors, perhaps the most admired is Warren Buffett. In contrast, short sellers, who search the market for overvalued assets in order to sell them short, are routinely vilied by governments, the popular press, and, not surprisingly, by the overvalued rms themselves.1 Trading against an overvaluation involves the additional cost of maintaining a short position until the asset declines in price and, therefore, a persistent overvaluation is more common than a persistent undervaluation. A positive or negative mispricing may arise when initial news about a rms fundamentals moves the stock price up or down and feedback traders buy or sell additional shares in response to past price movement without regard for current valuation, thus continuing the price trend beyond the value justied by fundamentals.2 However, because of the potentially nontrivial costs of short selling an overvalubanned short selling for much of the 18th and 19th centuries, Napoleon declared short sellers to be enemies of the state, and many countries today either ban or severely restrict short selling. It is easy to get others riled up against short sellers; they are making money precisely when other investors are losing it. Lamont (2004) describes a variety of tactics that rms employ against short sellers. On average, the rms in his sample that started various actions against short sellers ended up losing 42% of their market capitalization over the next three years, suggesting that they had indeed been overvalued, just as the short sellers suspected. 2 In addition to feedback traders, institutional restrictions may serve to amplify past price movements. For example, many institutions are forced to sell their shares of a stock when the rms market capitalization falls below
1 England

Electronic copy available at: http://ssrn.com/abstract=1793420

ation will be less readily eliminated and because positive price bubbles are more common, they will be the main focus of this paper. Hence, we can dene a bubble occurring when an assets trading price exceeds the discounted value of expected future cash ows (CF): Pt > Et CF , (1 + r)t =t+1

(1)

where r is the appropriate discount rate.3 Since it may be difcult to estimate the required compensation for risk, an alternative denition may be used that replaces the discount rate with the risk-free rate, r f : Pt > Et CF . t =t+1 (1 + r f )

(2)

When the assets cash ows are positively correlated with market risk, as is the case for most rms, the required rate of return is strictly greater than the risk-free rate and the discounted-cashow formula represents an upper limit of the justiable range of fair values. Likewise, when it is difcult to forecast future cash ows for a particular asset or rm, an upper bound of forecasted cash ows for other rms in the same industry or asset class may be used. In many papers on bubbles, agents are willing to knowingly pay more than the fair value for an asset because they hope to resell it at an even higher price and would pay a strictly lower price if forced to hold the asset until maturity (e.g., Stiglitz (1990)). This view of a bubble implies not only that the current price level is too high relative to fundamentals, but also that one would observe a pattern of rapid price increases followed by a rapid price collapse, with both stages of the bubble accompanied by high trading volume. This hump-shaped pattern of prices and of share turnover is typically viewed as an irrational phenomenon that is a product of uncontrolled speculation and gambling. We will start with a brief overview of rational models of bubbles before moving on to models that contain irrational behavior by at least one group of agents.
the institutions investible universe. This selling pressure, now unrelated to past news, causes a further price decline. In addition, a decline in institutional ownership may reduce the stocks liquidity, making it even less attractive to investors and forcing the price to drop even further. 3 We will use the terms discount rate and required rate of return interchangeably.

1.1. Rational models

The literature on rational bubbles derives conditions under which bubbles can occur when all agents are perfectly rational. One powerful conclusion is that when all agents are perfectly rational and all information is common knowledge, bubbles can exist for an innitely-lived asset if the bubbles rate of growth is equal to the discount rate. To see this, suppose that the price of the asset, Pt , includes a bubble component, Bt , in addition to the fundamental (fair) value component; that is, Pt = Pt
fair

+ Bt . Therefore, for an innitely-lived asset, the total price is equal to the sum

of the discounted cash ows (which represents the fair value) and the present value of the future bubble component: Pt = Et CF Bt+T + limT Et . t (1 + r)T =t+1 (1 + r)

(3)

Let us assume that the bubble grows at a rate rB , such that BT = Bt (1 + rB )T t and suppose further that this rate of growth is lower than the discount rate: rB < r. Then the present value of the bubble is zero and it cannot exist. Now suppose that the bubbles rate of growth is higher than the discount rate: rB > r. In this case, its present value is innite and, again, the bubble cannot exist. The bubble component of the price can exist without bursting only if its expected rate of growth is exactly equal to the discount rate: rB = r.4 This condition allows us to eliminate many potential rational bubbles. In particular, it implies that bubbles cannot be present whenever there is an upper bound for the asset price. For example, there is an upper price limit for assets with close substitutes, since consumers will switch to a substitute whenever the asset becomes too expensive. Also, if an assets required rate of return is higher than the rate of growth of the economy, a bubble in this asset cannot exist since it would outgrow the aggregate wealth of the economy. Now, suppose that an asset is not innitely-lived. Then the bubble will surely burst at the end of the assets life, T , when the asset is liquidated at its fair value. But if it is common knowledge
4 Fiat

money is an example of an innitely-lived asset with a bubble, since the intrinsic value of at money is

zero.

among all agents that the bubble is sure to burst at time T , why would it not burst at time T 1, since at that time no one would be willing to buy the asset at an inated price. By the same logic, the bubble cannot exist at time T 2, T 3, and so on, up until the present. This backwardinduction argument leads to the conclusion that a bubble cannot exist for a nitely-lived asset. However, Allen, Morris, and Postlewaite (1993) show that, when common knowledge is absent and short sale constraints bind, a bubble can exist for a nitely-lived asset. In their model, agents are asymmetrically informed about the terminal dividend on the asset and cannot sell the asset short. A bubble in this setting is dened as a state in which all agents know that the asset is overvalued, but they do not know that other agents know it as well (i.e., there is a lack of common knowledge that was assumed in the previous backward-induction reasoning). They cannot learn the other agents private information from market prices, which, due to the complicated information structure, are not fully revealing until the nal trading period. Agents are willing to hold an overvalued asset because they hope to resell it at an even higher price to another agent who may value the asset highly in certain states as a result of his particular information structure. By assuming that ex-ante asset allocations are inefcient, this model gets around the no-trade theorem of Milgrom and Stokey (1982), stating that agents will not tradeno matter what private information they might receiveif their ex-ante asset allocations are efcient (the no trade theorem will be described in more detail later).5 Let us now return to an innitely-lived asset. If the assets price contains a bubble component, then, as T goes to innity the bubble component of the price grows innitely large and the
T price-to-cash-ow ratio approaches innity ( BT 1 and P

PT CFT

as T ). Bothered by this

implication of rational bubble models, Froot and Obstfeld (1991) propose a different model in which a bubble is not a function of time but rather a function of the fundamentals. The rationale for this model is that investors might be bad at forecasting the stream of future cash ows and, therefore, condition their valuations too much on the current realization of cash ows. The authors refer to this class of bubbles as intrinsic bubbles because they are deterministic functions
(2004) is able to achieve an equilibrium in which bubbles can exist with a simpler setting and without assuming a lack of common knowledge.
5 Conlon

of the fundamentals alone. Relabeling slightly the authors notation and translating their formulas from continuous to discrete time in order to be consistent with our earlier exposition, the bubble component can be expressed as a function of the current cash ow: B(CFt ) = cCFt , (4)

where c and are constants. The exponential term needs to be set to satisfy the rational bubble requirement that the bubble component grows at the assets required rate of return: Bt+1 = Bt (1 + r). Assuming that the expected cash-ow growth rate is equal to g, next periods bubble
component will, therefore, equal Bt+1 = cCFt+1 = cCFt (1 + g) . Hence, the exponential term

has to be set to satisfy the condition: 1 + r = (1 + g) . Assuming a constant discount rate and a constant cash-ow growth rate, the fair-value component of the price can be expressed using the Gordon growth formula: Pt
f air (1+g) = CFtrg . Therefore,

the market price can be described as the sum of the fair value of the asset and the intrinsic bubble component: Pt = CFt (1 + g) + cCFt . rg (5)

Empirically, this specication can be tested with the following statistical model for the price-tocash-ow ratio: Pt = c0 + cCFt1 + t , CFt (6)

where the error term t could capture the fad component of pricesa shock to the demand for a stock that is unrelated to fundamentals. Under the assumption of no bubbles, the price-to-cashow ratio should be constant and, therefore, the last two terms should be zero. However, in the data, the price-to-cash-ow ratio is increasing in time. Using data for the S&P 500 index over the 1900-1988 time period and aggregate dividends in place of cash ows, Froot and Obstfeld (1991) estimate the intrinsic bubble component in prices (determined by both c and ) to be signicantly

positive, thus rejecting the non-bubble hypothesis. Moreover, they estimate that, as of 1988, the non-bubble component of the S&P 500 price was less than 50% of the index value.6 The intrinsic specication of a bubble offers an advantage in that a bubble does not have to explode relative to the fair value as time goes on. The bubble can even disappear entirely when the stochastic cash ow falls to zero, imitating a burst of the bubble. Overall, this modeling choice is more closely aligned with the empirical observations of bubbles and it also explains the seemingly puzzling empirical facts that (a) stock prices are more volatile than dividends and (b) prices overreact to dividend changes.

1.2. Irrational models

Here we provide a brief overview of irrational models of bubbles. The unifying assumption behind this class of models is that at least one class of agents is assumed to be irrational. Bubbles can easily arise if agents disagree about the fair value of an asset and face short sale constraints. If the optimists are boundedly rational (or simply dogmatic about their beliefs), they will fail to take into account that other agents in the economy have more pessimistic views than they do but cannot sell the asset due to short sale constraints. The resulting market prices will be too optimistic relative to the fair value which is probably in between the two sets of beliefs. Prices will converge down to the fundamentals only when all the uncertainty about the assets value is resolved and investors beliefs converge to a common view. Therefore, this type of bubble will burst at the time of the resolution of uncertainty. Miller (1977) provides a simple static model for an overvaluation generated by disagreement and short sale constraints. Scheinkman and Xiong (2003) present a dynamic continuous time model based on Millers intuition. The dynamic setup allows this model to achieve even higher levels of overpricing than a static model does because agents will choose to pay a premium over their valuations today in hope of reselling the asset at an even higher price tomorrow.
6 When

the model is applied to the most recent data, it indicates that the non-bubble component is only 33% of

the price.

Feedback mechanisms are chronicled in many accounts of asset pricing bubbles as well as in a large number of theoretical models; they allow bubbles to grow for a period of time before the eventual collapse. A simple description is as follows: In response to positive news, an asset experiences a high initial return. This is noticed by a group of feedback traders who assume that the high return will continue and, therefore, buy the asset, pushing prices above the fundamentals. The additional price increase attracts more feedback traders, who buy additional shares and push prices even higher, thereby attracting subsequent feedback traders, and so on. The price will keep rising as long as more capital is being invested. Once the rate of the new capital inow slows down, so does the rate of the price growth; capital might start owing out, causing the bubble to deate (rather than burst).7 Shiller (2002) argues that media attention amplies feedbacktrading tendencies in the market. As more investors become interested in an asset, the media sense the general interest and increase their coverage, attracting more attention from potential investors, who then buy the asset and drive up prices, attracting more media attention, and so on. Consistent with Shillers hypothesis, Bhattacharya, Galpin, Ray, and Yu (2009) show that the news media paid disproportionately more attention to internet stocks than non-internet stocks during the internet bubble period. The news stories were generally positive, but following the bubble collapse, turned negative. Feedback models give bubbles the avor of a Ponzi scheme: The growth of a bubble is sustained by the inow of new money and the investors who get in on the bubble early and get out before it bursts stand to prot at the expense of the latecomers. An example of a model that contains feedback traders is Hong and Stein (1999); the model includes two groups of tradersnews watchers and momentum traders (another label for feedback traders). Neither group is completely rational. News watchers observe private signals about the asset fundamentals but do not condition on past prices. Momentum traders do not observe the signals about the fundamentals and condition their trading decisions entirely on past price changes.
traders can also respond to price decreases by selling their holdings, thus ensuring the continuation of low returns. Feedback trading has been suggested as a possible explanation of the price momentum phenomenon, rst documented in an empirical study by Jegadeesh and Titman (1993). The authors show that stocks that have performed well or poorly over the past six to twelve months continue to perform well or poorly over the next six to twelve months.
7 Feedback

Because new information diffuses slowly across the population of news watchers, prices react gradually to new information. Because momentum traders know that news watchers underreact to news, leaving money on the table, the strategy of conditioning trades on past price changes would be protable in expectation. However, since news watchers cannot tell whether they are trading early or late in the news cycle, prices end up overshooting the fundamentals. The model of DeLong, Shleifer, Summers, and Waldmann (1990) is slightly different but has similar implications. The model contains three types of traders: positive feedback traders, who, like the momentum traders in the previous model, base their trading demands on past price movements; informed rational speculators, who trade in response to news about the fundamentals and in anticipation of future price movements; and passive investors, whose demand depends only on an assets price relative to its fundamental value. Introducing rational speculators destabilizes prices and causes them to overshoot the assets fundamental values. When speculators receive a signal about the fundamental value of the asset, they correctly anticipate that, in the future, feedback traders will base their demands on the past price change and the price will overshoot the fair value. The speculators, therefore, buy the asset today and resell it to feedback traders at a higher price tomorrow, making money at the expense of the feedback traders.8 This model produces a troubling prediction that rational traders will not trade against the future anticipated mispricing that is sure to occur as a result of feedback traders overreacting to past price changes; instead, rational traders will trade with the mispricing, buying more of the asset today in order to resell it at inated prices. (The tendency of rational arbitrageurs to jump on the bandwagon rather than trade against mispricing will be discussed again in the context of the model of Abreu and Brunnermeier (2003).) Just like the Froot and Obstfeld (1991) model described earlier, DeLong, Shleifer, Summers, and Waldmann (1990) offer an explanation for why prices overreact to news about the fundamentals.
to the short horizon of the model, prices do not overshoot their fundamentals in the absence of speculators, but they could if the number of periods were larger because feedback traders would trade on past price movements, pushing prices past their fair values.
8 Due

In response to a frequent critique of behavioral nance modelsthat competitive arbitrage forces will promptly eliminate all mispricingthe models of DeLong, Shleifer, Summers, and Waldmann (1990) and Abreu and Brunnermeier (2003) show that, under some assumptions, rational arbitrageurs may amplify rather than eliminate the mispricing. Moreover, it turns out that costs of arbitrage tend to be nontrivial at the same time that the risk of potential mispricing is high, making it very costly to eliminate some types of mispricing. The reason is that mispricing arises when new information about a rm or an asset is difcult to interpret. Some agents, due to their particular skill or knowledge, may be better positioned to assess the impact of new information, which creates potentially large informational asymmetries between them and everyone else. When informational asymmetries are high, trading costs will also be high and will increase with the size of trade, reecting the risk that traders possess a considerable informational advantage. Given the large quantities that arbitrageurs typically trade, increased trading costs will either greatly reduce or completely eliminate their potential prots, leaving the mispricing intact (e.g., Sadka and Scherbina (2010)). The limits-of-arbitrage literature, as it pertains to bubbles, is reviewed in more detail later in the paper. The case of nitely-lived asset bubbles is closely studied in experimental papers, which are described later in this paper. Bubbles arise very frequently in experimental markets, and their presence is often attributed to the lack of common knowledge of rationality among traders. In other words, traders expect bubbles to arise because they believe that other traders may be irrational. Not surprisingly, experimental studies show that introducing experienced traders into these markets reduces the frequency of bubbles. Consequently, optimistic media stories and analyst reports may help create bubbles not because investors believe these views but because they may indicate the existence of other investors who do, destroying the common knowledge of rationality. Rational models mainly focus on explaining how a bubble can exist when all investors are perfectly rational. Models that allow for some investor irrationality, however, pursue other objectives, such as trying to model the empirical regularities observed during well-known bubbles.

The majority of the papers reviewed below will focus on behavioral explanations of asset pricing bubbles.

2. Some well-known bubbles

There are many widely known instances of bubbles. Possibly the earliest example is the tulip bubble in Holland that started in 1634 and burst in February 1637. At the peak of the bubble, a single tulip bulb sold for an equivalent of $60,000 today. The South Sea bubble involved the market price of an English rm called the South Sea Company. This rm had no assets but told investors that it had come up with a strategy to earn enormous prots in the South Seas. During the rst half of 1720 the stock price rose by over 700%, then fell during the second half of 1720 to about 50% above what it had been at the start of the year. The Mississippi bubble refers to the rapid rise and fall in the share price of a company founded by John Law that was initially called Compagnie dOccident and later renamed Compagnie des Indes, but was always popularly known as the Mississippi Company. The company was based in France and, at its founding in August 1717, was given control over trade between France and its Louisiana and Canadian colonies. In May 1719, John Law also obtained control over trade with China and the East Indies. In effect, the company controlled all trade between France and the rest of the world outside of Europe. Later, the company also purchased the right to mint new coins in France and the right to collect most French taxes. By January 1720, it had become Europes most successful conglomerate and European investors, who knew little about the remote colony of Mississippi at the time, were excited about the possibility of nding gold and silver there. The companys expansion was nanced by issuing shares, the price of which rose dramatically as the companys reach expanded. Share price rose from around 500 livres tournois in January 1719 to 10,000 livres in December 1719. The market became so active that even working-class people began investing in the companys shares. Stock prices began to fall in January 1720 as investors started selling shares in order to turn capital gains into gold coins. The company tried to get

10

investors to accept paper money rather than gold coins and agreed to assume that the share price was 10,000 livres, which caused a runaway ination that reached a monthly rate of 23%. Finally, Law devalued shares in the company in several stages during 1720; by September 1721, the price had dropped to its pre-bubble price of 500 livres. The U.S. has experienced many bubbles and crashes, but the most devastating in the last century occurred when the period of fast economic expansion often referred to as the Roaring Twenties came to a sudden halt in October 1929. The crash involved the collapse of both stock and real estate prices. As documented by Nicholas and Scherbina (2010), using a hand-collected dataset of transaction prices, by the end of 1932, real estate prices in Manhattan had fallen by 67% from the third quarter of 1929 and, unlike stock prices, stayed down for the remainder of the decade. If both the dividend income earned from the stock market and the net rental income earned from the real estate holdings had been reinvested back into their respective price indices, the stock market would have outperformed the real estate market by a factor of 5.2 from 1920 to 1939. The performance of a dollar invested in both indices is plotted in Figure 1. Mortgage lenders may have suffered large losses, limiting future lending. Additionally, White (2008) argues that the collapse of the housing sector greatly depleted households wealth, contributing to the severity of the Great Depression. In the 1980s, Japan experienced a rapid run-up in equity and real estate prices. From 1980 to the peak in 1989 the Japanese stock market rose 373% in real terms and fell by 50% in the next three years. Land prices followed a similar pattern. They almost tripled in the second half of the 1980s. At its peak in 1990, the market value of all the land in Japan was four times the land value of the United States. By the end of 1993, Japanese land prices had dropped by almost 50%. Some argue that the collapse of the bubble had a lasting effect, slowing down the rate of economic growth up until the present. The dot-com or internet bubble started around 1995. From that time until March 2000, when the bubble started to deate, there was a rapid growth in the internet sector and related elds, fuelled by the supply of new internet IPOs. The mysterious nature of the new technology added to 11

its allure. The internet-heavy NASDAQ Composite rose from 775.20 in January 1995 to 2,505.89 in January 1999 and more than doubled from this point to its peak of 5,048.62 on March 10, 2000, after which it started declining, reaching a low of 1,314.85 in August 2002. During the bubble period, investment banks responded to the high demand for internet shares by loosening their standards for the types of rms they typically took public. A large fraction of the new internet IPOs never generated any prot; the general thinking was that these rms would offer their services for free in order to capture market share and would start generating revenue later. Many of the new companies had the same business model and competed in the same market, ensuring that the majority of them would fail. Following the collapse of the dot-com bubble, the Federal Reserve lowered interest rates, which helped fuel the bubble in the housing market that followed (the subprime housing bubble will be described later in the paper). More recently, the Chinese stock market became overheated. Xiong and Yu (forthcoming) document that in the 2005-2008 period of their study, bubbles were frequently observed in put warrants with long maturities, ranging between six months and two years, issued on 18 Chinese companies. These warrants were all but sure to expire worthless, yet they traded in high volumes and at inated prices throughout their lives. What is remarkable about such bubbles is that they were observed on assets with nite maturities, so investors knew with certainty that prices would converge to the fundamentals by the warrants expiration dates. Xiong and Yu (forthcoming) argue that the combination of (a) differences of opinion about the potential trajectory of the underlying asset and (b) the legal ban on short selling any nancial securities in China, including warrants, is to blame for the observed bubbles. Hoyt (1933) describes several cycles of land bubbles that occurred in Chicago before 1933. Reinhart and Rogoff (2009) detail many instances of bubbles that occurred in emerging markets. They point out that many bubbles are instigated by cheap credit and they make an interesting observation that housing markets take longer to recover from a crash than equity markets. This is consistent with the U.S. experience during the Great Depression, documented by Nicholas and Scherbina (2010).

12

These examples illustrate that bubbles can burst (as was the case with the stock market crash in October 1929)9 or can deate gradually (as was the case with the dot-com bubble). Even then, the period over which a bubble deates is generally much shorter than the period of its build-up. Most likely, speculative attacks or regulatory changes lead to a quicker deation than sentiment reversals, which are likely to be more gradual.

3. How are bubbles initiated?

In rational models, a bubble cannot be createdit must already be present when the asset starts trading (consider the case of at money). In the irrational models, the initial overvaluation can arise for a variety of reasons. Some examples are discussed below. Historically, most bubbles have a compelling and sensible story behind them. For example, the dot-com bubble fed on the argument that the new technology would bring great improvements in productivity; similar lines of reasoning were offered during the past railroad and electricity booms. Land-price bubbles were often justied by the logic that an ever-growing population combined with a limited supply of land is sure to make land scarce. During the recent U.S. housing bubble, the frequently heard argument was that securitization would allow investors to diversify the idiosyncratic risk of real estate and permanently increase real estate prices. Brunnermeier and Julliard (2008) argue that housing price run-ups are frequently initiated by the money illusion. This term was coined by John Maynard Keynes and refers to investors tendency to think of money in nominal rather than real terms. Agents suffering from the money illusion make their rent-versus-buy decision by comparing the current monthly rent with a xednominal-interest-rate monthly mortgage payment, failing to take into account that rents will increase with ination while mortgage payments will remain constant for the duration of the loan. This is a mistake. Consider, for example, a scenario in which ination is expected to be high for the duration of the mortgage loan. The schedule of nominal mortgage payments will take into
9 Some

studies dispute that there was a stock market bubble in the U.S. in the 1920s.

13

account the high future expected ination, making the initial mortgage payment higher than the initial rent payment for a comparable property. However, an agent prone to the money illusion will fail to foresee that rent payments will increase over the time-span of the mortgage in order to keep up with ination and would, therefore, choose renting over buying, which would push house prices down. On the other hand, when ination expectations are low, the attractiveness of buying will increase. Put formally, the current house price, Pt , should be equal to the discounted value of future real rent payments for a comparable property, Rent :

Vt = Et

=t+1

Rent
real 1 + r

(7)

real where r is the expected real discount rate.10 Assuming that real rent payments and the real

discount rate are constant over time, the price-to-rent ratio should equal the inverse of the real dis1 count rate: V /Rent = rreal . If agents suffer from the money illusion, they will mistakenly discount

the stream of future rent payments with the nominal rather than the real rate, which would imply that the price-to-rent ratio will equal the inverse of the nominal discount rate: V /Rent =
1 rnom .

Since rnom = rreal + in, the price-to-rent ratio will be decreasing in expected ination. The data support the money illusion hypothesis for housing markets: Brunnermeier and Julliard (2008) show that changes in price-to-rent ratios are negatively related to changes in expected ination but not to changes in real interest rates. Consequently, an unexpected decrease in ination expectations will lead to an initial increase in housing prices. Attracted by the initial price increases, feedback traders may continue purchasing housing assets, leading to a continuation of price increases. Indeed, Case and Shiller (1989) document price momentum (or the continuation of past returns) in housing prices, indicating a departure from market efciency. Hong, Scheinkman, and Xiong (2008) present a theory for how bubbles may arise in new technologies. It has been previously discussed that, when investors disagree about the value of an asset and short sale constraints bind, the assets market price will be too high if the optimistic
10 This

formula ignores real estate taxes, maintenance costs, and the tax benet of ownership, which can be easily

added in.

14

investors are dogmatic about their beliefs or simply fail to take into account the inability of the pessimistic investors to express their views. With this setting in mind, the authors set out to explain how disagreement between investors could arise, initiating a bubble. Their model assumes that two sets of advisors make recommendations to uninformed investors. The rst set of advisors are those who understand the revolutionary effect of the new technology and assign it a higher valuation than do the second set of advisors who do not appreciate the new technology. Advisors in the rst set exaggerate the extent of their optimism in order to differentiate themselves from those in the second set of advisors who try to mimic them. When at least some investors fail to take into account the rst set of advisors incentive to inate their assessments, a pricing bubble arises. Expansion of credit, frequently set off by nancial liberalization, is another common cause of asset pricing bubbles (many accounts of such bubbles are provided in Reinhart and Rogoff (2009)). Allen and Gale (2000) develop a model in which limited liability, which allows borrowers to declare bankruptcy if they cannot repay, induces risk-loving preferences in borrowers. Since borrowers get to keep the upside of their investments but face only a limited downside, they exhibit a preference for risk. Their willingness to buy risky assets at inated prices initiates a bubble and the magnitude of the overvaluation increases with the riskiness of the asset.

4. How are bubbles sustained and perpetuated?

Bubbles persist if investors and money managers herd in their investment decisions and arbitrage forces fail to burst the bubbles. Herding occurs when agents derive utility from being wealthier than their peers and, in the case of money managers, when their compensation is based on relative performance. DeMarzo, Kaniel, and Kremer (2008) introduce nonstandard preferences to explain how bubbles can grow once formed. They consider a relative wealth model, in which an individual agents utility depends not only on her absolute wealth but also on her relative wealth (the so-called 15

keeping up with the Joneses preferences). If that dependence is strong, agents will prefer to participate in bubbles as long as other agents do so in order not to fall too far behind their peers wealth during the bubbles upside. The authors show that the relative wealth effects are necessary in order to sustain bubbles. Shiller (2002) provides another reason why money managers would prefer to herd in their investment decisions. Due to limited time and resources, they cannot thoroughly investigate every potential investment. A money manager observing many other money managers investing in a particular asset may conclude that that decision is based on compelling private information and may then choose to add that asset to his or her portfolio.11 Going against conventional wisdom is very costly while the bubble is on the rise; managers who cannot keep up with their peers suffer fund outows as investors reallocate funds to the more successful managers. Often, reputational penalties are more severe when the manager is wrong at the time when the crowd is right than when everyone is wrong. As mentioned earlier, being compensated based on relative performance is another powerful reason for mutual fund managers to herd. These considerations explain contagion in investment decisions that lead to sustained bubble periods (e.g., Lux (1995)). According to evidence presented in Lamont and Frazzini (2008), mutual funds are, to a certain extent, forced by investors to invest in high-sentiment stocks and industries and thus perpetuate bubbles. The authors show that investors dynamically allocate money to funds that invest in high-sentiment stocks. For example, during the dot-com bubble, investors greatly favored funds investing in high-tech stocks. As a result, sentiment-driven investors earn sub-par returns over the subsequent few years. The authors call this the dumb money phenomenon. The role that the popular media play in directing the attention of potential investors to a particular asset has not been extensively studied in the current literature, although it could be key in churning bubbles. News stories often focus on assets and industries with good past performance.
a popular account of the recent U.S. housing bubble, Lewis (2010) describes a few of the very small number of hedge fund managers who realized that mortgage-backed securities contained a bubble; these managers were all outsiders with respect to Wall Streets investment community, which provided them with sufcient separation to be able to think independently.
11 In

16

Even if investors might be skeptical that this performance will continue, news stories signal the existence of others who have a positive outlook and thereby encourage speculation. As will be discussed in more detail later, media stories can also signal a change in sentiment to a large group of arbitrageurs at once, leading to the burst of a bubble.

4.1. Trading volume

Abnormally high trading volume is a very important characteristic of a bubble.12 However, traditional asset pricing models have trouble explaining not only abnormally high trading volume but even the existence of trading in general. The no-trade theorem of Milgrom and Stokey (1982) states that, in the absence of portfolio rebalancing needs, there will be no trading, since if someone wants to trade, other agents will rationally assume that the decision is prompted by private information and will therefore refuse to take the other side of the trade. In order to explain trading, models introduce liquidity traders who need to trade due to exogenous shocks. These traders, on average, lose money to the informed traders. Similarly, a decision to trade can be modeled by ex-ante inefcient asset allocations. However, even with these additional assumptions, traditional models are unable to explain the changing patterns of trading volume associated with the different stages of a bubbles life cycle. In the early stage that precedes the speculative frenzy, trading volume is relatively low. It drastically increases during the middle stage of a bubbles life cycle, as the past price increases begin to be noticed by a wide cross-section of investors and speculative trading commences. The demand for the asset at this time is very high. In order to meet this demand, additional supply is often provided by means of IPOs, secondary equity offerings, new start-ups, and, in the case of real estate bubbles, the construction of new housing. As the rate of the inow of new capital starts
12 For example, during the dot-com bubble, the price run-up of internet stocks was accompanied by heavy trading. Hong and Stein (2007) document that monthly turnover of internet stocks exceeded 50% in 12 out of 24 months preceding the internet index price peak in February 2000, while the average turnover for non-internet stocks was in the range of only 10-15%. After the internet index decline, the turnover of internet stocks dropped to the average market level.

17

to drop, the speed of the bubbles growth decreases, potentially leading to a decrease in trading volume. In the later stages of the bubble, incidences of fraud increase as investors try to get rid of the overvalued asset by preserving an illusion of rising prices. For example, Hoyt (1933) writes about how, in the later stages of the 1920s real estate bubble in Chicago, an illusion of rising prices was created by arms-length transactions in which properties were exchanged at inated prices between related parties. Subsequently, the bubble begins to deate. The interaction of returns and trading volume may, thus, offer information about the life-cycle stage of a bubble.13

4.2. Why are bubbles not arbitraged away?

The literature points out a number of reasons why bubbles are not arbitraged away. First, there is always a risk that, instead of collapsing, the bubble will continue to grow and arbitrageurs will have to close or scale back their bets in order to meet margin calls in order to maintain their short positions in the overvalued asset (e.g., Shleifer and Vishny (1997), Gromb and Vayanos (2002), and Xiong (2001)). Another source of risk is that the assets fundamentals may change such that the high price can be now justied. This risk is especially worth considering when the asset is not closely correlated with another asset in the economy such that it could be hedged away. Cycles in the housing market have the potential to be more severe because the costs of arbitrage are very high and the market is dominated by households, which are less sophisticated than the professional money managers who dominate the stock market. If each arbitrageur is relatively small, it takes the coordinated effort of many arbitrageurs to burst a bubble; otherwise, the bubble will persist. In the model by Abreu and Brunnermeier (2003), a bubble develops when a new technology assets fundamental value, which has been initially growing at an appropriately high rate g, fails to revert to a slower steady-state growth rate r at time t0 because investors incorrectly believe that there has been a paradigm shift leading to a new economy with permanently higher growth rates. Hence, the asset becomes overvalued
a related study by Lee and Swaminathan (2000) documenting the interaction between trading volume, price momentum, and return reversals.
13 See

18

starting at time t0 . If the fair value of the asset at time t0 is P0 , then the fair value, Pt t > t0 is Pt
f air

f air

, at time

= P0 (1+r)(tt0 ) . Yet, when the asset continues to grow at the high growth rate g, the

market price of the asset, Pt , will be Pt = P0 (1 + g)(tt0 ) and the bubble component, which is the difference between the market price and the fair value, is Bt = P0 (1 + g)(tt0 ) (1 + r)(tt0 ) . The formula indicates that the bubble grows with time and increases with the difference between g and r. By assumption, arbitrageurs can short sell only a limited amount of the asset and it takes a fraction k of arbitrageurs selling short the asset to crash the bubble. Another key assumption is that arbitrageurs become aware of the bubbles existence only sequentially and therefore cannot coordinate their attack on the bubble. The sequential awareness eliminates the perfect competition among arbitrageurs assumed in rational models. The common knowledge of the bubbles existence (i.e., I know that there is a bubble, I know that others know that there is a bubble, others know that I know that others know, and so on), which is usually assumed in rational models, is at all times absent in this setting due to sequential awareness. In order to induce arbitrageurs to trade against the bubble, the model assumes that the bubble will burst for exogenous reasons at time t0 +. Yet, since arbitrageurs do not know exactly when t0 was, they do not know when the bubble will burst. The striking conclusion of this model is thatmuch as in DeLong, Shleifer, Summers, and Waldmann (1990)upon becoming aware of the bubble, arbitrageurs will optimally choose not to short sell the overvalued asset but rather to ride the bubble for some time. This represents a failure of the view that rational investors always exert a correcting pressure on prices. Here, arbitrageurs choose to participate in the mispricing over a period of time, ultimately increasing their prots at the expense of the irrational investors. The lack of common knowledge about the bubble allows it to persist. The lack of a synchronization mechanism among arbitrageurs is ultimately to their advantage, allowing them to ride the bubble for some time before eventually attacking it. The length of time that the arbitrageurs will wait before attacking the bubble increases with (a) the disagreement among the arbitrageurs about when the bubble started, (b) the fraction of arbitrageurs, k, required to succeed in the attack, and (c) the excess growth rate of the bubble, g r. If these values are sufciently large, the time of the speculative

19

attack may be deferred up until the time that the bubble bursts for exogenous reasons, allowing the arbitrageurs who found out about the bubble early to reap maximum prots. Consistently with the prediction of this model and that of DeLong, Shleifer, Summers, and Waldmann (1990), Brunnermeier and Nagel (2004) show that, during the dot-com bubble, hedge funds followed the optimal strategy of riding the bubble rather than attacking it, then optimally selling out of their positions before the bubble started to deate.

4.3. Misaligned incentives

Financial crises in the U.S. and around the world bring to light the highly problematic incentive structures which apply to important market players and which help perpetuate bubbles. Equity analysts hold back negative views about the rms they cover, mutual fund managers herd, rating agencies are reluctant to issue low bond ratings, and accounting auditors overlook questionable reporting choices. Furthermore, when a bubble arises, many market players see an increase in prots due to the increased volume of business and face a limited downside when the bubble nally bursts. Moreover, the market players who do suffer losses in a bubbles collapse are frequently bailed out by governments trying to prevent large-scale bankruptcies that may cripple the nancial sector. The incentive problems of important market players are described in more detail below. Equity analysts incentives are not perfectly aligned with telling the truth. In the aftermath of the collapse of the dot-com bubble, it was revealed that analysts frequently issued strong buy recommendations while privately holding pessimistic views about the rm. There were three reasons for this. First, analysts fear that, by being negative about a rm, they may lose favor with its management and be shut out of future communication. Regulation Fair Disclosure, adopted in 2000 in response to analyst scandals, is desgined to prevent selective information disclosure but has not been entirely effective. Second, despite the so-called Chinese Wall, analysts stand to prot from the investment banking business they help generate by issuing favorable stock recommendations. Third, because sell-side analysts are paid a fraction of the trading commissions 20

that their analysis brings to their rms trading desksand due to the widespread reluctance to sell shortit is easier to generate trade by issuing buy rather than sell recommendations. Analysts with negative views may prefer to keep quiet or drop coverage altogether. Scherbina (2008) shows that when analysts keep quiet, the news is typically that future returns are low. Rating agencies and accounting auditors are paid by rms rather than by investors and are understandably reluctant to cause trouble for their clients and risk losing business. An agencys choice of whether or not to perform its duties honestly is determined by the trade-off between near-term prots and the long-term payoff of preserving its own reputation. Many rms choose the short-term approach to prots; rating agencies have often assigned overly positive bond ratings and auditors have overlooked accounting irregularities. Even if it may be in the best interest of the rms shareholders to adopt a long-term view, the rms executives are more short-termoriented due to a compensation structure that rewards current prots. Better corporate governance mechanisms are needed in order to reduce the wedge between the interests of a rms shareholders and the actions of its executives. Institutional money managers, such as mutual funds, pension funds, university endowments, and hedge funds, enjoy limited liability. These institutions typically collect fees that are based in part on the value of their assets under management. This pay structure creates an incentive to ride a bubble in order to generate fund inows. When the bubble eventually bursts, the downside is limited due to limited liability. Moreover, as long as money managers herd, they are likely to suffer similarly in the event of a crash; because investors evaluate a managers performance on a relative basis, outows may, therefore, be minimal. Allen and Gorton (1993) note the inefciency of mutual fund managers incentives and make a slightly different argument for how mutual funds investment strategies may exacerbate bubbles. They present a model with two types of managersskilled and unskilled. Skilled managers can correctly identify undervalued investments and make a prot. Unskilled managers lack this ability and instead invest in bubbles, hoping that they can make money while the price is still rising and sell it before the crash. However, even if the fund suffers losses in the crash, the limited 21

liability structure limits the downside. As long as unskilled managers make a prot, they can pool with the skilled managers in equilibrium and acquire money to manage. A similar willingness to participate in a bubble would be observed with any limited liability incentive structure in place. Allen and Gale (2000) develop a model in which investors borrow their investment capital from banks. Their downside is limited because they can avoid repaying their debts in case of investment losses by declaring bankruptcy. However, they get to keep the upside of their investments. This convex payoff structure generates a preference for risk and for riding bubbles. These considerations add to the popular concern that the nancial industry welcomes the formation of new bubbles as it enjoys increased prots due to higher trading commissions, larger investment banking proceeds due to increased IPO and SEO volume, and the investment prots generated on the bubble upside. The downside risk is limited by the implicit government guarantees to bail out the nancial sector in the event of a large-scale collapse. These fears become even starker when considering the limited personal liability of rm executives.

5. What causes bubbles to burst or deate?

A bubble may burst or deate for a number reasons: the eventual reversal of the sentiment, a speculative attack, or government intervention. In order to keep growing, a bubble needs an inow of new investment capital. As the inow of new capital slows down, prices begin to atten and, as a result, the initially optimistic sentiment reverses, causing the bubble to deate. Of course, it is difcult to predict the exact time of the sentiment reversal. If it is linked to the slowing of the bubbles growth, it will coincide with the exhaustion of the supply of new investors. Indeed, there is some evidence that bubbles burst after a large fraction of non-sophisticated market participantssuch as householdsis observed investing in the overpriced asset. Some joke that the end is near when the new MBAs start applying in droves for jobs in the high-sentiment industry.

22

If a bubble is driven by the high valuations of overly optimistic investors in the presence of short sale constraints, the crash will come at the time when these investors are forced to revise down their views. For example, Scherbina (2008) shows that, for stocks with high levels of analyst disagreement about future earnings, the largest price drops are observed at the time of earnings announcements, when much of the uncertainty about future payoffs is resolved. A bubble can also burst when short sale constraints become less binding, allowing pessimistic investors to enter the market and drive prices down to the fundamentals. For example, Ofek and Richardson (2003) trace the end of the internet bubble to the expiration of the lock-up provisions on many of the internet IPOs. The authors point out that the internet bubble was largely driven by an overvaluation of many internet IPOs during the bubble period. Between 80% and 85% of the shares of these new internet IPOs were held by insiders, venture capitalists, and angel investors who were restricted from selling their holdings by lock-up provisions.14 Besides severely limiting the number of shares potentially available to be borrowed and sold short, these restrictions also prevented rm insiders, who were potentially better informed, from selling their shares and correcting the overvaluation. The authors show that many of the lock-up provisions expired between October 1999 and April 2000, such that almost $300 billion of shares were unlocked in a short period. The sudden increase in the number of unlocked shares coincided with the fall of the Morgan Stanley internet index from 1,030 on March 1, 2000 to 430 on April 30, 2000. Bubbles caused by an expansion of credit will deate when credit tightens, which happened in Japan in 1990, precipitating the collapse in the Japanese equity and real estate markets. Governments may tighten credit for exogenous political reasonsfor example, by limiting the inow of foreign capitalor purposefully in order to squash a bubble. Bubbles are sure to burst before the terminal date for assets that are nitely-lived. For example, in the case of the Chinese warrant bubbles, the warrants expiration dates were known in advance and it was common knowledge that the bubbles would deate on or before that date.
generally require that existing stockholders do not sell their shares for a certain time period after the IPO (with 180 days being standard). The stated purpose of this restriction is to prevent ooding the market with additional shares before the shares issued during the IPO are absorbed.
14 Underwriters

23

Interestingly, Xiong and Yu (forthcoming) observe that the bubbles did not burst suddenly on the last day of trading, but deated gradually, with price decreases accelerating six days before the option expiration; this period was also characterized by heavy trading. Finally, a bubble will also burst if arbitrageurs attack it by selling short a sufcient amount of the overvalued asset.

6. Bubbles in experimental settings

A large number of experimental studies have consistently replicated the bubble phenomenon. Many of these studies have built on the experimental design of Smith, Suchanek, and Williams (1988). The experiment in that paper is conducted in the following way: The market consists of traders who are, at the beginning of the experiment, endowed with the asset and cash. They are free to trade the asset over the course of the experiment, which consists of 15 (or 30) trading periods, each lasting a maximum of 240 seconds. At the end of each trading period, the asset pays an uncertain dividend derived from a known probability distribution. All information is common knowledge among traders by virtue of it being verbally announced to all traders in the room at the beginning of each trading period. All traders who wish to buy or sell one unit of the asset can type their bid or ask prices on the computer screen and only the highest bid and the lowest sell offers are displayed to the entire market. In order to accept an offer, a trader needs to conrm this by touching the computer screen. The traders cash endowments are at all times adjusted by the accumulated capital gains and losses as well as the accumulated dividends. Traders can continue to purchase asset units as long as they have sufcient cash to cover the purchase price. Short selling is not allowed. At the close of the market, a traders endowment is equal to the sum of the capital gains and losses from trading and the dividends earned. The experiment revealed that price bubbles appear frequently (a bubble is observed in 14 out of 22 experiments) and more so when subjects are less experienced. Furthermore, the mean price in the rst trading period is always below the expected value of future dividends, consistent with 24

traders exhibiting risk aversion. The initially low price might help create an expectation of the future capital gain, possibly giving rise to a bubble. The collapse of the bubble is preceded by a thinning buy relative to sell activity and is accompanied by a trading volume lower than that accompanying the bubbles rise. This experiment informed future experimental studies by highlighting that it is not necessary to provide traders with divergent dividend expectations in order to induce trade. Even in the presence of common knowledge and common priors, trades are motivated by the differing price expectations that arise because of the uncertainty regarding the actions of other traders and by the diversity in risk attitudes. Dufwenberg, Lindqvist, and Moore (2005) set out to see whether traders experience helps prevent bubbles from appearing in experimental markets. The setup was very similar to Smith, Suchanek, and Williams (1988), but a subset of traders had the experience of having previously participated in three rounds of the game. The authors found that mixing together experienced and inexperienced traders, even when the fraction of the experienced traders was only one-third, eliminated or substantially reduced the incidences of bubbles. Given that, in real markets, the fraction of experienced traders is substantially greater than one-third and that their experience is more substantial, the authors questioned whether bubbles can be attributed to the prevalence of inexperienced traders in real markets. The authors made a valid observation that the real market is relatively free of bubbles most of the time, consistent with the outcome of their experiment, and is only once in a while swept up by a bubble craze. Some follow-up experimental studies relaxed short sale constraints with varying consequences. For example, Ackert, Church, and Deaves (2002) found that allowing short selling made experimental markets more efcient and moved trading prices closer to the fundamentals. In contrast, Naruvy and Noussair (2006) found that permitting short selling did not make markets more efcient. Their experimental markets retained many of the properties associated with positive or negative asset bubbles: high transaction volume, large swings in price relative to the fundamentals, and sustained trading at prices different from the fundamentals. 25

7. The real consequences of bubbles

In a Wall Street Journal opinion editorial, Gjerstad and Smith (2009) wondered why the collapse of some bubbles has a minimal effect on the economy, as was the case with the dot-com bubble, while the collapse of other bubbles leads to a large economic downturn, as was observed after the subprime mortgage bubble collapse of 2007. It seems surprising, since the collapse of the subprime mortgage bubble wiped out less wealth than the collapse of the dot-com bubble. The authors argue that the difference is that while the losses suffered in the dot-com bubble collapse were conned to the owners of the overvalued technology stockssuch as hedge funds, mutual funds, and wealthy individualsthe housing market losses were quickly transmitted to the nancial system via the exposure of the lending institutions and investment banks. This disrupted the functioning of the nancial system, impeding its ability to perform its economic role of lending to households for durable goods consumption and to rms to nance production and trade. Similarly, the banking sectors exposure to real estate losses leading up to the Great Depression led to widespread bank bankruptcies and contraction of the money supply. The authors argue that, when a nancial crisis originates in consumer debt (and especially when it is concentrated at the low end of the income distribution), it can be transmitted quickly into the nancial system. Generally, bubbles on assets that are used as collateral for borrowing can be transmitted into the wider economy. Real estate holdings are often used by rms as collateral in order to increase the rms borrowing capacity. Chaney, Sraer, and Thesmar (forthcoming) estimate that real estate holdings are a signicant portion of corporate balance sheets. For example, in 1993, 58% of public rms in the United States reported at least some real estate ownership and, for these rms, real estate accounted for 19% of their total market value. As was previously mentioned, real estate prices often contain a bubble and are prone to large uctuations, which poses a problem when real estate holdings are used as collateral. Chaney, Sraer, and Thesmar (forthcoming) show that price uctuations in corporate real estate holdings inuence rms debt capacity and, through this channel, investment. In particular, during the studys 1993-2007 sample period, a one-dollar increase in the value of corporate real estate increased corporate investment by approximately six 26

cents. Not surprisingly, the sensitivity of investment to collateral is stronger for more nancially constrained rms. Gan (2007) studies the effect that the land value collapse in Japan in the early 1990s had on corporate investment and nds an effect of a comparable magnitude: For every 10% drop in land value, the investment rate of the manufacturing rms in the study was reduced by 0.8%.15 Peek and Rosengren (2000) also focus their study on the Japanese crisis of the 1990s but direct their attention to documenting that the collapse of the equity and real estate bubbles in Japan was transmitted to the U.S. via the lending channel. The authors note that many Japanese banks lent to commercial real estate companies in the U.S. and that, when the Japanese banks suffered losses following the real estate and equity markets collapse, less credit became available to U.S. commercial real estate rms. For lack of an alternative source of funds, real estate construction activity slowed in the U.S. regions most reliant on Japanese lending. This situation repeated itself much more forcefully following the collapse of the U.S. housing bubble. Besides leaving the traditional banking system in shambles, it severely affected the so-called shadow banking system, made up of hedge funds and investment banks, that had by then become an important source of corporate credit.

8. The subprime mortgage bubble

The origins of the recent housing bubble can be traced to the low-interest-rate environment that followed the collapse of the dot-com bubble, which made housing investment seem more attractive than an investment in stocks and bonds.16 In addition, a newly popular securitization
and Schaller (2001) investigate whether the bubble in Japanese equity markets inuenced corporate investment by reducing the cost of capital during the bubble period and increasing it following the bubbles collapse. They show that the pattern of corporate investment was indeed inuenced by the trajectory of the bubble: Investment was above the predicted level before the crash and below the predicted level following the crash. However, the authors leave unanswered the question of whether the additional investment made during the bubble period was efcient. This important question is addressed by Fahri and Panageas (2004); using U.S. data, they nd that the additional investment induced by overvaluation-driven decreases in the cost of capital is, on average, inefcient. 16 Large inows of foreign capital, especially from China, into U.S. treasury and agency bonds also contributed to low mortgage rates.
15 Chirinko

27

process, which involved pooling mortgage loans into mortgage-backed securities (MBSs) and subsequently pooling MBSs into collateralized debt obligations (CDOs), allowed investors to diversify away the idiosyncratic risk of regional real estate price movements, further lowering mortgage rates. These developments are the reason behind the initial rise in housing prices that was subsequently amplied by further capital inows into the housing market. The securitization process had the unfortunate side effect of creating a moral hazard problem for the lending institutions, since they no longer held the loans on their books.17 Their primary objective became to increase the number of loans made, which was done at the expense of loan quality. The competition among lenders for new loans led to a proliferation of the types of loans designed to attract subprime borrowers with few assets and low income. These loans (the most widespread being adjustable-rate mortgages) required little or no money down and low initial payments that were scheduled to increase to prevailing market rates in a few years. For example, the average down payment made by Alt A borrowers (a category between prime and subprime) fell from 14% in 2000 to only 2.7% in 2006. The would-be feedback traders who could not previously obtain a mortgage loan now could. Those who were especially optimistic about the prospects of the housing market frequently owned several properties, hoping to resell them. The borrowers faced their own moral hazard problem. Many of them were remortgaging their existing homes by taking loans against the accumulated home equity. Wiping out the home equity (or requiring little down payment) created an incentive for the borrowers to walk away from the house in the event that mortgage payments exceeded the cost of renting elsewhere. This set the stage for a potentially quick collapse of the bubble, because a small initial downward price movement could be quickly amplied. Just like securities analysts during the dot-com crisis, bond rating agencies failed to sound the alarm. This could have been the result of both incentive problems and a series of faulty
mortgage originators were required to keep a portion of the loans on their books in order to reduce the moral hazard problem; however, the high demand for new loans at the time overshadowed concerns about the increase in risk exposure. As a result, many lending banks suffered large losses and went bankrupt after the housing market collapse.
17 Some

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assumptions in their risk models. For example, the models relied heavily on recent house-price data that showed consistent price increases. The implication was that, in the event of a borrowers default, the loan value could be recovered by repossessing the house. Of course, this assumption was violated when house prices started to decline. The models also overstated the benets of cross-regional diversication; while the assumed correlation in housing returns across regions was as low as 30%, the actual correlation turned out to be close to 100% at the time when house prices started to fall. Moreover, investment banks routinely gamed the rating algorithms by delivering loan pools at the very bottom of the desired rating grade. Furthermore, the loan pools combined borrowers with high and low FICO scores but were rated based on the average FICO score. Rating agencies, fearful of losing business to competitors, did not press for detailed information on the individual loans. As a result, many highly risky subprime loans received investment-grade ratings; investors, blindly trusting these ratings, did not demand a high enough rate of return to be properly compensated for their risk exposure. In this environment, highly risky loans were made at low mortgage rates, which led to even further price increases. Speculation in the housing market was abundant and the investment strategy of ipping properties was promoted by the success stories reported in the news media. As in previous bubble periods, the market was dominated by the optimistic investors. If there were pessimists who would have liked to short the housing market or the mortgage-backed securities, they lacked the means to do so. As during the Roaring Twenties, the rise in housing prices was accompanied by a construction boom. Many new houses were built to supply the market with additional units of the overvalued asset, especially in the areas that experienced signicant price increases. When the prices eventually collapsed, the unsold inventory of new housing was supplemented by the staggering number of foreclosures, exacerbating the fall in house prices. If the Great Depression is any indication, house prices are likely to stay low for a long time, until the housing demand nally catches up with the housing supply.

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Between 2004 and 2006, the Fed raised the interest rate 17 times, from 1% to 5.25%. Around that time, many of the initially low teaser-rate mortgages were being adjusted up to market interest rates and subprime home owners who could not afford the high interest payments were unable to renance with lower-rate mortgages. Many of the borrowers had zero equity in their homes and chose to default and walk away. Increased interest rates thus had the effect of lowering housing prices. The largest decline in house prices occurred in 2007. Prices of mortgage-backed securities also collapsed, but with a delay. Fostel and Geanakoplos (2011) argue that the price drop of mortgage-backed securities can be traced to the introduction of credit default swaps (CDSs).18 A CDS is a derivative contract on an underlying bond that ensures the buyer against the bonds default. Since many of the mortgage-backed securities were traded over the counter but not on exchanges, they were impossible to sell short; buying CDS contracts offered the closest alternative. A CDS buyer takes a bet that the underlying bond will default and the seller takes a bet that it will not. Holding a long position in a CDS contract can be costly: It requires both posting a collateral, which can be large, and making agreed-upon quarterly spread payments, which can be thought of as insurance premia. Nonetheless, the introduction of CDS contracts relaxed the short sale constraint in the mortgage-backed securities market, bringing prices down to the fundamentals. Whether or not they understood that the rising real estate prices were a bubble, many sophisticated money managers initially took long positions in the housing market by holding MBSs and CDOs and selling CDS contracts. As was predicted by the models of DeLong, Shleifer, Summers, and Waldmann (1990) and Abreu and Brunnermeier (2003), the sophisticated investors, such as Goldman Sachs and its hedge funds, successfully rode the bubble and switched to betting against it just in time before it crashed (Lewis (2010)). Goldman Sachs may have been lucky with its timing or may have simply waited to reprice the mortgage-backed securities in which it made markets until after it had switched its bet (as alleged by Lewis (2010)). Other investment banks
18 See

also the model of Hong and Sraer (2011).

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followed, switching to the short bet, but because of the delay, they were already more exposed to losses on their long positions. When the housing and credit bubbles collapsed, trillions of dollars invested in MBSs and CDOs evaporated and a large number of commercial and investment banks, insurance companies, and hedge funds suffered large losses and either failed or were bailed out or sold off to other institutions at re-sale prices. Financial markets froze. The economy fell into the worst recession since the Great Depression. Few would argue that the country would have been better off had the housing bubble been avoided. The economy suffered many deadweight losses as a result of the bubble. Superuous housing stock was built and previously vacant land was unnecessarily developed. Needless to say, this capital could have been put to more productive use. After prices fell, construction projects came to a halt and the vacant properties, without any upkeep, deteriorated. As credit markets froze, more positive-net-present-value investments were forgone, further contributing to the prolonged economic slump. A drastically expanded government, required to administer and oversee the nancial sector bailout, and the direct costs of corporate and personal bankruptcy proceedings further consumed resources that could have been used more productively elsewhere. This raises the question of whether the government could have done more to prevent the bubble. Prior to the crisis, the longstanding government attitude was that markets work well and any mispricing would be corrected by arbitrage forces in due time. This argument failed to acknowledge the extent to which the incentives of important market players were misaligned. Moreover, the so-called Greenspan put implied that the Federal Reserve would not interfere by raising interest rates as bubbles grew but would step in and lower interest rates to help the economy when bubbles burst, contributing to the risk-taking incentives on Wall Street. At the time, it was argued that the role of the Federal Reserve was to balance ination and unemployment and to create an environment for steady economic growth but not necessarily to squash asset pricing bubbles. Finally, it became apparent during the crisis that large investment vehicles, such as hedge funds,

31

function as important suppliers of capital. When they suffer losses as a result of a bubble collapse, the supply of capital elsewhere in the economy dries up and the economic growth rate slows. The Financial Crisis Inquiry Commission recently determined that the crisis could have been avoided if the U.S. government had paid more attention to the warning signs: an explosion in risky subprime mortgage lending, an unsustainable rise in house prices, widespread unscrupulous lending practices, steep increases in homeowners mortgage debt, and a spike in investment banks trading activities, especially in mortgage-backed nancial products.19 Financial rms were blamed for a combination of poor risk management and poor governance that enabled individual traders to take on too much risk with very little exposure to the downside. In the aftermath of the crisis, policy makers introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act, which aims to improve the monitoring and incentives of Wall Street players as well as to strengthen investor protection.

References
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19 It

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Figure 1. Real Estate and Stock Market Indices with Reinvestment. The gure plots the stock market and Manhattan real estate investment indices. The investment proceeds (dividends and net rental income, respectively) are assumed to be reinvested back into the index.

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