Hyman Minsky and the Financial Instability Hypothesis
Luz A comas
Professor: Michael Hamuicka
Financial Management – FIN 534
The current turmoil on the Stock Market has taken a lot of people by surprise. One person who, were he alive today, wouldn’t be the least bit surprised, is Hyman Minsky, who predicted that events like this would be a regular feature of a deregulated financial system. He developed what he called “The Financial Instability Hypothesis”, and anyone who wants to understand today’s events needs to know about it.
The following is just an introduction to Minsky's ideas. Minsky’s research focused on ...view middle of the document...
Disagreeing with many mainstream economists, he argued that these swings, and the booms and busts that can accompany them, are inevitable in a free market economy, unless government steps in to control them, through regulation, central bank action and other tools. He opposed the deregulation that characterized the long 18 years of Greenspan era. No wonder we are hearing a lot of talks about regulations recently. (Introduction to Minsky Theory. 2008)
Minsky broke down the process from stability to instability into three types of debt phases: hedge, speculative, Ponzi.
Hedge phase describes that buyer’s cash flows cover interest and principal payments for borrowers who obtains a debt to buy an asset. This way, the debt is self-liquidating, fully hedged, so it is a stabilizing factor in this economic phase.
Speculative phase is a step further on the risk side. In this phase, cash flows cover only interest payments, but not enough to amortize the principal. Obviously, this is less stabilizing since borrowers (or in this case on its way to be speculators) are betting on: interest rate is not going up, and the value of the collateral will not decline. The longer an economy is stable, the more incentive to speculate, and the more speculative borrowers become.
Ponzi phase is the last phase toward the end of the bubble. In this phase, cash flows cover neither interest rate nor principal, and it all depends on rising asset prices to keep the borrowers afloat. In the mortgage market, it becomes option-ARM, a negative amortization loan, or subprime with no ability of paying back, and all the mortgage backed securities (MBS). In other fixed income market, it becomes collateralized debt obligations (CDO), SIV, leveraged loans which private equity firms use for their leveraged buyouts, relying on their acquired business to maintain historical high revenue growth and profit margin.
Different than speculative phase, this whole phase is hinged on asset price (or operating profit margin for private equity firms) to go up. They can’t just stay flat or not decline, they have to go up, otherwise their investments will get wiped out. They are also betting on future buyers will buy these overvalued assets from them, assuming more new buyers will buy the same assets at even higher price from future buyers. It is an escalation of buying high and selling even higher.
In these three step process, the tendency of markets becomes more risky as they become seemingly more stable. The longer the markets seem to be stable, or appear more secure the more risky and unstable they become. The false hope of security leads investors to extrapolate stability into the distant future.
In the Ponzi phase, the rising asset prices become a self-fulfilling prophecy. As more people enter the market and become speculators, they drive up the value of the collateral. In turn, they can borrow more to buy more assets to drive up...