A Moment with Minsky

Just as the markets were buckling in mid-August under the threat of a worldwide credit crisis, The Wall Street Journal ran a story about a relatively obscure economist named Hyman Minsky. Although he died in 1996 at the age of 77, one of his theories about the way markets operate is particularly germane to individual investors today.

Many economists believe that markets are essentially efficient—that is, asset prices reflect all available information. Minksy took a different view. He believed, to quote The Journal’s story, “that when times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much.”

The willingness to take risk can even lead to a decision to borrow money to take on more risk (right, hedge fund managers?). Eventually, those investors can’t realize enough gains from their investments to pay for the debt they took on to acquire them. As a result, lenders tighten up and call in their loans. In his book, The Financial Instability Hypothesis, Minsky described this sequence of events as “a collapse of asset values.”

Economists have coined this phenomenon “a Minsky moment.” When it’s really bad, they call it a “Minsky meltdown.” Whether the recent stock and bond market shakeup is a “moment” or a “meltdown” is arguable, but it’s clear that investors have underpriced risk.

Rational markets want to assign a proper value to risk. That’s the whole idea behind a discount rate, which is used in determining the present value of future earnings and measures the risk of receiving those earnings down the road. Let’s say you buy a government bond for $50 and it pays $100 in one year. The discount rate is used to calculate what that $100 would be worth today. The higher the discount rate, the more risk an investor takes on.

If investors take on too much risk and have to sell their risky (and not-so-risky) investments to pay off their debt, the financial markets decline. This phenomenon is evident in the current subprime mortgage crisis, and now economists are paying close attention to Minsky’s somewhat dire theory.

The Heat of the Moment

How does one avoid being caught up in a Minsky Moment? When I look back over our practice at Wealth Enhancement Group, I can think of several times when we were worried about this actuality, but the opposite has also been true: At times, the market has exacted too much risk premium for an investment, making it attractive because of its artificially low price.

For a time in 2002 and 2003, bond profit margins were unusually high. This was particularly true for below-investment-grade bonds known as junk bonds. Many investors bought junk bonds, reasoning that the market had injected too much risk into that sector.

Since then, those spreads have narrowed substantially, with investors “chasing yield” and bidding up the prices of those bonds. Investors aren’t receiving enough reward—or a high enough yield on the bonds, since bond prices and yield move in opposite directions—for the risk they’re taking. In other words, bond investors had pushed corporate bond prices, relative to U.S. Treasury securities, to unusually low levels.