Why Do Bubbles Burst?

Published: Tuesday, 22 Mar 2011 | 10:38 AM ET

Ivory Johnson, CFP, ChFC
Scarborough Capital Management, Inc

The financial markets have spent the last two years uncharacteristically civil, dismissing massive government deficits and loose monetary policy as innocuous byproducts of the economic recovery. Our timeless dance with capital, however, is occasionally contaminated with greed and mismanagement, causing pronounced speculations that increase prices beyond any reasonable measure of value, thereby causing a bubble.

When technology companies had a bright idea in the 1990’s, they were forced to raise large sums of money to bring it to market. In exchange for their investment, venture capitalists demanded shares of stock in the new company, anticipating large profits when the firm went public and traded on a national exchange. Of course, they were not permitted to sell these shares in the first four or five years, and that fueled the unwarranted appreciation of prices.

Richard Bookstaber points out in “A Demon of Our Own Design” that only 10 percent of the company’s shares were eligible to trade, while the other 90 percent had to wait four or five years from the time the internet companies went public before they could be sold. With few shares available, a small demand resulted in large gains. Unfortunately, $50 billion worth of shares became eligible in December of 1999, $65 billion came due in January 2000 and $100 billion was unlocked over the next three months. It goes without saying that the venture capitalists wanted to immediately realize their returns, flooded the market with shares and the dot com crash was in full swing. The collapse of the internet bubble had less to do with economics than it did the exit strategy of investors.

The robust housing market made even less sense, but getting something for nothing was too good to pass up.

It’s important to note that from 2007 to 2010, $1.5 trillion in adjustable rate mortgages began to reset at higher interest rates, a third of which took place in 2007 alone.

Many homeowners couldn’t afford the bloated mortgage payment and foreclosures began to increase, which only led to additional delinquencies when neighboring homeowners were unable to refinance their obligations without the required equity. The housing market didn’t collapse because bank executives suddenly realized that workers who earned $50,000 weren’t qualified to buy a $700,000 home, it was instead a series of scheduled events that triggered the downfall.

A market crisis has two prevailing qualities: tight coupling and interactive complexity. Tight coupling suggests that components of a process are critically interdependent; they are linked together with little room for error or time for recalibration or adjustment. Tight coupling in the financial markets exists because information begets trading and the trades are entered and executed without pause. Once a letter is mailed, the sender can do little to stop its delivery.

Interactive complexity measures the way components of a system connect and relate; their relationships can vary at a moment’s notice. The financial markets have both characteristics, such that one seemingly harmless event can set off a cascading effect which cannot be stopped. Once the venture capitalist began selling their shares and homeowners couldn’t refinance mortgages that served as collateral for large segments of the fixed income market, their respective bubbles quickly burst in a disorderly fashion.

Economic conditions have little effect on the unceremonious bursting of bubbles, as they are more likely event driven. The Federal Reserve currently buys 70 percent of the treasury bonds through QE2, which is scheduled to end in June. Should the Fed relax the printing press, who will pick up the slack and buy our bonds? Perhaps the U.S. Treasury can refinance $5 trillion at the current rate of 1.21 percent over the next 30 months and local governments can do without 20 percent of the stimulus money that’s scheduled to dry up this spring – what a neat party trick that would be. A cynic is nothing more than a concerned optimist who knows something isn’t quite right; don’t be surprised if history repeats itself once more.

Ivory Johnson is the director of financial planning at Scarborough Capital Management, Inc. He is a Certified Financial Planner, a Chartered Financial Consultant and a frequent guest on CNBC. Mr. Johnson attended Penn State University, where he received a Bachelor of Science degree in finance.

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