Introducing the Minsky Theory - Stability Is Destabilizing

Hyman Minsky, Ph.D. (1919 - 1996), was an economist and professor at Washington University in St. Louis, but stayed in New York during last 10 years of his life. A few years ago, almost no one heard of him, until the current credit crisis. I first heard of him last year from an interview given by Jeremy Grantham of GMO, who was also only aware of him two years ago. With the recent subprime mess, suddenly his theory becomes a lot more pertinent and popular these days.

Minsky's research focused on understanding and explaining financial crises. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, like right now, even to companies that can afford loans, and the economy subsequently contracts.

Minsky's core model is known as "Financial Instability Hypothesis" [FIH], which simply declares stability is inherently destabilizing. "A fundamental characteristic of our economy," Minsky wrote in 1974, "is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles."

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 regulation recently.

Minsky broke down the process from stability to instability into three types of debt phases: hedge, speculative, and Ponzi.

In the Hedge Phase, buyers' cash flows cover interest and principal payments for borrowers who go into debt to buy an asset. This way, the debt is self-liquidating, fully hedged, so it is a stabilizing factor in this economic phase.

The 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 their way to being speculators) are betting on the idea that the nterest rate is not going up, and the value of the collateral will not decline. The longer an economy is stable, the more there is an incentive to speculate, and the more speculative borrowers become.

The 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 MBS. In the fixed income market, it becomes 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.

As opposed to the Speculative Phase, this whole phase is hinged on asset price (or operating profit margin for private equity firms) going 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 future buyers will buy these overvalued assets from them, assuming more new buyers will buy the same assets at even higher prices from future buyers. It is an escalation of buying high and selling even higher.

In this three-step process, the markets become more risky as they appear to become 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 the value further. Eventually, financial systems are inherently susceptible to destructive bouts of speculation. Once the asset prices decline, as presently in the housing market, suddenly everyone realizes that the emperor has no clothes.

Additionally, complex financial derivative products contribute and accelerate this destabilizing process. Minsky indicated that banking is a profit-seeking business, "Bankers are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market". Well said. Investment banking is basically to "innovatively" package and securitize assets acquired, and then to market and sell them to unsuspicious investors at profits.

However, I am sure in 1970s, Minsky would have never imagined the level of "innovation" from investment banks creating complex financial instruments such as mortgage backed securities [MBS], collateralized debt obligations [CDO],, and CDO tranches, let alone CDO-squared (tranches from CDO tranches), CDO-cubed (tranches on top of CDO-squared), or the most abusive, credit default swaps [CDS]. The greater the layers of derivatives on top of each other, the more sensitive they are to any tiny change in the underlying variables and assumptions. No wonder many AAA rated CDOs have only 50% rate of recovery, and everything else including AA and single A is pretty much all wiped out.

There is no doubt that we are in the reverse Minsky process, with asset prices falling and collateral being wiped out, risk premiums moving to the stratosphere, deleveraging everywhere, lack of lending, no refinancing, and the economy contracting in jobs, income and spending. We just hope that hyperinflation like 1970s doesn't join this ongoing party at the worst possible time, and also that the present reverse Minsky process is not going to be as long as the forward process.

Comments

[Eric Fox:]

Minsky's theory does have some applicability to the situation today. However, on average corporate balance sheets are not weak, with high cash balances. There are sectors where that is not true obviously, like Financials and Homebuilders.

2008 May 08 10:45 AM

[Malkiel:]

It's a shame nobody reads Hegel any more now that Communism is done. Making a passing reference to the "dialectic" here would have brought instant nods of understanding from the audience...

2008 May 08 11:18 AM

[caveatBettor:]

I am not wise in Hegelian matters, but wouldn't a dialectical progression of time that resulted in the triumphant end of history determine that we eventually stop reading Hegel?

If so, Hegel is a genius. In order to discredit his philosophy, we would have to read him in perpetuity.

2008 May 08 12:07 PM

[tuj:]

Do you read the rest of the site you contribute to?

static.seekingalpha.co...

seekingalpha.com/artic...

seekingalpha.com/artic...

2008 May 08 02:16 PM

[Jason Rines...:]

Well written and I agree with the theory. Go further down into the theory and you can boil it down to human nature. When stable and we have the basics of life more then covered, we ask 'what else is there to explore, conquer etc'. We fight boredom in other words. I would daresay if we could travel to other worlds right now to explore and colonize, we would not see this kind of behavior like we are now in our point in history. Human nature does not change, at least until we know more about genetics and self-evolve. Until then, we will see one last world war in my opinion as the bored attempt to take more from those whom are not bored trying to become stable.

2008 May 08 05:25 PM

[whidbey:]

You know, price competition in a micro analysis will, in theory, compete away excessive profits leaving only the margin required to attract capital, if investors demand competitive returns from debtors. The role of "excess capital" is not discussed since by definition it can not exist. All excess funds would be unemployed in the economy and preferences shift to leisure v. work. (the idle rich?) Liberals see a role for taxation of "excess capital", but the problem is they do not know what "excess" means. Booms and busts are to be preferred over another clumsy tax system. Stability theory is an illusion leading to dis-allusion. Cycles are us.

2008 May 09 10:45 AM

[Malkiel:]

Caveat, Francis Fukuyama declared an end to history in the '90's but it made a comeback...

2008 May 09 12:51 PM

[Danny Newton:]

I think this gentelman has perfectly described and explained the motivation behind the spending cycles in the Tennessee legislature.

2008 May 09 03:55 PM

[curious cat:]

a little too much mynsky in my julip, thank you. so, he recognized a system that swings to extremes. hey, i was there in the seventies. it looked pretty extreme back then, too. we managed to come out of it without anyone firing nukes.

eventually, we bankrupted russia, mostly because they forgot they could keep printing money, i guess. maybe because we had naked pictures of gorbachov with a bear, who knows? the important thing is that we can go to china for the olympics, thanks to nixon, but does anyone remember him? no, all they talk about is mynsky this and mynsky that. the man died in obscurity, let him rest.

2008 May 11 02:58 AM

[thomast2:]

Thank you all very much for your feedback.

Thanks to a reader, I am just aware of that in early 1990s, when MBS appeared, Minsky anticipated the problems they would cause. In his 1992 article titled: “The Capital Development of the Economy and the Structure of Financial Institutions”, Working Paper No. 72, The Jerome Levy Economics Institute of bard College, he wrote:

"The securitization of standard mortgages was a technique by which Savings and Loans and Mortgage companies originated mortgages which were then packaged as securities for the portfolios of holders such as pension funds, life insurance companies, mutual trusts and various international holders. Because of the way the mortgages were packaged it was possible to sell off a package of mortgages at a premium so that the originator and the investment banking firms walked away from the deal with a net income and no recourse from the holders. The instrument originators and the security underwriters did not hazard any of their wealth on the longer term viability of the underlying projects. Obviously in such packaged financing the selection and supervisory functions of lenders and underwriters are not as well done as they might be when the fortunes of the originators are at hazard over the longer term. All that was required for the originators to earn their stipend was skill avoiding obvious fraud and in structuring the package."

Well, even he put it politely at the beginning of the wild MBS era, he pointed out that the fundamental here was the underlying moral hazard issue. And we saw how moral hazard had caused things totally out of control 15 years later.

2008 May 13 01:10 PM

[jimmy46:]

I was born knowing this.
I just use different terms: GREED & FEAR

The cycle starts with greedy people borrowing as much as the can of OPM <other people's money>.

When the amount of debt that can't be paid back reaches some critical point, FEAR takes over and lenders liquidate the bad debt.
Panic, Depression, Resession.
Changing the name doesn't change the way the game is played.

The government learned a small lesson from the great depression:
people shouldn't be allowed to buy common stock with only 10%
down.
Too bad they didn't extend that lesson to other areas.

Why do people think they should be able to buy a house with nothing down?
It's absurd. At very least, 10% down.

And hedge funds, REITS, and Ibanks shouldn't be able to have 20-60 times leverage.

2008 May 21 11:23 PM