The Price of Everything - Eduardo Porter [109]
The dot-com crash was preceded by the Asian financial crisis, with subsidiary bubblettes from Russia to Brazil, when a surge of money into promising “emerging markets” abruptly went into reverse. Similar dynamics caused investors to pummel the Mexican peso during the tequila crisis a few years before. Japan’s Nikkei 225 stock index tripled in real terms between January 1985 and December 1989, only to fall 60 percent over the next two and a half years.
The very concept of a financial bubble is three hundred years old, added to the vernacular of finance in 1720 when French, Dutch, and British investors succumbed to euphoria over the potential of new trade routes across the Atlantic—pushing up stock prices before they ended in a precipitous crash. The British South Seas Company was established to buy the debt of the crown. To make money, it was given a royal charter to exploit trade routes between Africa, Europe, and Spain’s colonies in America. Spain and Britain being at war, the routes were of dubious value. But that didn’t stop investors from jumping on the vaunted opportunity. The share price of the South Seas Company soared. So did the shares of the maritime insurers covering its trips. Pretty soon, every investment looked like a great deal. Newspaper ads were offering a chance to invest in “a company for carrying out an undertaking of great advantage, but nobody to know what it is.”
In a move ostensibly implemented to curb the rampant speculation but aimed in fact at protecting the royally chartered trading companies and maritime insurers from competition, in June of 1720 the British Parliament passed a law barring companies that didn’t have a license from the Crown from raising money on the stock market. It also barred chartered companies from changing the purpose of their charter. The law was officially called “An Act to Restrain the Extravagant and Unwarrantable Practice of Raising Money by Voluntary Subscription For Carrying on Projects Dangerous to the Trade and Subjects of the United Kingdom.” But it came to be known as the Bubble Act. And many analysts have suggested that this single act precipitated the bubble’s rupturing. By September it had crashed, and in December, Jonathan Swift penned “The South-Sea Project,” which started:
Ye wise philosophers, explain
What magic makes our money rise,
When dropt into the Southern main;
Or do these jugglers cheat our eyes?
And ended:
The nation then too late will find,
Computing all their cost and trouble,
Directors’ promises but wind,
South Sea, at best, a mighty bubble.
A REGULARITY THAT stands out in these spurts of overenthusiastic invention is the exuberance of the institutions providing finance. This can be prompted by newly discovered investment opportunities—like the Internet or the transatlantic slave trade. But it can also be fueled by changes in the rules governing financial institutions. During the housing boom, financial inventions like floating rate and reverse amortization mortgages were instrumental in bringing less solvent buyers into the American housing market, creating a whole new class of financial product—the subprime loan. In the years of the bubble’s rise, the monthly payments needed to buy a $225,000 house with a standard thirty-year, fixed-rate mortgage and a 20 percent down payment were about $1,079 a month. With an interest-only adjustable-rate mortgage, payments would fall to $663. With a negative amortization mortgage, initial monthly payments could fall all the way to $150.
Mortgage banks wanted to lend but weren’t much interested in their borrowers’ ability to pay. They were slicing up the mortgages and gluing them back together into structured products called “Residential Mortgage-Backed Securities”—RMBS in the jargon—that they sold to other financial institutions, who often had no idea of what they