It Takes a Bubble

In the clear light of the post-subprime bubble, we can see how remarkably similar it was to the dot-com bubble that burst just before it.

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Say what you will about economic bubbles, it’s only after they burst that you realize how badly they were distorting our collective perception. In the clear light of the post-subprime bubble, we can see how remarkably similar it was to the dot-com bubble that burst just before it. Most notable is the use of financing vehicles to mask true value. Enron’s special-purpose entities, which hid the corporate parent’s underlying liabilities, are first cousins to the collateralized debt obligations that tucked sketchy mortgages into highly rated (and poorly understood) securities, where they ticked away and ultimately exploded.

The bubbles also floated aloft on a disconnect between risk and executive compensation. The dot-com bubble exposed the flaw in stock options: executives received enormous rewards for pushing up stock prices but lost nothing if they destroyed value instead. Accordingly, many took shortsighted measures to pump up results; others resorted to fraud. Executives, in effect, had no “Skin in the Game,” a problem many companies are trying to correct now by urging or insisting that top officers buy stock.

There’s a key difference between the two bubbles, however: when dot-coms fizzled they left a lot of 20-somethings realizing just what “rich on paper” really means. The mortgage crisis, in contrast, continues to unfold in wider and wider ripples throughout the economy. Bankers made fortunes buying (with other people’s money) and selling overvalued securities with little downside risk to themselves. The broad impacts of the downside risk to those who must pay for them are analyzed in “Atonement: How companies are paying for the transgressions of the banking sector.”

Eventually, the sun will glint brilliantly off the expanding curve of yet another inflating bubble. Let’s hope that when that happens we aren’t blinded by the glare.

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