The Kindleberger model of crisis

Kindleberger's argues that there are three phases to a price process that occur during a financial crisis – mania, panic, and crash. This is the more traditional view relative to other analogies such as a hangover or grief “model”.

Manias take place during a business cycle expansion when economic agents switch from liquid to real or financial assets. The expansion changes risk perceptions and causes investors to believe that returns will be higher than historical patterns. Over-optimism about a business expansion coupled with cheap credit is the magic elixir for a mania. The asset mania does not have to be in all markets. It can be localized to markets which are going through large changes or where it is difficult to provide clear valuation. In fact, pricing of new technology is more likely to be mis-valued or have a mania. In the current case, there has not been much history on many new mortgages products and the CBO market is still in its infancy.

The panic phase is characterized by a stampede, a race for changing real or financial assets into money. The demand for liquidity and safe assets causes excessive changes in pricing of the risky asset. New buyers for the assets to be sold have to be given a discount to take on the risk associated with the falling market. In many cases, the stampede can come from a single catalyst, an event that changes the perception on the valuation of the risk assets. The change in perception could be as simple as a change in the price momentum. In the case of housing, a slowdown in the ascent of residential real estate was enough to start to have an impact on the ability of some borrowers to pay for their loans.

Crash is the final outcome of the process preceded by panic and mania. The crash comes when there market becomes a one way bet against the asset. Expectations are all negative and there does not seem to be a reversal in negative fortunes in sight.

These stylized descriptions provide more contexts for explaining a financial crisis but also have a problem of not being precise. What is the difference between a panic and crash? What are the visible signs we have made the transition.

Compared to these phases, a focused model can be summarized in five different, yet relatively contemporaneous stages of displacement, boom, overtrading, revulsion, and tranquility. Having five stages may seem a little better, but again there are not precise definitions for these periods. There is no measure to say how long it will take to move from one phase to another. However, with real estate, the time it will take to resolve the crisis will be longer than for assets that have to be market to market. If there is not forced selling, a home-owner can always wait before realizing a loss The problem with this crisis is that the sensitivity of homeowners to changes in the mortgage rate is greater than what we may have seen in past recession where everyone was locked into fixed rate financial. You can provide any number of descriptions for the crisis, but what is needed are a set of policy alternatives. Solution part of crisis is harder to describe.