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Essay: The dotcom bubble or housing bubble

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  • Published: 21 June 2012*
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The dotcom bubble or housing bubble

Dot.Com & Housing Bubbles

The dot.com bubble or housing bubble is one of the economic phenomena or lack of a better word an abnormal market trend the financial market concepts fail to anticipate and forecast. It is an economic mishap that results in trading high equity volumes at prices that are considerably at variance with their intrinsic and fundamental values”. It is a trade in stocks or assets with inflated values While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty, speculation, or bounded rationality.And the economic reality is that prices under such circumstance fluctuate erratically, and complicated to predict from the normal supply and demand mechanism. Often time this economic mishap become identifiable only in retrospect, when or after prices begin to drop precipitouly with the influx of market participants. The resultant drop in prices which is now characterized as a crash or a burst in the economic and financial circles indicates an end of a market run seen as a positive feedback that is beyond the normal market mechanism that determines the equilibrium price under normal market circumstances.

The effects of economic bubbles are generally impact negatively on the economy because they tend to cause misallocation of resources into non-optimal uses. In addition, the crash that usually follows leading to precipitous droping of the fair value of assets can destroy a large amount of wealth and causing continuum economic malaise to investors and public confidence as whole. A protracted period of these occurances can simply prolong the resultant adverse economic downturn and price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate through the corridors of other financial markets as evidenced by both dot.com and housing bubbles.

When the bubble inevitably bursts, enterpretueuers and other investors who hold on to these overvalued assets usually experience a feeling of lost and tend to cut discretionary spending which hinders economic growth or, worse, exacerbates the economic slowdown. In an economy with a central bank, the bank may therefore attempt to keep an eye on asset price appreciation and take measures to curb high levels of speculative activity in financial assets. This is usually done by increasing the interest rate (that is, the cost of borrowing money) (Historically, this is not the only approach taken by central banks.

While it is not clear what causes bubbles, there is evidence to suggest that excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the Federal Reserve in US and Central banks in other jurisdictions, which asset markets are then caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation. For example, Axel A. Weber, the president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles." According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate.

In an essence, economic bubbles often occur when too much money is chasing after too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamental values to an unsustainable level. Once the bubble unravelled the central bank is left with the work to reverse its monetary regulations and soak up the liquidity in the financial system or risk a collapse of its currency. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Advocates of this perspective refer to (such) bubbles as "credit bubbles," and look at such measures of financial leverage as debt to GDP ratios to identify bubbles.

Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset, and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value. There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".

The one true constant with all bubbles is that they create excess demand and production. Once the bubble deflates, which it always does, a contraction or consolidation has to occur to alleviate the excess. And these were what the effects the Dot Com Bubble and the current Housing Bubble brought about. In both cases there were huge consolidations, bankruptcies, and deterioration of asset values.

The "dot-com bubble" was a speculative bubble covering roughly 1998-2000 (with a climax on March 10, 2000 with the NASDAQ peaking at 5132.52) during which stock markets saw their equity value rise rapidly from growth in the more recent Internet sector and related fields. While the latter part was a boom and bust cycle, the Internet boom sometimes is meant to refer to the steady commercial growth of the Internet with the advent of the world wide web as exemplified by the first release of the Mosaic web browser in 1993 and continuing through the 1990s. The Internet may well be the most interesting phenomena to have happened in many years and undoubtedly, its benefits are innumerable making people’s lives a whole lot easier. According to Robbani (2001), the development and growth of the Internet was the best ground-breaking event to ever take place in the world today and asserted that it would be unimaginable to do anything without Internet access, for it has become an integral part of most people’s lives.

As many start-up dot-coms made their way into the new-economy, the belief that the Internet was revolutionizing the way to do business started to gain strength encouraging many more companies to go on-line, even traditional companies setting-up online branches and a great many went public, with an “obvious psychological effect… on all the traditional business is the thinking that ultimately people will run all of their daily activities by using Internet.”The period was marked by the founding of a group of new Internet-based companies commonly referred to as dot-coms. Companies were seeing their stock prices shoot up if they simply added an "e-" prefix to their name and/or a ".com" to the end, which one author called "prefix investing". Initial Public Offerings (IPOs) for dot-coms skyrocketed during this boom era. One start-up (Globe.com) for example was worth more than USD80-million on the first day of offering (Byrne, 2001). Other net start-ups were also bagging similar bargains. Prices were soaring because speculation had that, e-commerce was the new way to do business, thus Internet companies were projected to make high returns in the future. This however, did not happen. The NASDAQ took a steep plunge after March 2000

2 (Fox, 2000), and this led to the downfall of many Internet companies. It marked a

black era in the world of business; the beginning of the end for the dot-coms What happened to the e-economy was typical of an economic bubble. The Internet bubble emerged because investors overvalued the future earnings of Internet companies (Glasner, 2000)

Housing bubble also in the same fashion was characterized by rapid increases in valuations of real property until they reach unsustainable levels relative to incomes and other economic elements. Some believe the crash of the dot-com bubble mutated to the housing bubble in the U.S.

Yale economist Robert Shiller said in 2005, “Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national obsession is poker.”Ralph Block wrote in 2005: "Many baby boomers appear to have decided that the stock market won’t provide them with sufficient assets with which to retire, and have taken advantage of “hot” real estate markets and low down payments to speculate in residential real estate. The number of homes bought for investment jumped 50 percent during the four year period ending in 2004, according to the San Francisco research firm LoanPerformance."

However, the housing bubble transformed into the current full scale subprime mortgage crisis which started in late 2008. Housing bubbles may occur in local or global real estate markets. In their late stages, they are typically characterized by rapid increases in the valuations of real property until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability. This may be followed by decreases in home prices that result in many owners finding themselves in a position of negative equity—a mortgage debt higher than the value of the property. The underlying causes of the housing bubble are complex. Factors include historically low interest rates, lax lending standards, and a speculative fever.However, a critical look at government interventions and regulation may be at the heart of this problem. Let’s look again at the historical background of the crisis would suffice to give us enough fact to back our assertions regarding this housing phenomenon. The U.S. housing bubble was pumped up, along with the hunt for even greater risk, when the U.S. Federal Reserve Bank, not wanting the market to set exchange rates, cut interest rates to record-low levels. U.S. politicians pumped up risk-taking and housing prices further through deductions, tax benefits for home savings accounts and restrictions on new construction. By means of legislation, subsidies and government-sponsored enterprises, they managed to generate mortgages even for people that the market deemed uncreditworthy. The quasi-governmental institutions Fannie Mae and Freddie Mac developed the securitization of mortgages (allowing lenders to package and sell mortgage debt, thus replenishing their capital to make further loans). Wall Street fell madly in love with these mortgage-backed securities once the credit-rating agencies — which had been given a legally protected oligopoly by the government — declared them to be safe investments. The central position of Fannie Mae and Freddie Mac reinforced confidence that the government would intervene if the housing market ran into trouble. The Fed’s safety net and the federal government’s deposit insurance made banks dare to take big risks because they could privatize any gains and socialize any losses.

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