By Brendan Brown (auth.)
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Additional resources for Bubbles in Credit and Currency: How Hot Markets Cool Down
These speculators at the rear margin would not typically be embraced by lending institutions. The lenders would be sensitive to the risk of the downtrend in prices continuing and wiping out the value of the loan and in the case of a panic they would be running scared (closing their loan shutters). That is a different dynamic to that of a warm market where the speculators at the lead margin of the dominant mood (optimism) are adding to positions in assets which are normally expected to provide compensation for risk (positive risk premiums) and drawing on credits from lenders influenced in part by similar optimism (possibly beyond rational bounds as we have seen above).
A high loan to asset value ratio (and low credit spread) encourages the participation of speculators who regard (correctly) their borrowing as effectively the same as writing a cheap put option at a high striking price (only a small margin below current price) on the real asset they are purchasing. Such speculators may well regard the actual consequences of loan default as small, not least because they have fenced themselves in from recourse (by the lender) to other parts of their portfolio. How asset market warmth can fuel irrationality in credit market In principle, it could be that the irrationality on occasion associated with the credit cycle (sometimes described in its boom phase as a “credit bubble” if indeed the temperature in the credit markets – or one segment of these – reaches high level) reflects the failure of one key sub-sector of the equity market, that for lending institutions, in the context of warm conditions in an important real asset market, to trade on the basis of appropriately cautious risk calculations (as just outlined).
In normal times (under temperate market conditions – for equities and other real assets) banks become more 24 Bubbles in Credit and Currency willing to lend during a strong phase of the business cycle when profitability is high and rising and real asset prices are firm. There is nothing irrational about that. The lenders realize there is some probability of an eventual cyclical downturn but their gains in the meantime (in terms of margin between borrowing and lending rates and of other fees) should more than compensate for the expectation of some rise in bad debts in an eventual cyclical downturn (which should already appear in the far distance as viewed by decision-makers with good probabilistic vision).
Bubbles in Credit and Currency: How Hot Markets Cool Down by Brendan Brown (auth.)