The global economy has reached a “Minsky Moment”
US economist Hyman Minsky came to the public eye after his model on asset bubbles unerringly predicted the boom and bust of tech stocks (unfortunately Minsky didn’t live to see his fame – he died in 1996). The credit bubble deflation that global financial markets are now facing is following a similar pattern.
Minsky’s underlying theory was that stability breeds instability. Long periods of economic stability result in investors taking more and more risk. As demand for risky assets increase, there is a compression in the risk premium. Leverage begins to grow in predictable stages as investors take advantage of easy credit access to borrow excessively, and end up overpaying for assets.
Minsky believed there were three types of borrower, who are increasingly risky in nature. Hedged borrowers are able to meet debt payments from cash flows. Speculative borrowers can meet interest payments, but have to keep rolling the debt over to pay back the original loan (think Northern Rock). Ponzi borrowers (named after the Ponzi pyramid scheme in the US) aren’t able to repay interest or the original debt, and rely on rising asset prices to allow the debt to be refinanced (think sub-prime borrowers). The longer economic stability lasts, the greater the portion of Ponzi borrowers. Financial institutions react to stability and low risk premiums by increasing leverage and devising ways of getting around regulations in an effort to drive profits higher (think of off-balance sheet financing such as SIVs).
The ‘Minsky Moment’ comes when risk appetite goes into reverse. “This is likely to lead to a collapse of asset vales”, wrote Minsky. It looks like May this year marked the inflexion point, when the spread (ie excess yield over government bonds) available on US and European high yield bonds reached all-time lows. Spreads have widened considerably over the past few months, but as we’ve argued on this blog, we think the repricing of risk has only just begun. The Ponzi sub-prime borrowers have already been hit, but the speculative borrowers are only starting to be hit, and the hedged borrowers are still sitting comfortably. We’re still at the early stages of forced selling, as CDOs liquidate, hedge funds unwind, and investors reduce leverage.
Many thanks to George Magnus, Senior Economic Adviser at UBS, who has written a number of pieces on Minsky this year.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.
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