Booms, Busts and Herd Mentality

Jan 22
10:23

2009

Jose Roncal

Jose Roncal

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Wall Street, the housing market and the whole economy have all gone from boom to bust. The global economic meltdown is a stark reminder of how giant bubbles tend to over-inflate until they reach critical mass and inevitably dash our hopes and dreamsdreams of comfortable retirements, steady incomes, education for the kids and even roofs over our heads.

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Wall Street,Booms, Busts and Herd Mentality Articles the housing market and the whole economy have all gone from boom to bust. The global economic meltdown is a stark reminder of how giant bubbles tend to over-inflate until they reach critical mass and inevitably dash our hopes and dreamsdreams of comfortable retirements, steady incomes, education for the kids and even roofs over our heads. The current crisis and recession is touching virtually everyone and the pieces are likely to continue falling well into the future.

How do we move forward? If you're looking for a place to put money that promises a decent return, we encourage you to proceed with caution. We also encourage you to read our new book, The Big Gamble: Are You Investing or Speculating? There's an entire section filled with colorful tales of people who were so anxious to receive big returns, they got swept up in herd mentalitya condition caused by the temporary insanity of believing that something that sounds too good to be true, might actually be true. It's a condition that's led to ruin for many throughout history, and human nature being what it is, it's a condition that persists today.

Bubbles and Psychology

Many people are reeling from their financial losses and are in such a fragile state, they're vulnerable to herd mentality and primed for further losses.

Throughout history, a few dramatic economic bubbles have created such financial havoc that they've left us shaking our heads in disbelief, saying, "What were they thinking?" But to be fair, any one of us might get swept up in what former Federal Reserve Chairman Alan Greenspan termed "irrational exuberance" and be tempted to do a little trend-chasing of our own.

So, maybe you didn't get caught up in the tulipmania that swept through the Netherlands in the 1600s, back when a single rare tulip bulb could be sold for the price of a nice little bungalow along a canal in Amsterdam. You didn't get caught up because you weren't there, but where were you during the tech bubble of the late '90s?

If you were to analyze all roads leading up to a bubble, you'd discover that author Peter Garber had it right when he wrote, "Bubbles lie at the intersection between finance, economics and psychology." In this case, the word "psychology" specifically refers to the financial folly of herd mentality. In our opinion, psychology should top that list as the root cause for most of the events in our current crisis.

The tech bubble is still fresh in our minds, but today the term bubble refers to the housing bubble of 2004 to 2007. It's the bubble that led to sub-prime mortgages and triggered the unprecedented series of events that could end up costing the U.S. Government (taxpayers) $7.76 trillion dollarsnot counting billions more in lost investments and corporate failures.

Housing Slump and Bad Mortgages

How did a bunch of bad home loans push our financial system to the edge of a cliff and plunge the world into recession? It's complicated, but we'll try to simplify it.

The housing market was sizzling hot a few years ago. In some areas of the country, home values were escalating at unsustainable double-digit rates. With the Bush administration pushing the "Ownership Society" meme, owning a home was becoming an entitlement and everybody wanted in.

Wall Street and lending institutions were eager to oblige. So-called ninja loansthe lowest quality of sub-prime loanswere extended to people who had no income, no job, no assets. The housing bubble was underway.

In saner times, borrowers might have stopped to realize that they were getting in over their heads, especially with adjustable rates that would eventually shoot up. But herd mentality rationalizes with: "if lenders are making it this easy to own a house, and if everybody else is buying, I'd be crazy to miss this opportunity."

Of course, most lenders believed that housing prices would keep rising, so relaxing their standards didn't seem so risky. But by mid-2007, the housing bubble was turning into a housing bust and the financial downfall began. Sub-prime borrowers defaulted leaving behind empty houses and unkempt lawns, thereby reducing property values and adding to the market decline.

But it was Wall Street`s securitization of these mortgagesmortgage-backed securities that eventually turned the housing slump into a full-scale banking crisis. Major brokerage firms had bought up risky mortgages, sliced and diced them, then bundled them into packages and sold them as securities. Course no one really knew what these securities were worth, not the sellers, and certainly not the buyers.

The situation might have been more manageable had it not been for some other murky contracts related to the securitiescredit default swaps complex and cryptic documents sold as insurance policies to protect the underlying value of the mortgage-backed securities. They were such meaningless contracts, they lead to the collapse of companies that backed them, including AIG, the nation`s largest insurance firm.

Consumers Share the Blame

We can't blame everything on Wall Street. Herd mentality has lulled the consuming public into irresponsible and compulsive shopping habitscharging more and saving less. They have created their own individual debt bubbles and charged themselves into a credit crisis they can no longer manage. Between 1990 and 2007, credit card debt jumped from $214 billion to $937 billion, while our nation`s savings rate is the lowest in the developed world.