Bubbles:A primer

Outline:

• The Dutch Tulip Bubble
• Dot.com bubble
• 2008 Financial Market Crisis

The Dutch Tulip Bubble
It is generally thought to have been introduced to the Dutch in 1953 from Turkey. They were different from any other plants present in Europe at the time and thus they became luxury products. It became extremely lucrative to deal in Tulips with a single voyage yielding up to 400% in profits for the sailors. By 1636 it had become the Netherlands fourth leading export.

A non-fatal virus called Mosaic infected the plants causing "flames" of colour to appear on their petals. This increased the rarity of these flowers. Already selling at a premium, the price began to rise dramatically according to different virus alterations. This lead to speculation in the futures markets which saw Tulips exchange hands ten times a day. Garden centres began to filling up inventories for growing season. This further fuelled the prices leading to a 20-fold increase in one month! Soon the mania spread to most of the population with people willing to trade 12 acres pf land or a ten year salary for a skilled merchant for a single tulip.

The crash came, inevitably, when people tried to cash out causing a domino effect where the market collapsed. The Government did try and step in to stem the crash but their attempts were futile. The traders were left with essentially worthless tulips.

Dot.com bubble
Originally, the internet had been developed by the US military who had underestimated demand for it. It users had skyrocketed to 18 million users. It happened to coincide with the low interest rates set by the fed after the Taxpayer's Relief Act of 1997 that left investors hungry for returns. Internet companies started popping up along with buzzwords: "consumer-driven", "new-paradigm".

These seemed to put the investors in a trance as they invested millions in companies that weren't making cash or even worse making losses. The investors expected these companies to grow to Microsoft size as shown by their mottos: "get big fast", "get large or get lost". The thought of tantalising profits made the market lose it's collective mind. That year saw 457 IPO's making most employees millionaires and some billionaires(Mark Cuban).

The music stopped when the companies started reporting huge losses or folded completely. The crash was exacerbated by the 9/11 attacks, the Japan recession caused a sell-off and Greenspan raised interest rates.

2008 Financial Market Crisis
Another low interest rate period which coincided with high global savings rate caused investors to look for higher returns around the globe. Coincidentally a housing boom was taking place in the U.S. Skyrocketing home values caused people to take out mortgages in for spending. This led to the invention of Mortgage Backed Securities(M.B.S) which in some way hid the real risk of these loans. Most lending institutions had lowered their rating standards, they gave out loans to "anyone with a pulse and credit score" - sub prime loans. These were packaged and sold in various financial products such as Collateral Debt Obligations(C.D.O's) and MBS.

When the default rates started to increase these securities essentially became worthless. Some banks were extremely levered up and had significant exposure to the markets. They were facing an insolvency crisis and furthermore a credit freeze. Banks were either acquired like Bear Sterns by JP Morgan or allowed to like Lehman Brothers. Aggressive government actions eased panic and saved the world economic system.

Review

• Bubbles are caused when people are willing to spend more for a product that it's intrinsic value.
• Sometimes the fed can inflate bubble by low interest rates

PS:If you want a more in-depth look of the 2008 Financial Market Crisis watch a movie called The Big Short.