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It's All About Asset Bubbles

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High leveraging is almost always linked to a financial crisis, and we could very well be in the tail-end of an asset bubble.

There's plenty of buzz about asset bubbles lately, given the fact that there are certain similarities between today's financial landscape and the one leading up to the Great Recession of 2008.

An asset bubble - which occurs when the prices of assets spike for an extended period of time and exceed asset values based on fundamentals - makes the likelihood of a financial collapse much more likely, at which time the bubble finally bursts. These so-called "bubbles" require leverage and a certain amount of credit. After all, in order for the prices of various types of assets to skyrocket (including prices of real estate, stocks, and bonds), there needs to be access to credit and the power to leverage.

The most recent financial debacle in 2008 shows just how impactful the bursting of an asset bubble can be in the U.S., and across the globe. Brought on largely as a result of the housing market crash, the financial chaos nearly a decade ago had a significant negative effect on both the U.S. and global economies. As such, economists want to know all they can about asset bubbles, including how they are impacted by high leverage.

Leverage Plays a Role in All Financial Crises, Including the More Recent Great Recession

Leverage allows consumers and corporations to make large purchases that they would otherwise not be able to take on based on their own personal financial resources. While leverage can certainly have some positive effects - such as expanding consumer buying power and giving businesses the chance to finance projects that they otherwise couldn't afford to do on their own - too much leverage can have severe consequences.

Leverage can lead to financial stress when defaults and delinquencies set in. Jobs are lost, corporations and government entities lose money, and even foreign companies can be negatively impacted as a result of trade. When used in excess, a high level of financial leverage has played a key role in various financial crises in the U.S. and across the globe, including the more recent Great Recession of 2008.

In this particular crisis, excessive credit risk-taking by lenders was made much worse by high leverage, which drove the creation and inevitable tumble of the housing price bubble.

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The Great Recession is a prime example of how high leverage can lead directly to the formation and inevitable bursting of an asset bubble.

Throughout the majority of the 2000s, the real estate sector saw significant growth that led to skyrocketing housing prices far past typical inflationary pressures. Mortgage leverage reached historic levels, an effect that was amplified by the securitization of mortgages. The financial sector held a total debt of $36 trillion in 2007, from a much lower $3 trillion in 1978.

Credit default swaps (CDS) also played a key role in the financial crisis from 2008. CDSs were instrumental in helping increase leverage during the housing boom. The amount of leverage in the financial sector grew exponentially as mortgage lenders ramped up their lending and investment institutions borrowed a great deal in order to boost profits on securitization transactions. In fact, leverage ratios were as high as 40:1 among some banks.

By the time the bubble burst, millions of households ended up underwater because leverage climbed so high and housing prices plummeted so far.

The Link Between Leverage and an Asset Bubble Cannot Be Denied

There is certainly a close association between financial crisis and high leverage. Such a link between the two can have incredibly dire consequences if prudent and immediate steps are not taken to attempt to limit leverage. This is why it's crucial to understand the association between both high leverage and asset bubbles in order to avert such situations from having the type of ramifications previous asset bubble bursts have had on the economy.

Selling Off Risky Loan Assets to Optimize Loan Portfolios

While prudent underwriting practices are certainly warranted to avoid the act of overleveraging and thereby becoming vulnerable to the bursting of an asset bubble, lenders and banks need to take precautions. In an effort to retain a highly profitable loan portfolio that's hedged against risk, selling off risky assets in favor of more robust ones is warranted.

Optimizing loan portfolios by selling risky assets and acquiring more sound, short-term assets is the way to go, yet it should only be done with the help of a reputable asset management company.