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