In a speech last month, Fed Chairman Bernanke asked for a theory on why the housing meltdown had a much different impact on the economy and financial stability than the dot-com bust.
Regular readers know that the FDR Framework is the theoretical construct that easily explains the difference in the impact on the economy and financial stability.
Specifically, the dot-com meltdown occurred in a sector of the financial market characterized by transparency. Since investors had all the useful, relevant information in an appropriate, timely manner, they could assess the risk of the individual stocks and adjust their exposure to what they could afford to lose.
On the other hand, the housing meltdown occurred in the sectors of the financial market that are characterized by opacity. These sectors include structured finance and banking.
Without all the useful, relevant information in an appropriate, timely manner, investors could not properly assess the risk. Instead, they relied on third party risk assessments. These risk assessments came from the Fed and the rating agencies.
By relying on the third parties who under-estimated the risk in the housing market, investors acquired an exposure that exceeded what they could afford to lose. BofA or Citigroup would be an example of one type of investor who concentrated risk and invested more than they could afford to lose. Subprime mortgage borrowers would be an example of another type of investor who invested more than they could afford to lose.
The distinction between losing what you can afford to lose and losing more than you can afford to lose is important.
In the former case, like the dot-com bubble, you are unhappy and have the option to cut back marginally on your expenditures to rebuild your net worth.
In the latter case, like the housing bubble, you are unhappy and are forced to cut back significantly on your expenditures.
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