…After reading the Sunday NYT, we found it time to dust off the Charles Kindleberger classic titled “Manias, Panics, and Crashes: A History of
Financial Crises”: We highly advise that clients either read or re-read this masterpiece, especially at this stage of the business and credit cycle (past the peak): Chapter 6 on the “Critical Stage” is a must-read since, at least as it pertains to the housing ($23 trillion) and mortgage market ($10 trillion), this is where we are today. Kindleberger identified five distinct phases – “displacement,
euphoria, distress, panic, and then crash”. Between 2002 and 2006, as far as residential real estate was concerned, we had been in the ‘euphoria’ stage,
defined as when “new opportunities for profit are seized, and overdone”. When an estimated 37% of banking sector profits were derived from lapsing loan loss reserves in the past three years, a byproduct of new and innovative methods the
lenders used to ensure that delinquent borrowers stayed current (see the OCC’s John Dugan’s speech to a group of bankers back in March 7th). At the peak of the housing mania in 2005, the U of M consumer sentiment survey showed that 25% of the real-estate investing public believed now was a good time to buy a home because prices were heading higher and it was a great investment (that number
from a historical perspective was off the charts and we commented on it at the time). We have moved on from ‘euphoria’ to the ‘distress’ phase, which, as the NYT clearly illustrated, generates unexpected failures, bankruptcies, and defaults
(as an aside, the long-time MIT prof and author of over 30 books, was also an architect of the Marshall Plan that provided the strategy for rebuilding the global economy following WWII).

…This is key (page 114): “Causes of distress are difficult to disentangle from symptoms, but they include … rising bankruptcies, the end of price increases in commodities, securities, land, buildings or whatever else may have been the
object of speculation. These developments may all be interrelated, symptoms that the credit mechanism has been stretched taut, beyond normal limits … The end of a period of rising prices leads to distress if investors or speculators have become used to rising prices and the paper profits implicit in them. Of course, it is difficult – many would say impossible – to distinguish in advance a pause in a
continued upward movement from a topping out that presages downturn. Uncertainty on this score is itself a cause of distress. A more powerful cause of
distress occurs after a period in which credit has been stretched in an effort to make capital gains: such gains are then no longer available, even on paper. Then creditworthiness declines and a fixed line of credit suddenly becomes dangerously high”.
In this chapter on the Critical Stage, we also see that hundreds of years of history has to offer this – and the constant evolution of financial innovation and risk-reduction s does halt the investment mania process which is part of human nature: “The system is one of positive feedback. A fall in prices reduces the value of collateral and induces banks to call in collateral and induces
banks to call loans or refuse new ones, causing mercantile houses to sell commodities, households to sell securities, industry to postpone borrowing, and prices to fall still further. Further decline in collateral leads to more liquidation.”
The story goes on from there, but this is the history of post-bubble phases. Oh yes – for those who think the Fed will not be cutting rates, or that this will just introduce moral hazard because the so-called ‘Greenspan put’ will merely morph
into the ‘Bernanke put’, should also have read of Chapter 9 of ‘Manias, Panics
and Crashes” (“The Lender of Last Resort”).