I belong to a local business persons' group and I gave a presentation a few weeks ago.
An interesting question arose as we talked about the financial crisis that occurred five years ago.
The question was whether what happened in the financial markets would happen again. My answer was yes. The reality is that bubbles have happened again and again throughout history. Greed, euphoria and fear play equal parts in any good bubble.
The latest bubble was at its core caused by real estate. Government deregulation, banks no longer requiring down payments and securitizing of mortgages led to an overheated market.
Large bets were placed based on the delusion that housing prices would not go down. Then they did. Leverage, such as taking a loan on a house, can amplify the ability of our population to do business, buy cars, go to college and buy a home. It allows resources to be amplified to benefit all involved.
For example, just think how long it would take for you to save enough money to pay cash for a car, let alone a house. Instead, we put in a down payment, say 10% or 20%, and are able to enjoy the car or house while we pay off the loan. Leverage helps us to buy things we couldn't otherwise afford.
Ever take advantage of a 12 month-same-as-cash deal to pay your dental bill or to buy an engagement ring? The problem with leverage is when you can't pay the monthly bills and the asset backing the loan isn't worth as much, and that is what happened to real estate across the U.S.
From the bottom to the top, banks, securities firms and people took risk based on ever-rising home prices. When the bubble burst, people couldn't make their mortgage payments (perhaps due to balloon payments, lost jobs or over-leverage) and the houses ended up being worth less than the loans on them.
This is a good case for requiring down payments on real estate so that the owner has skin in the game and protects the debtor if the price goes down. The difference with this bubble was the depth and breadth of housing in our economy. It created jobs through construction, mortgage lenders and all the stuff that people bought for their houses.
It also increased real estate taxes as home values increased. Everyone was fat and happy. Market prices are always subject to supply and demand. As demand dwindled and over-supply occurred, we were trapped in a large economic quagmire from which we are just recovering.
It took a lot of government intervention to stop a larger meltdown, not only here but around the world and we are still seeing the effects of the worst recession since the great depression.
Another bubble in recent memory was the 'dot com' or internet bubble. In the late 1990's, the internet was coming to the forefront and everyone wanted a piece of the action. It went something like this: No sales, no assets on your balance sheet but want to start a business on the internet? No problem! You can do an IPO and raise lots of money.
For every Amazon and Ebay that survived, there were a multitude of businesses that went belly up, as did investor portfolios, when the internet bubble burst. If you want to see the steep fall, take a look at a graph of the tech-heavy Nasdaq from 1990 to today. We still have not recovered to the highs of March 2000 and the internet bubble.
The concept was that the internet and internet commerce had welcomed in a new day and had changed our whole economy. The misconception was that internet stocks would never go down (sound familiar?) and any internet stock was a sure thing.
Greenspan coined it "the Goldilocks Economy," which meant it was not too hot and not too cold. While the internet bubble bursting took a lot of people's 401(k)s and IRAs down, it didn't create the 'Great Recession' like the real estate bubble of 2008 did. It did not reach as many areas of the economy but it did put a dent in people's retirement plans and definitely was a warning sign for those who did not heed the need for diversification and stuck all their money into the internet and its related technology.
What's next on the horizon? Are we creating another bubble with the Federal Reserve buying bonds and leaving interest rates incredibly low? What about the high level of student loans? Or the large amount of car loans? Bubbles are hard to spot but we feel them when they pop.
Is there any way to avoid bubbles as an investor? Keep an eye out for euphoria. When newspapers, pundits and everyone -- including all your neighbors -- thinks something is a "no risk" situation and "nothing can go wrong," it is time to run for the hills. Anything that always goes up, won't.