The Effects of Asset Price Bubble Bursts Finance Essay

The outbreak of financial crises is now more than 2 years ago. Out of many factors responsible for the occurrence of the current financial crisis one important factor is the rise in the asset prices which is followed by a collapse and the widespread default. Bursting of the asset price bubble often leads to financial crisis. Some historic examples of crisis due to bubbles in asset price are the Dutch Tulipmania, the South Sea bubble in England, the Mississippi bubble in France and the Great Crash of 1929 in the United States. Examples of the crisis due to bubbles in real estate and stock prices can be seen in Japan in the late 1980's. Norway, Finland and Sweden had similar experiences in the 1980's and 1990's. In emerging economies financial crisis have occurred in countries like Argentina, Chile, Indonesia, Mexico, Malaysia, Thailand and South Korea.

The focus and motivation behind this paper is to look at the bubbles in the asset prices and what leads to the creation of bubbles and further recession in the economy. Chapter 1 gives an introduction about the bubbles, stages and phenomenon involved in the asset price bubble. In Chapter 2 we discuss about how bubbles are created in asset prices due to uncertainty about the asset payoffs i.e. uncertainty in the real sector and anticipation of the credit expansion which is the uncertainty in the financial sector through a formal model. In chapter 3 we focus on the methodology of detecting a bubble and the effects of the bubble burst in the economic and financial sector. In chapter 4, the possible actions that are required to be taken by the policy makers and how crisis could be prevented is discussed and thereafter the paper is concluded with some remarks and discussion.

STAGES AND PHENOMENON

An economic bubble is referred to as a situation where assets or products are traded at a value which is higher than their fundamental value. There are many kinds of bubbles that have been observed in the past like stock market bubble, real estate bubble and dotcom bubble and there have been many explanations suggesting uncertainty, speculation, bounded rationality, credit expansion as the cause of these bubbles.

The bubbles in asset prices have three distinct phases: The first phase is the conscious decision by the Central bank to increase the amount of lending in the economy as a step towards financial liberalization. This credit expansion leads to the rise in the asset prices such as real estate and stocks. The second phase is when the bubble of rising asset prices bursts and stock and real estate markets collapse over a long period of time. The third phase is characterized by the default of many firms and other agents that have borrowed to buy assets at inflated prices. These defaults can lead to banking crisis since banks are overexposed to the equity and real estate markets Then foreign exchange crisis occur because of the dilemma faced by the government to lower interest rates to ease banking crises or raise interest rates to protect the currency. Finally, the real sector of the economy is affected with significant fall in the output and recession which lasts for long.

Japanese bubble in 1980's and 1990's reflects this phenomenon. Asset prices rose steadily in most of the period of 1980's due to the financial liberalization in order to support the US dollar. The stock exchange reached its peak during 1989. In order to fight inflation, the bank of Japan tightened the monetary policy which led to sharp fall in the interest rates in 1990's. Stock prices and real estate rises also followed the similar trend. The third phase was the defaults and retrenchment in the financial system that also adversely affected the real economy. In Norway similar event occurred where lending increased by 40% in 1985 and 1986 and then oil price collapse helped to burst the asset price bubble and caused severe banking crisis and eventually recession. Amongst emerging economies Mexico was also affected by similar problem. In the early 1990's banks were privatized and financial liberalization occurred. Bank credit to private non financial enterprises increased from 10% of GDP to 40% of GDP in 1994 and stock markets also rose significantly. With the Colosio assassination and the uprising in Chiapas triggered the bubble burst and as a result the prices of assets and stocks went down and banking and foreign exchange crises occurred.

In the above three examples there is the same basic progression of three stages but they also exhibit differences. The most important nature of the events is the bursting of the bubble and in many cases a change in the real economic activity triggers the bubble burst.

BUBBLES IN ASSET PRICES

Asset prices are related to the amount of credit and how uncertainty about asset payoffs can lead to bubbles in an intermediated financial system. Investors borrow in order to invest in risky assets and they avoid losses in the low payoff states by defaulting on the loan. This risk shifting causes the assets to be priced above their fundamental value and bubble is created.

The credit expansion has an originating effect on the asset prices as it encourages the investor to fund the risky investment. But along with credit expansion the uncertainty and the anticipation of future credit expansion can also increase the current asset price. Risk can originate both in the real as well as in the financial sectors. Both the concepts of rising asset prices are discussed below in the form of models.

ASSET PRICING WITH UNCERTAINTY GENERATED BY THE REAL SECTOR

This model analyses the effect of uncertainty in the price of the risky assets that leads to the creation of bubble. The source of uncertainty is the randomness of the real asset returns.

There are two time periods, t= 1,2 and a single consumtion good at each date

There are two assets: a safe asset (variable supply) and a risky asset (fixed supply). The safe asset, Xs has a fixed return r to the investor i.e. the rate of return is rXs units of the consumption in 2. The risky asset, Xri has a return RXri in 2, where R is a random variable with a continuous positive density h(R) on the support [0, Rmax] with a mean RAŒ….

The return on safe asset is determined by the marginal product of capital in the economy. The equilibrium or the market clearing condition for capital goods is:

r=f' (Xs)

The risky asset also has a non pecuniary cost of investing, c(x), the purpose of which is to restrict the individual portfolios so that in equilibrium borrowers make positive expected profits.

Now there are risk neutral investors who borrow from banks to invest in the safe and risky assets. There are also risk neutral banks who lend to the investors under restricted simple debt contracts as they cannot condition the terms of the loan on the size of the loan or on asset return.

Now investors can borrow as much as they want at the going rate of interest. For the safe assets, any rate of return on the asset not equal to the contracted rate of interest would be inconsistent with the assumptions of the competition in the corporate sector and so in equilibrium the return on the safe asset is equal to the contracted rate of interest on loans.

The investor who has borrowed from the bank to invest in risky asset does not bear the full cost of borrowing if the investment turns out badly. This convexity generates a preference for risk.

We now analyze the behavior of the investor.

Assumptions: All investors are treated symmetrically and will be charged same rate of interest r. Banks supply loanable fund B inelastically and the rate of interest adjusts to clear the market.

The optimization problem faced by the representative investor is to decide how much to borrow and its allocation between the two types of asset.

The total amount borrowed is: B=Xs+PXri where P is the price of the risky asset. The repayment to the Bank will be: r (Xs+PXri). The liquidation value of the portfolio is rXs+RXri. Therefore, the payoff to the investor at date 2 is

RXri-rPXri

So investor's problem is: maxwhere Xri≥ 0 (1)

where R* = rP is the critical value of the return to the risky asset at which the investor defaults.

The optimal amount of safe asset is indeterminate and so it drops out from the investor decision problem.

The market clearing condition for the risky asset is: Xri=1

The market clearing condition for the loan market is Xs+PXri=B where Xri=1

The equilibrium is described by the variables (r, P, Xs, Xri) where portfolios (Xs, Xri) solves the decision problem given the parameters (r, P) and the above two market clearing conditions are satisfied. There exists a unique equilibrium if RAŒ… A‹Æ’ c' (1) and the bank supply amount of credit B inelastically at rate of interest r which adjusts to equate the funds demanded with funds supplied. A borrower will default when the realized rate of return will be less than the rate of interest i.e. R<rP. This difference in contracted and the realized rates of return is borne by the banks.

The importance of this model is that it explains the risk shifting problem and the fact that risky asset is in fixed supply. Borrowers are attracted towards risky asset because they fall back on their loans in case of losses. When the asset return is high they receive the surplus and banks get their fixed return. So this implies that borrowers will bid up the price of the asset above its fundamental value which is the classic definition of a bubble. But the question is what the fundamental value is?

The fundamental value can be defines as a value that an individual investor would be filling to pay for one unit of risky asset if there were no risk shifting, other things being equal. In this case the investor will choose the portfolio as follows:

Max (Xs, Xri) ≥0 subject to Xs + PXri ≤ B

Using first order conditions and Xri=1, the fundamental price is

P*= 1/r [R-c'(1)]

The equilibrium price with risk shifting is: P= [

We can see that PA‹Æ’P*, that is there is an asset price bubble as long as the probability of default is positive.

The risk shifting behavior is important for the creation of a bubble. It also points out a fact that the degree of riskiness of an asset determines the size of a bubble. Increase in the riskiness of an asset will increase the size of a bubble and also the probability of default.

ASSET PRICING WITH UNCERTAINTY GENERATED BY FINANCIAL SECTOR

Financial liberalization leads to an expansion of credit which increases the price of the assets and hence feeds the bubble in asset prices. These higher prices are further supported by further increase in the credit and asset prices. Neither the amount of financial liberalization and credit expansion is foreseen nor does the Central bank have full control on the amount of credit. Also there may be other economic changes like changes in policy, administration external environment that can alter the extent and amount of credit expansion. The model discussed below reflects how the uncertainty in the extent of credit expansion can increase the magnitude of the bubble.

There are 3 time periods, t=0,1,2 and single consumption good at each date

Assumptions: B is the amount of credit available for lending and is partially controlled by the central bank.

Central bank can influence the amount of credit available in the economy by altering either reserve requirements or quantity of assets available to be used as reserves. This creates uncertainty among the investors and they rationally anticipate an expansion in B.

At date 0, the level of B1 is treated by agents as a random variable with a positive, continuous density k (B) on the support [0, B1max]. The price of the risky asset at date 1,

P1 (B1) and is also a random variable.

The safe asset pays rt x at date t + 1 if x is invested at date t = 0, 1. The owner of the risky asset receives a payoff of Rx at date 2.

There is short term borrowing at dates 0 and 1.

Entrepreneurs initially own the asset in fixed supply. At date 0 they sell it to the investors who own them till date 1 and then these new investors sell the risky assets at date 1 to final group of investors who own them till date 2.

Investors in the risky asset incur the investment cost c(x) at each date t = 0; 1.

Now the risky asset has a certain return RAŒ…. It is risky because it is a long-lived asset and is subjected to the fluctuations at date 1. Now the uncertainty comes entirely from the credit expansion B1. Now the equilibrium price of the risky asset at date 1 when there is no uncertainty involved is:

P1=

Let P1 (B1) denote the equilibrium value of the risky asset's price at date 1 when the credit level is B1, then P1 (B1) is continuous and increases in B1. Then representative investor's problem at date 0 is:

Max X0R≥0

where,

P0: price of the risky asset at date 0.

(X0S, X0R): portfolio chosen at date 0.

r0: borrowing rate at date 0

B*1: value of B1 at which the investor is on the verge of default at date 1:

P1 (B*1) = r0P0

Equilibrium is defined by the variables (r0, P0, B*1, X0S, X0R), where the portfolio (X0S, X0R) solves the investor's decision problem given (r0, P0, B*1), and the following market clearing conditions are satisfied:

X0R = 1

X0S + P0X0R = B0

r0 = f0(X0S)

There exists a unique equilibrium if E [P1 (B*1)] A‹Æ’c' (1), equilibrium price will be

P0= (

Here the uncertainty about B1 took place of the uncertainty about R. When there is financial liberalization the uncertainty arising from government and central bank policies on credit expansion can dwarf the uncertainty and the agency problems with real payoffs on asset. It is the interaction between financial uncertainty and agency problem in the intermediation that leads to asset bubbles and subsequent severe financial crises.

EFFECTS OF ASSET PRICE BUBBLE BURST

Asset price crashes or bursts have often been associated with declines in the economic activity, financial instability and sometimes large budgetary costs from the recapitalization of the banking systems. The asset price bust has effects on both macroeconomic and financial activities. While every asset price bust is different and depends on circumstantial factors such as the underlying shocks, the analysis shows that asset price busts and concurrent macroeconomic developments in the postwar period in industrial countries share common patterns that provide a relevant point of reference for assessing the current busts. These patterns are identified using event analysis-that is, on the basis of their timing, which does not imply causality.1

The procedure used to identify booms and busts in asset prices and turning points in these prices for the postwar period is based on the method developed in business cycle analysis and involves two steps:

Determination of asset price cycles- turning points in the level of broad equity price indices define the cycles in those prices. Typically Bull and Bear markets are the asset market equivalents of expansion and recessions.

Identification of booms and busts- based on the full set of bull and bear market, booms (busts) were identified as those episodes with large price increases (decreases). Busts begin one quarter after the peak and end with the trough quarter. Booms begin with the peak and end with the subsequent peak and they are identified on the basis of price increases over the full cycle.

Equity price turning points were identified using quarterly real equity price indices for 19 industrial countries. The regular equity price indices were deflated using consumer price indices. The primary data source for these prices was the IMF's International Financial Statistics.

The analyses suggest main points:

Equity price busts on average occurred about once every 13 years, lasted for about 2.5 years and involved price declines of about 45 percent (though the busts in the mid-1970s averaged about 60 percent) and only about one-fourth of equity price booms were followed by busts.2

Asset price busts leads to output losses reflecting declines in the growth rates of private consumption, investment in machinery and equipment and investment in construction and housing prices. On average, the output level three years after an equity price bursts was about 4 percent below the level that would have prevailed with the average growth rate during the 3 years up to the bust.

There are significant price spillovers across asset classes. In an equity price bust, housing prices tended to decline in tandem with equity prices, while in a housing price bust equity prices fell more quickly and by a larger amount than housing prices. Asset price busts are also linked with reductions in the growth rates of private credit and broad money.

The magnitude of the asset price fall during a bust depends in part on the size of the run-up in prices prior to the bust. Similarly, the extent of the slowdown in investment growth during a bust depends in part on the earlier pace of investment.

Market-based systems tended to suffer larger output losses than bank-based systems during equity price busts. This is consistent with the high exposure of banks to real estate lending, and the importance of equities in household assets in market-based systems.

Asset price booms are generally associated with a large increase in corporate investment and borrowing, driven by strong domestic demand, strong expected rates of return, and strong cash flow. Once the uncertainty regarding the expected profitably becomes clear or that corporate financial health is in danger, this process is reversed, as firms try to adjust by retrenching their balance sheets and reducing investment. The impact of the recent equity price bust on corporate balance sheets has so far been somewhat smaller than in the episodes of the late 1980s and early 1990s-in part because valuations have remained above historical levels, sharply lower interest rates have helped shore up corporate liquidity, and the boom was concentrated in the information technology (IT) sector, where low leverage helped mitigate spillovers to the banking sector. However, corporate leverage remains relatively high, and may continue to be a drag on recovery for some time, particularly in Europe where investment is largely financed through bank borrowing rather than equity.

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