We know quite a lot about how financial bubbles start. First, there is a macro-economic setting which almost always has the same characteristics. The economy is seemingly in good shape. Economic policy is expansive. It is easy to get hold of credit. It is cheap to borrow. In addition, we usually have some macroeconomic imbalances, such as budget or current account deficits, which means that there is plenty of money in circulation in the economy.

When times are good and it’s cheap to borrow, what then? Well, it means credit expansion right across the board. But in one particular asset class, credit is expanding more than average and, consequently, the price of the asset rises very much and in a very short time. The price of high quality commercial properties in Gothenburg, the most tight real estate market during the late 1980s, rose in real terms by almost 200% from 1987 to 1990, when the bubble burst and the Swedish real estate crisis, and soon thereafter the banking crisis, became visible to all.

Naturally, the bankers in charge, and the bank managers lending in the business frontline, have the key if we want to avoid a bubble (and in the next step a financial crises). For bubbles does not build up without credit. To my knowledge, a financial crisis has never, at least not in modern times, occurred without extensive credits involved. And credit at reasonable prices.

Why is credit flowing abundantly?

Why don’t the bank managers say no? Why do they continue to increase lending? According to the literature, there are at least five reasons why bankers do not say no to new credit in a buoyant and expanding macroeconomic setting.

First, at the time when the credits are granted there are no signals of over-valuation of the critical asset. During the crucial three years before the Swedish banking crisis, 1987-90, the property valuation agencies consequently told the Swedish banks that the enduringly increasing prices on commercial property were justified. And in the current crisis, the U.S. rating agencies, Standard & Poor, Moodys and the other, gave high ratings (AAA, etc.) to the so-called structured products, including to the assets based on sub prime loans. In both cases the valuations appeared to be completely out of touch with reality.

Second, the supervisory authorities have nothing to say on the rapid increase in lending. Banks and other financial institutions are sensitive to what the regulator, or the central bank, thinks and says. But there are no signals from either. In Sweden, The Financial Supervisory Authority [Finansinspektionen ] and the central bank [Riksbank] in the late 1980s had no objections to the banks’ rapid credit expansion. And speaking of the ongoing financial crisis, Federal Reserve in practice encouraged U.S. banks to take part in the increasingly hectic lending to housing until the bubble burst, and that includes the so-called sub-prime loans, the loans that eventually proved to be the very origin of the crisis.

Third, there is a high degree of herd instinct in the financial sector industry. All banks, all investment banks, all hedge funds and all other shadow institutions, seems on the whole to do as all others within its category do. Of course, there are occasional exceptions. But the prevailing herd instinct creates in the industry as a whole a kind of uncritical approach to the weak signals of higher risks that do exist, and the frantic lending will continue (on the implicit grounds that every institution still behave the same way).

Fourth, business is excellent. Remember that one of the basic conditions for a bubble to develop is that times are economically good. Typically, the stock market is in an upward trend, unemployment is low and consumption is high. In short, there is optimism in the economy, even euphoria just before the bubble bursts. And banks and other financial institutions earn a lot of money, maybe more money than ever before, like the Swedish banks did previous to the crisis of the 1990s. And the global financial industry has never had higher profits than during the ten year period from the late 1990s up till the outbreak of the current crisis in late 2007. In such an environment, before the bubble has burst, there isn’t much room for reflection, it’s business as usual.

Fifth, the banks and the other lenders don’t have the accurate understanding of risk. On the formation of a bubble there is an absence of risk culture in the financial system on the real critical point, i.e. in understanding how risk is being built in one decisive asset. For example, in late 1980s the Swedish banks lacked a risk culture that could have told the responsible bank executives (and I was one of them) that the market price, the value, of an attractive commercial property can actually be halved in a very short time, and make fool of all the risk calculations made by the bank. We simply didn’t think the unthinkable. For decades, the Swedish banks were accustomed to negligible losses on the financing of commercial property. That experience proved to be worthless, and we didn’t realize it until it was too late. It also meant that risk wasn’t given the right price. In other words, the lending rates for loans secured by commercial real estate were far too low.

Similarly, one can dissect the cause of the current crisis. There was no risk culture in the financial system in the U.S., Europe and elsewhere which made it possible to understand in advance that the global spread of risk through structured products could lead to a general crisis of confidence in the system, and in the next step to a liquidity crisis. On the contrary, everybody seemed to think that the broad spread of risk was rather positive. However, the structured products sold to investors around the world was so complicated that very few really understood what they had bought – and what kind of risk there were in the asset they had added to their balance sheets. When uncertainty spread like wildfire in the global financial community late summer last year, confidence on the interbank market was lost in just a few weeks. We can safely assume that before September 2008 no insider understood that there was an imminent danger of total collapse in the global financial system in the sense that the interbank market would stop working – and quite soon thereafter bring many banks and other financial institutions to bankruptcy. Now the financial system in general, and the interbank market in particular, did escape from disaster with a cry of distress. But for a few days in October last year no one in the industry could be sure what was going to happen.

Is this the whole truth? Do these five reasons explain in full why not the bankers said no? Yes, judging by the academic literature, different mixtures of these five reasons explain excessive lending when a bubble is building.

Nevertheless, I think that a piece of the puzzle is missing.

As long as the music plays, you will dance

The Swedish banking crisis in the 1990s had a peculiarity which does not apply to the current crisis – no one foresaw the crisis. Before autumn 1990 when the bubble burst, no person with authority in real estate and banking had in public said that the banking industry, and the commercial real estate companies, were heading for economic disaster. The valuation agencies had not done it. Nor the Financial Supervisory Authority and the Riksbank, nor the Finance Ministry.  And before September 1990 one couldn’t find any clear statements of banking and real estate savvy professors, journalists or other commentators saying that we were building up large risks in the balance sheets of the banks and finance companies. Even the stock market was blind to what was going on. It wasn’t until the summer of 1991, several months after Nyckeln [a finance company] went bankrupt and the bubble burst, that the bank index started to decline against the general index for the Stockholm Stock Exchange. It was, in other words, only at that time, the stock market had discovered the ongoing banking crisis. Stock markets are usually said to be good at foreseeing things. It didn’t work this time.

It is also worth considering that there were only professionals involved in the Swedish banking and real estate crisis. The owners of commercial properties are typically big corporations run by professional people. Only a negligible part of the commercial properties were owned by individuals. It’s different with the current sub-prime crisis. It is about housing, about ordinary people who buy and mortgage their homes.

There is also another difference. In the U.S. there were a number of authoritative people who clearly, several years before the crisis, described in books, in articles and in other ways, that a financial bubble was building in the housing market. Robert Shiller, economics professor at Yale, is probably the most well-known. He warned in his book Irrational Excuberance from 2005 for what was going to happen. He talked explicitly about a bubble in the U.S. housing market. And he presented, among other things, an eye-catching chart of the housing price developments since 1890 (see attached diagram). The message in the chart is crystal-clear – this cannot continue, the housing bubble is going to burst soon. Moreover, his message was very attentive.

It means that there were many directors and executives in the U.S. banks and other financial institutions who knew that there was a housing bubble in the pipeline and that it was a matter of time before it would burst. Yet, as far as I know, not any U.S. leading financial player ended the financing of, and the trade, in structured products. By and large, business as usual continued until the autumn of 2007, several years after Robert Shiller and others had sound the alarm. How does it come? 

My hypothesis can easily be formulated as follows: The banker who actually understands what’s going to happen cannot change anything for: As long as the music plays, you must dance. If you don’t want to dance, you must leave, or damage your career. It’s possible that persons who haven’t worked in a financial institution have difficulties to understand that it actually may function that way. But so it does. An organization “at top gear”, which make more profitable business than perhaps ever before, who haven’t heard of any objections to their businesses from the authorities , such an organization will, literally, dance until the music stops. The manager who tries to block this momentum won’t succeed. Only a convinced leader at the top and a united board can go against the tide. It’s more in theory than in reality that such a thing is going to happen.