Try to Avoid Minsky Moments

Hyman Minsky was an economist whose theories were largely ignored during his lifetime and forgotten since his death in the mid 1990’s. They were forgotten until they became glaringly relevant during the financial crisis of 2008.

Even today, his work on financial cycles and fragility hasn’t found its way into economics textbooks, but it’s starting to. His work might have been ignored because of his argumentative personality or maybe his ethnicity excluded him from being fully accepted among the elite of economics theorists. I suspect the real reason was that his work went against the thinking of the time, which imagined prosperity without end and demanded freeing the banks and other financial institutions from any restraint.

From what I’ve been able to learn, Minsky’s big idea was that banks and other lenders become increasingly reckless until asset prices eventually collapse. We saw this in the early 2000s when a boom in the US property market was perpetuated by so-called NINJA loans where the applicant had no income, no job and no assets. But immediately the crisis started, getting a bank to lend money was like pulling teeth.

One lesson from this, for any financial system, is that banks should be more conservative when the market is hot, but more liberal in the aftermath of a crisis. That’s not happening in Australia, where the banks have had to increase their capital following the Murray Inquiry. This means they will have to be even more careful about lending money than they are now. So it’s going to be a longer recession here in Australia than it needs to be.

The lesson for me is to take notice when the banks start making it easier to get home loans. Australian banks never offered NINJA loans but there were low doc and no doc loans offered (requiring little or no documentation from the borrower to prove their ability to pay). Next time round they will use different names for these easy loans, it’s a sign the market is topping.

Of course, Minsky wasn’t the first person to notice market cycles. The ancient Romans knew about and documented several. Before the Romans, the ancient Egyptians and Babylonians institutionalised market cycles with their ‘jubilee’ system. A jubilee occurs every 50 years. To mark the jubilee, the Pharoah forgave all debt. If you owed someone money, they could no longer collect it. In this way the market cycles were controlled and predictable.

So Minsky didn’t invent the market cycle, his big idea was fragility. He noticed that the longer the cycle continued and the looser lending practices became, the more fragile the overall market became. So, the longer the cycle and the more stable the system appears to be, the worse it will be when it collapses. Have you ever seen a big tree that got blown over in a storm revealing the termites and fungus that have eaten it out from inside? Me either, but there’s an analogy for you.

How can I apply this idea to trading? What about a company that has long been considered a ‘blue chip’? The share price has risen steadily over many years with a stable board drawn from the elite business circles. Perhaps they’re a bit lazy about defending their interests from disruptors who want to eat their lunch? Perhaps their systems are a bit calcified? Perhaps they’re hiding a few embarassing problems from their shareholders? I think it’s better to buy a good company a little while after it’s started to rise than a famous company many years into its dominance.

For the longest time, Australian banks have been seen as the safe stock market investment. They’re the anchor of any superannuation portfolio, promising a guaranteed dividend. But since Murray is demanding tighter capital adequacy, miners and retailers are doing it tough and the Sydney housing market is looking a bit toppy – maybe now isn’t the time to be buying banks. I hope I’m wrong about that, I bought a fair slice of bank shares just before I came across Minsky’s theories.

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