Today, the Federal Reserve Bank of Boston President Eric Rosengren gave a short presentation entitled “The Role of ‘Financial Myths’ in the Financial Crisis” that very succinctly covered several of the major “myths” behind recent financial turmoil as well as outlining two very important potential “myths” for the future.In past mega-bubble episodes, key concepts drove enthusiasm and, more importantly, lack of proper evaluation of risk on the part of government and major financial institutions.
The myth of "limited buildable land" worked to fuel a massive property bubble in Japan in the 1980s that, after peaking out in 1990, has been on a steady decline ever since.
The “dot-com” bubble in the late 1990s was pumped primarily by the concept that valuation fundamentals didn’t matter anymore and that all that was important was the popularity of the various internet companies, a myth that was put to rest when tech stocks topped-out in early 2000 and crashed hard literally wiping out all the gains of the prior 5 years.
The Great Housing Bubble was, particularly for financial institutions, driven by the basic concept that nationally, home prices simply don’t decline in the United States.
While that was more or less true for the period before 2006, professional analysts missed the fact that national home prices had seriously overshot any semblance of fundamental valuation leaving open the very real possibility that what was considered impossible would actually come true.
As home prices peaked in the U.S., banks quickly began to realize that they had overestimated the value of diversification of their real estate related holdings and pulled back on lending and other forms of participation further exacerbating an already collapsing situation.
As the above list shows, myths can infect just about any asset class affecting property, equities and likely just about any other market where unusual performance needs to be substantiated in order to maintain the status quo.
Rosengren goes on to cite two myths that may be shaping up in the wake of the financial crisis, namely the plight of European sovereign and U.S. state debt.
Both issues are essentially functioning with the same potential myth, that is, that both insolvent European countries like Greece and Ireland and insolvent states like Michigan and California could fail to meet their debt obligations requiring restructuring WITHOUT causing larger fallout to the global and national economy.
While it would not be unusual for this myth to have widespread faith given the massive rescue operations engineered by the European Central Bank and the Federal Reserve during the worst of the economic crisis, many believing that the authorities would stop at nothing to contain fallout coming from massive “too big to fail” situations, it may inevitably turn out that these cases of massive insolvency have no easy solutions and that widespread fallout is inevitable.
