Every mania is based on an illusion

Economic growth, Financial Events

I first wrote about the subprime crisis two months ago, as it began to be noticed in the press. Housing represents an important source of chemicals demand, and so it seemed to have potentially major implications for the chemical industry. Since then, it has become clear that the crisis could have far-reaching implications, if not properly handled. I therefore thought it might be useful to summarise the insights I have gained via a letter to the Financial Times, which they have kindly published this morning. I thought you might like to see it.

From Mr Paul Hodges.

Sir, There is another reason Washington should follow your excellent advice and “resist” the urge to intervene in the subprime crisis (“Subprime loans – subprime solutions”, editorial September 1). This is that the scale of the problem is probably too large for any congressional action to be effective.

All investment manias have their illusion. They then gain in strength as the “fact” underpinning the illusion becomes more widely accepted. Thus large numbers of dotcom investors came to believe that “page-clicks” would lead to profits. So US house-buyers, and lenders, all began to believe that house prices would always rise.

When brokers pushed unaffordable loans to low-earning borrowers, they were sure that increasing property values made subprime loans bankable. The ratings agencies were happy to consider AAA ratings, because their models showed that US house prices hadn’t declined nationally since the Great Depression. And central banks were keeping global interest rates low, thus encouraging investors to chase the higher yields on offer.

The problem is that the whole story turns out to have been an illusion. The S&P/Case-Shiller US home price index is firmly in negative territory, while the number of unsold houses is climbing. A “buyer of last resort”, such as the Federal government, would probably now need to emerge if the situation is to be stabilised.

Even Congress would surely balk at the amount of money that this scale of intervention would require. Unfortunately, therefore, the myth behind the US housing mania is likely to become increasingly transparent, as the fallout from it widens.

Published: September 4 2007 03:00 | Last updated: September 4 2007 03:00

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