The Minsky Moment

Guest blog from Coreco’s Rob Gill on how relevant Professor Minsky’s work is in identifying the mysterious “bubble”.

During my 20 year career in Financial Services I’ve had the dubious honour of a front row seat to two of the biggest booms and busts in history.

In my first career in Investment Banking, I worked in Equity Trading from the late 1990s and witnessed first-hand the internet boom and subsequent bust. I then started my second career in 2006 as a Mortgage Broker, saw property prices and mortgage activity reach fever pitch in 2007 and lived through the painful bursting of the bubble from 2008 onwards.

This experience of two financial crises has led to no little introspection over their causes, how they might have been spotted and even prevented. The bubble analogy is a good one- once formed bubbles are virtually invisible, are guaranteed to burst eventually and leave a mess directly proportional to the size of the original bubble. Prevention is better than cure, which is only possible if route causes can be identified.

The US economist and professor Hyman Minsky passed away relatively unknown in 1996. His Financial Instability Hypothesis however, published in 1992, gained credence in the years following the sub-prime crises as it gave a near perfect explanation of its causes and the events which led up to it.

Minsky believed that asset bubbles were fuelled by borrowing, with lending practices going through three distinct phases. In the first stage, lenders act conservatively and restrict borrowing to what Minsky termed “Hedge” borrowing. A Hedge borrower makes payments to both cover the interest and repay the principle. In mortgage parlance, a standard repayment mortgage where the borrower will own the asset by the end of the term.

As lenders and borrowers become more confident, the second stage or “Speculative” borrowing develops where the borrower is only repaying the interest. In the mortgage market this means Interest Only finance, including of course the vast majority of Buy to Let.

The third stage identified by Minsky is what he termed “Ponzi” borrowing (named after the infamous Charles Ponzi). Borrowing now occurs where the borrower is reliant on rising asset prices to meet the interest payments. The classic example are subprime mortgages themselves where borrowers had to regularly release equity just to meet the mortgage payments, which was only possible if the property value was rising. In the UK 125% LTV residential mortgages and high LTV Buy to Let finance (where the rental payments didn’t cover the total costs of financing the mortgage and running the property) were also examples of Ponzi borrowing.

This Ponzi borrowing eventually leads to a crises of confidence amongst lenders and borrowers when they realise assets cannot keep increasing in value, the loans cannot be serviced and a fire sale of assets begins. This is the oft referred to “Minsky Moment”, a crises of confidence which quickly spirals into ever lower asset prices, reduced lending and so on. The bubble well and truly burst.

Having predicted characteristics of the 2008 crises, it’s instructive to compare Minsky’s theories to the current property market in the UK. Even during the worst of the crises, interest only borrowing, while less prevalent than it was, never went away entirely for either residential or Buy to Let mortgages. It would seem therefore that, since 2008, the UK mortgage market has sat somewhere between Hedge and Speculative borrowing, and is certainly a long way from any Ponzi borrowing….or is it?

There is an argument that high loan to value mortgages are Ponzi borrowing. Realistically any such borrowing requires a fairly quick rise in property prices to make the situation comfortable for the lender and the borrower. Indeed, if Help to Buy is to be temporary, the only way borrowers can remortgage in the short to medium term is if the price of property increases (either so they can remortgage at a lower LTV, or lenders grant high LTV lending without Help to Buy due to rising property prices).

The other sector of the market which could include Ponzi borrowing is, perhaps counter-intuitively, “cash” buyers. Current figures show that over 35% of all purchases are by cash buyers (the highest proportion in recent history). These figures however only measure UK mortgages granted on the property being purchased. They do not measure mortgages obtained overseas, non-mortgage borrowing or borrowing on other properties such as a let to buy or additional borrowing parents.

As every estate agent and mortgage broker can tell you, cash buyers often turn out to be borrowing from someone, even HNW borrowers tend to borrow against another asset or remortgage the property after completing with cash. Any of this, from parents effectively using their pension fund who then might struggle if it can’t be repaid, through to “hot money” from wealthy foreigners who’d have no qualms putting that money elsewhere if their London trophy asset stopped performing, could count as Ponzi borrowing.

This work by Hyman Minsky chimes with my own personal experience of two major asset bubbles. Certainly the last property boom & bust involved obvious examples of Ponzi borrowing and anyone involved in the property and mortgage markets should keep an eye out for similar signs going forward.

If, of course, it’s not too late already.

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