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How are bubbles formed? :: Business Line

You must have heard investors or other stock market experts speak about bubbles with a troubled look on their faces. The expressions imply that bubbles bode ill for the asset in which they are forming. So what does the word ‘bubble’ mean in the financial context?

A bubble develops when the price of an asset — stock, bond, housing or a commodity such as gold or oil — starts rising and overtime shoots up to unjustifiable higher levels. That is, the surge in prices cannot be explained by the fundamentals of the asset.

For instance, the price of certain stocks may rise to very high levels that cannot be reasoned out on the basis of the current performance or the future prospects of the companies concerned. Then comes the bubble burst with the market undergoing a correction in the form of a sharp fall in the price of the asset. Usually, a bubble takes a while to grow while the crash happens relatively faster.

While bubbles have developed in a variety of asset markets, it is the ones in the stock markets and real estate markets that have had a larger disruptive effect. As regards the impact of a bubble burst, it may be restricted to the particular market or it may engulf the larger economy. For instance, it was the stock market that bore the brunt of the burst of the dotcom bubble in early 2000. But the burst of the US housing bubble (2003-07) precipitated into a wider financial crisis in 2008, the impact of which was felt by the US and the world economy for years to come.

FUELLING MARKET

Multiple factors are believed to work towards fuelling a market bubble. Investors with an extremely optimistic outlook, herd behaviour, low interest rates and easy credit availability are some of these.

The dotcom bubble of 1997-2000 saw investors pumping in money in hoards into the stocks of new Internet companies driving up their prices to sky-high levels. A strong belief in the growth potential of these new technology companies drove investors to even ignore company financials. But overtime, it was realised that many of these companies did not have sound businesses. Then came the panic selling making the market crash. Many of these companies went bankrupt and investors lost large amounts of money.

Likewise, in the US housing bubble, housing prices rose rapidly led by low interest rates and the easy availability of credit (banks lending money to even those with poor credit record). Given the limited supply, housing prices began too shoot up, making it an even more attractive investment.

Banks packaged their housing loans into securities (mortgage-backed securities) that were sold off to investment firms such as Lehman Brothers who sold them off to those keen on investing in the US. In the process, while banks passed off their lending risk, investment firms were now earning returns from the ‘safe’ housing sector. All was well, till the housing prices started to decline (falling below the value of loans taken) and interest rates began to rise making the not-so-creditworthy borrowers to default on their loans.

Given the link formed by mortgage-backed securities between the housing and the financial sector, the burst of a bubble in the former created a crisis in the latter with investment firms going bankrupt and markets crashing as investors pulled out money.

PREDICTING MOVES

Given the adverse consequences that follow the bursting of a bubble, is there a way to find out a bubble in the making? It is widely believed that it is only in hindsight that one can know that there existed a bubble, which is often confused with a market boom. It is difficult to figure out whether a rise in prices is driven by reasonable expectations or not. There are others who, however, claim that development of bubbles can be identified with some of them already warning of another US housing bubble on the horizon.