Bubbles in Credit and Currency: How Hot Markets Cool Down by Brendan Brown (auth.)

By Brendan Brown (auth.)

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26). Given the heterogeneity of opinion which now becomes increasingly evident in the market-place, where should lenders position themselves – with the more optimistic or more sober members of the investing public? In principle the shareholders – actual and potential – in the relevant lending institutions could play an important role in setting the pace. If the shareholders (actual and potential) are ultra-optimistic about the implications of the initial speculative displacement, then the managers (in the lending institution) must tailor their business decisions accordingly in order to preserve their jobs.

It is one thing to enter a long series of gambles which are in no way distinctly timetabled and another to enter the game to take place say within the next three months. In the context of the 1931–3 cold market in US equities, the big events which excited speculation on an exit (from the cold) included successive action by the Federal Reserve to expand the monetary base (the large-scale open market operations which started in Spring 1932), emergency lending by new government agencies (especially the Reconstruction Finance Corporation), and eventually the coming into office of a new Administration (under President Roosevelt) committed to a New Deal.

These included subprime mortgages packaged into CDOs that were in turn split in different “tranches”, the most high-yielding of which had special appeal to hedge fund managers, amongst others). In turn the further revving up (of the financial industry) fed back into more warmth (for the underlying asset market – the residential real estate market in the present example). Sometimes, however, a revving up of the financial intermediary business might have no direct impact on asset markets (in the form of temperature warming).

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