How to spot the next bub­ble: 10 years on from the col­lapse of Lehman

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Ex­actly 10 years ago the in­vest­ment bank Lehman Broth­ers went bust, partly be­cause of a col­lapse in cer­tain prop­erty-re­lated as­sets. Low in­ter­est rates had led to a boom in mort­gage bor­row­ing, with lenders al­low­ing high-risk borrowers to buy homes they could not af­ford.

To fi­nance the boom, loans were pack­aged into mort­gage-backed bonds and sold on, dis­guis­ing the risk and ex­pos­ing the fi­nan­cial mar­kets to a time bomb – wait­ing to blow up as soon as in­ter­est rates rose and borrowers were un­able to pay back what they owed.

When rates did go up, an in­crease in mort­gage pay­ment de­faults set off a chain re­ac­tion that brought banks to their knees and crushed share prices.

Some are now con­cerned that we are mak­ing the same mis­takes again. Jens Ha­gen­dorff, pro­fes­sor of fi­nance at the Univer­sity of Ed­in­burgh Busi­ness School, has no doubt that we are in an­other prop­erty bub­ble, hav­ing en­joyed low bor­row­ing costs for the best part of a decade.

Dave Laf­ferty of in­vest­ment man­ager Natixis said that, while some things had im­proved since the Lehman col­lapse, “the fi­nan­cial sys­tem to­day ap­pears no less brit­tle than it did 10 years ago”.

He added that share prices had po­ten­tially peaked in Amer­ica, which has ex­pe­ri­enced one of the long­est bull mar­kets of all time. “The mar­kets are not over­val­ued, but I think at some point this year we will hit ‘peak eu­pho­ria’, after which there will be a nat­u­ral slow­down,” Mr Laf­ferty said.

Prof Ha­gen­dorff added: “No one can ac­tu­ally call a bub­ble. Even pro­fes­sion­als are poor at spot­ting the peak of a mar­ket. But the in­di­ca­tors for a bub­ble have been flash­ing red for some time: shares and bond prices are high, there are jit­ters in emerg­ing mar­kets, there are high lev­els of debt and in­ter­est rates are go­ing up.”

His­tory shows that a bub­ble can be hard to spot. One of the ear­li­est recorded was the Dutch tulip bub­ble of the 1600s, when newly dis­cov­ered rare tulips be­came pop­u­lar and their price soared. The mar­ket crashed when it be­came ap­par­ent that the flow­ers were trad­ing far above their in­her­ent value.

More re­cently, around the turn of the mil­len­nium, the so-called dot­com bub­ble burst after in­vestors had poured money into start-up in­ter­net com­pa­nies, bet­ting on rapid growth. When it turned out that many were mak­ing no prof­its, in­vest­ment dried up and busi­nesses col­lapsed. Econ­o­mist Hy­man P Min­sky iden­ti­fied five stages to look out for.

The first stage of a bub­ble is “dis­place­ment” – when in­vestors are at­tracted to some­thing novel. Ex­am­ples in­clude the emer­gence of the in­ter­net or cryp­tocur­ren­cies, or when in­ter­est rates fell to his­toric lows in Amer­ica at the start of the mil­len­nium.

Dis­place­ment leads to in­vest­ment, which brings me­dia cov­er­age and wider spec­u­la­tion. This fu­els more in­vest­ment, as the fear of miss­ing out grows. The feel­ing snow­balls and more and more people pile in.

Mas­sive flows of in­vest­ment and spec­u­la­tion drive prices far beyond the in­her­ent value of the as­set. For ex­am­ple, the value of the over­all cryp­tocur­rency mar­ket grew at enor­mous rates from the be­gin­ning of 2017, up from around $18bn (£13.7bn) to al­most $800bn a year later. The mar­ket has since fallen back and now sits at a value of around $200bn, ac­cord­ing to the cryp­tocur­rency data provider CoinMar­ketCap.

From tulips to Bit­coin, as­set bub­bles can be hard to call. Harry Bren­nan iden­ti­fies five key warn­ing signs to look out for

Hard to iden­tify, this is when the savvi­est in­vestors see that their hold­ings are over­val­ued and sell.

Fi­nally, as more and more people cot­ton on to the ex­is­tence of a bub­ble, they too start to liq­ui­date their in­vest­ments. Panic en­sues as in­vestors scramble to sell. Prices fall sharply as fear spreads and the bub­ble bursts. In some cases, as with Lehman Broth­ers and Bear Stearns, an­other in­vest­ment banking ca­su­alty of the credit cri­sis, com­pa­nies go bust.

Seven­teenth- cen­tury tulip spec­u­la­tion sent prices sky-high be­fore they crashed

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