Tulips & Mortgages: Centuries apart, and yet eerily similar

From time to time, an asset, or a class of assets, will become so popular among investors that its value will grow to exceed the inherent value of the asset.  This event is referred to as a financial bubble, as it is perceived that values become over-inflated, and must eventually deflate.  Historically, this has happened dozens of times to a greater or lesser extent, with the best remembered occurrence being the Internet Bubble of the late 1990's. 

The first recorded bubble occurred in the tulip trade in Holland in the early 17^th century.  An affliction struck a very small proportion of the tulip population; however, instead of killing the bulbs, it caused their next flowers to exhibit a spectacular coloring pattern, making the affected bulbs highly desirable.  Very quickly those bulbs began selling for a small fortune, and the owner of the only examples of the most rare of them is purported to have declined a sum equal to the combined annual income of hundreds of laborers for just a single bulb.  Tulipmania was born.  

Over the course of the next decade and more, tulips became the subject of ever increasing trade.  It should be pointed out that the tulip, while now commonly associated with the Netherlands, was then a relatively new introduction to Dutch culture, having recently been imported from the Near East.  The demand for tulips grew rapidly as "investors" saw their contemporaries becoming rich from the trade, and took whatever steps necessary to enter the market.  This market growth provided a stream of "greater fools" who proceeded to pay even more than the inflated prices that had been paid by bulbs' last buyers.  Bulbs which had been previously considered undesirable began to trade frequently, and for ever more exorbitant sums.  Growers even began selling "windhandel", or futures contracts, for as yet ungrown bulbs.  Ultimately, though, in 1637, the last greater fool entered the market, and prices collapsed. 

Many of these same patterns can be found in other bubbles that have happened since.  Development of a bubble seems to begin with a highly desirable asset in limited supply, and, as prices of the `original asset become prohibitive, other, similar assets also increase in value.  Ultimately, those late in arriving at the party wind up holding the least desirable items at the highest prices.  At the tail end of the Internet Bubble, newly released stocks of companies with tenuous business plans and little hope of ever achieving profitability would double, triple, or more on the first day of trading.  

The current mortgage crisis can be traced to the same roots.  This crisis is, however, significantly different in its affect on other sectors.  In Holland, when the demand for tulips collapsed, some investors lost everything, while others had become quite rich.  Ultimately, though, the effect on the country's economy was limited, because the stock exchange and major financial institutions had largely refused to participate. 

After September 11^th, Americans grew wary of travel, especially outside the country, and a new passion for homes and homeownership grew.  This led to an explosion in investment in home improvement, and in the construction of new homes.  Many refinanced mortgages, or took home equity loans, while others took new mortgages larger than their parents could ever have imagined. Just when it seemed that everyone who qualified had the largest mortgage they could take, investors and banks found new ways to expand the pool of eligible borrowers.  They did this just as the Dutch had expanded the market of available tulip bulbs: by lowering their standards. 

Initially, this wasn't a problem for investors and banks.  As hot as the housing market was, many homes were appreciating at 10-20% and more per year.  This made it easy for last year's less qualified borrower to refinance into a better loan, as previously missing equity had now become substantial.  When the lower standard loans proved successful (if somewhat less profitable than hoped due to the early payoff), even more investors and banks jumped at the opportunity to enhance their earnings. 

With these new loans came new ways for investors and banks to maintain a flow of capital.  The original mortgage-backed securities had come about in the 1980s when Salomon Brothers packaged a group of mortgage loans together and sold the right to receive future principal and interest payments on those mortgages.  New types of mortgage-backed securities called collateralized debt obligations, or CDOs, were developed, subdividing the asset into "tranches" based on differences in credit quality or repayment timing. 

Ultimately, though, this home-value appreciation trend was unsustainable.  Investors and banks began to lose huge sums.  Unlike the Dutch, though, the reach of "mortgagemania" went far beyond the taverns and produce markets where most tulips had traded.  3 of the 30 companies that comprised the Dow Jones Industrial Average (pdf) at the mortgage market's peak had major exposure to that market.  Also complicating the current situation is the fact that the underlying real estate assets for mortgages are universally demanded: everyone needs a place to live. 

It is this intimate relationship between mortgages, and the entire stock market, as represented by the three affected Dow component companies, Citigroup, General Motors, and JP Morgan Chase, that has caused the mortgage crisis to be as far-reaching as it is.  Since July 2007, when the first signs of the profundity of the crisis began to surface, investors have demanded as much as a 1% greater yield on mortgage investments than was previously needed, when compared to comparatively risk-free US Treasury notes. 

At present, the mortgage market is still in a state of flux, with announcements of additional underwriting restrictions now a regular occurrence.  Like the Dutch, though, Americans will get past this challenge, albeit with a somewhat steeper slope to climb considering the still increasing quantity of affected loans coming to light.  Adaptation and accommodation will be the keys to a quick turnaround.  Lenders which work to make the most of troubled securities will succeed, while those unable to look past their contracts will be most likely to join their already failed brethren.