Fintech

Chapter 5: Bubbles, Panics, Crashes and Crises

Bubbles, Panics, Crashes and Crises

Why study?

Could Fintech proliferation cause systemic failure?

Could Fintech help prevent systemic failure?

Incidence of B/P/C/C
Not so easy to define:
Bubbles can be characterized as a rapid escalation in asset
prices in excess of perceived valuations. Bubbles have been
observed in many markets and are most seriously of concern in
the big asset classes of equities, bonds and housing.

Fisher Black defined an efficient market as one in which price is

within a factor of 2 of value. So, if value is $100 million, an
efficient market would value the company within a range of $50
million to $200 million. This is an intuitive definition that
requires a reasonable range rather than a pinpoint value, but it
begs the question of how do we assess value?
Schiller on Fintech and bubble risk
2013 Nobel lecture, Robert Schiller (Schiller 2015): new financial
innovations might help in an imperfect financial world… reasonable
to accept the risk of bubbles:

“Such innovations can and certainly will cause some runaway

bubbles and abuse of ignorant investors. On the other hand, if
designed and regulated right, they could create a new way of
arousing animal spirits and focusing informed attention on venture
investments. Crowdfunding may be more effective in funding ideas
that are hard to prove; whose payoff is not immediate; that have a
subtle social, environmental, or inspirational purpose beyond mere
profits; and that only a small percentage of the population is
equipped to understand”.
 Selected Notable Events

Tulip bulb craze in the Netherlands 1637

South Seas Bubble in the UK 1720
The Mississippi Bubble in France 1720
Bank Panic in the US 1819
Panic of 1907
Great Depression 1929
Oil Crisis Global 1973
Savings and Loan Scandal US 1986
 Selected Notable Events

Wall Street Crash 1987

Mexican Crisis 1994
Asian Financial Crisis 1997
Russian Financial Crisis 1998
Tech bubble 1999-2000
Argentina Default 2002
Global Financial Crisis 2007-9
Greece bailout 2010-?
Other Recent Examples
Long Term Capital Management. “best and brightest” of
Wall Street and academia, including Nobel laureates. In
1998 it lost $4.8 billion and required a bailout.
Amaranth. This hedge fund lost $5 billion in 2006.
The 2010 “Flash Crash”. Algorithms operated by high
frequency traders caused U.S. equity markets to drop
600 points in 5 minutes.
The London Whale. Trading in Credit Default Swaps
causes J.P.Morgan’s London office to suffer losses of $6.2
billion in 2012.
Tulipmania
South Seas Bubble
Mississippi Company
Bank Panics
1870-1907- one panic every 18 months

Individuals lose savings

Loss of confidence in banking system

Banks liquidate loans: banks and businesses fail

Tight credit

Economy underperforms: Output and Employment suffer

Panic of 1907
October 1907: DJIA fell 50% in 3 weeks

Failed attempt to corner United Copper

Credit impact: Knickerbocker Trust

Cascading asset sales and defaults

J.P. Morgan leads rescue

Meeting on Jekyll Island, Georgia leads to 1913 founding of Federal

Reserve System
Great Depression
Roaring 20’s

Stock market doubled in 1928, and 1929

October 24, 1929: Black Tuesday, DJIA drops 25% in 2

days

4 related crises: stock market crash; bank failures;

international monetary collapse; decade of hardship
Dow Jones Industrial Average 1920-1940
Great Depression
Unemployment 25%

15 million people out of work (this would be equivalent to

roughly 40 million people looking for work today)

World GDP drops 15%

Agriculture prices weak/farms fail

Bank failures: 5000 in the 1920s, 8000 in the 1930s

Great Depression
1933 Bank Holiday: FDR closes banks for 3 days

Smoot Hawley Tariff Act and drop in global trade

Fed restrictive in 1928/29 and in response to

international forces

Slow, long recovery: GDP takes decade to return to

1929 level. Unemployment 15% in 1941
Great Depression
Regulatory Responses

Securities Act of 1933

 First federal law designed to ensure transparency in financial statements

for investors and to prevent fraud and misrepresentations.

Banking Act of 1933

 FDIC
 Insures deposits
 Glass Steagall
 Separates commercial banks from investment banking
Great Depression
Regulatory Responses

Securities Exchange Act of 1934 established the SEC

Banking Act of 1935 reformed the Federal Reserve

System putting the conduct of monetary policy in the
hands of the Board of Governors of the Fed.
Stock market indicators 1980-1987
Stock Market Crash of 1987
Bull market of the 1980’s

October 19, 1987: 22.6% one day decline

S&P 500 During 1987 Crash

Source: Carlson 2007

Causes

Dominance of institutional investors

Electronic order systems., large size trades

Program trading

Tape delays

Portfolio insurance

Index arbitrage
Dotcom Crash 2000
Nasdaq 1000 to 5000 second half of decade 1990s

Tech stocks 1999-100% gains; 2000-50% losses

New buzzwords: networking, information technology, web management, software

development

1999- 546 tech IPOs

Average 1st day gain 68%. 117 IPOs more than doubled on 1st day

VA Linux IPO gained 733 %

Bubble burst: March 2000 to October 2002 Nasdaq lost 78% of value
All-Transaction House Price Index for the United States
Global Financial Crisis
Housing boom 1990’2-2006

Bubble in housing prices

Financial innovations in derivatives and ABS

Agency problems

Criminal behavior

Risk management failure

Inadequate regulation

Community Reinvestment Act

Fed overly stimulative

Global stock markets losses
Housing collapse: evictions, foreclosures
Prolonged unemployment.
Business failures
Household wealth lost trillions of US dollars
Great Recession of 2008–2012
European sovereign-debt crisis
Dow Jones Industrial Average 2007- 2014
Derivatives Contributing to GFC
MBS

CDO

CDS
Agency Problems
Principal (Investor) depends on and is at risk to Agent
(Mortgage Broker)
Banks pass on risk, lose incentive for credit diligence
Rating Agency conflicts
Information problems – Investors have misleading,
inaccurate credit information
Common Features: Run-up and Crisis
Phases
Runup
disruption- new innovation in tech or finance
 Base of support
 Spreading interest

Euphoria, media interest

Boom
 Agency issues
 This tech is different

Profit-taking
 Early entrants sell interests
Crisis
Where did buyers go?
 Minsky moment: identifiable incident/sudden crash
Boom Phases

Source: Jean-Paul Rodrigue

Fintech Issues
Fintech risks
Fintech (tech) stock bubble risk

Cryptocurrencies

Market place lending

Securitization of MPL loans

Fintech opportunities
AI
Democratization and decentralization of finance
The Financial Stability Board 2017
Monitoring operational risk from third-party service providers
Mitigating cyber risks
Monitoring macrofinancial risks
Cross-border legal issues and regulatory arrangements
Governance and disclosure frameworks for big data analytics
Assessing the regulatory perimeter and updating it on a timely basis
Shared learning with a diverse set of private sector parties
Further developing open lines of communication across relevant
authorities
Building staff capacity in new areas of required expertise
Studying alternative configurations of digital currencies
Mark Cuban (2015)
current enthusiasm for tech stocks look a lot like the dotcom
bubble of 2000.
earlier investments were in public markets as opposed to a high
percentage now in private markets where prices are opaque and
buyers and sellers cannot meet as easily.
“Back then…the companies the general public was investing in
were public companies. They may have been horrible companies,
but being public meant that investors had liquidity to sell their
stocks.”
Are Cuban and others right about tech stocks overvalued or is
there a new paradigm?
And if they are right is this an acceptable risk?