Much has been made of the United States housing bubble in the general and financial news media lately. The bubble began just as the .com one ended in ignominy in 2001, and began to burst in 2006.  Compared to previous housing bubbles in the United States, it was distinguished by a significantly larger deviation from the roughly linear growth in home prices.  What is largely unappreciated is that this bubble is not confined to the US, but extends to many other developed nations. Ireland, for example, has experienced an home-price index increase of 33% to a paltry 12% in the US. [The Economist, April 5-11 2008] It remains to be seen what the global market effects of the emerging correction will be, but at least the causes can now be rooted out. Yale economist Robert Schiller discussed these, and specifically the contribution of network effects, in the New York Times Economic View column [http://www.nytimes.com/2008/03/02/business/02view.html?ex=1362114000&en=f450ee18dc5cde60&ei=5124&partner=permalink&exprod=permalink].

Inevitably, an occurrence of any financial bubble leads to cries for an explanation, which almost as inevitably are explained by two factors. One of the two responsible factors in housing bubble was the overavailability of credit and loose lending standards, which enabled people with limited assets besides their home to acquire mortgages. Exacerbating this were historically low interest rates and the development of new financial mechanisms for redistribution of investments. Market risk was aggregated and repackaged again into various vehicles with obscure technical names (collateralized debt obligations, mortgage-backed securities, structured investment vehicles) that were sold and resold. While decentralization of risk is generally good for the health of the economy, in this case too much was spread too thickly.
The other theme, common to many bubbles, is what former Fed Chairman Alan Greenspan referred to in passing as “irrational exuberance”, an undue escalation of asset values. This phenomenon is closely tied to network effects and informational cascades we have covered in class. Agents at all levels of the financial industry observe their counterparts’ activity, and perceiving it to signal an optimistic judgment of the market, underwrite similar ventures and acquisitions. This has a nasty tendency to be a self-reinforcing situation, exactly what Greenspan was referring to. Robert Schiller (who authored a book exploing irrational exuberance, appropiately titled “Irrational Exuberance”), appears almost precognitive in a 2005 NPR interview when he notes with some degree of alarm that in that year nearly 1/4 of homes were sold to investors rather than live-in homeowners. [http://www.npr.org/templates/story/story.php?storyId=4579179]

The most prominent members among the casualties of the bubble were Northern Rock, a UK bank that was effectively nationalized after a bank run and aborted buyout attempts. The other was Bear Stearns, a US investment bank that all but collapsed several months ago. Bear Stearns was heavily invested in capital markets at the primary (sale) and secondary (resale) levels. When these investments began to sour, the bank was bailed out by JPMorgan Chase with a Federal Reserve credit line, to lessen the risk of market lockup due to the trillions of dollars of transaction Bear Stearns was party to at some level.

Greenspan has remarked that his former job as Fed Chairman would have been much easier if he only had a device to gauge the level of market optimism. Knowing this, he could set interest rates and other variables at a level to ensure even and sustainable growth. Unfortunately for him and many others, no such contraption yet exists. When market gains are accompanied by an unwarranted upswell of investor confidence, conditions exist that can touch off a sort of cascade, whereby investment groups enter the same markets and inflate asset prices. Often, this results in a bubble – and a run on t-shirts lamenting the halycon days of the bubble.