Economics Stack Exchange Archive

How does the availability of financing affect price volatility?

I’ve heard that the increasing availability of financing for various things can grossly affect the supply/demand ratio and therefore cause dramatic changes in price. How exactly does this drive such price increases, or such price volatility, (if it actually does); and what, if anything, can be done to mitigate any bubble it might cause?

Answer 39

I’ve not heard that financialization necessarily causes prices increases, but rather that it has effects on price volatility. So-called “nervous” markets tend to increase the normal price variability that arises from uncertainty. But, there is no reason that financialization must increase volatility: for example, a financial market that is based on fundamentals and market research could indeed provide a smoothing effect in an otherwise reactionary market.

Answer 60

It's really hard in economics to make convincing arguments of cause and effect using real world data. There are just too many different things all happening at the same time to conclusively find meaningful correlations, and even meaningful correlations still can't teach us about cause and effect.

Having said that, here goes a crude attempt to show that financialization can lead to increases in prices, all other things being equal. I'll do this in 2 steps. First I'll show some data to establish plausibility for this theory. Second, I will explain the reasoning behind my theory to [hopefully] establish causality.

One of the most notorious financial products in recent history is the mortgage-backed security (MBS). This financial product allows investors all around the world to easily and relatively safely tap into the US mortgage market.

How popular were MBS? They grew in popularity in the late 90's and then exploded in the early 00's.

mbs_history_chart

What did home prices look like in this same period?

Here is the Case Schiller price index since 1890. Notice that this data is in constant dollars. In other words, when the black line goes up, that means housing prices are going up faster than the cost of the average consumer good.

case_schiller_history

Look what happens right around 2000... a huge spike.

Now as I said above, there are plenty of ways to rationalize away this spike. Cheap US monetary policy, new mortgage products, etc. So although the data plausibly supports my assertion, let me switch to reasoning about why the higher degree of financialization might increase home prices.

Most home shoppers begin by calculating what they believe they can afford. Usually they start with annual salary and work backwards to some monthly payment that they can handle. Then they start looking for loan products that match their monthly payment. These loan products can finance different amounts of principal depending on their terms. For example, a 15 year mortgage at 5% will finance much less than a 30 year mortgage at 5%. There are other mortgage products that might help you finance even more (get leveraged higher) such as low-LTV loans, ARM loans, reverse-am loans, etc.

So let's say two people, Adam and Bob, both want to buy the same house. Both make the same amount of money, but Bob's bank offers exotic and more highly leveraged loan products than Adam's bank. Adam places his bid on the house based on his monthly payment and the amount his bank will let him finance. If Bob had the same financing as Adam, then the story would be over. Bob would not be able to bid any higher since he and Adam have the same leverage.

But since Bob actually has higher leverage, he can easily outbid Adam for the house and Adam has no recourse -- Adam is already fully leveraged and cannot bid any higher.

This is a highly contrived example, but you can see how financialization can lead to increased leverage, and this in turn enables greater buying power, and greater buying power can bid up the prices. If the buying power of all people generally grows over time (i.e. highly leveraged mortgage products are made available to more people), then we'd expect that to raise prices dramatically since now all bidders would be equipped with greater buying power.

Answer 286

The availability of leverage can generally increase the volatility of tradable assets. In fact, the example given in your link, a TV, is a bad example of this phenomenon for that reason. Education is also a bad example for the same reason.

The seminal empirical economics paper on this topic is Lamont and Stein (1999): Leverage and House-Price Dynamics in US Cities. Their paper also cites some previous theory on the topic.

We use city-level data to analyze the relationship between homeowner borrowing patterns and house-price dynamics. Our principal finding is that in cities where a greater fraction of homeowners are highly leveraged–i.e., have high loan-to-value ratios–house prices react more sensitively to city-specific shocks, such as changes in per-capita income. This finding is consistent with recent theories which emphasize the role of borrowing in shaping the behavior of asset prices.

As for what can be done to mitigate potential bubbles, that is quite easy: restrict leverage (or what you have termed financing)!

Answer 323

It’s not the LEVEL of financing that increases price volatility, but CHANGES in levels of financing.

We’re really talking about an “acceleration model.” An increase (positive) change in financing will have an accelerator effect on prices, and initial volatility.

A decrease (negative) change in financing will have a dampening effect on prices. But volatility will increase initially.

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