When analysis GOES BAD!

A snippet from The Origin of Financial Crises:

As the credit expansion progresses, teams of diligent credit analysts look at the loans being made and assess these against the market value of the assets being bought. At each point in the credit expansion the loans match the value of the assets being purchased and the credit gets approved. At the aggregate level, the stock of debt in the economy grows in proportion to the valuation of the economy’s assets. As a result, as an asset bubble expands, the corresponding debt stock never looks excessive. Indeed, in true bubbles borrowers frequently have difficulty borrowing fast enough to keep pace with rising asset prices, and as a consequence leverage ratios frequently improve as a bubble progresses. Time and again the observation that these leverage ratios are dependent on rising asset prices is missed; even up to the very peak in the recent housing bubble naïve analysts were citing improving household balance sheets as a reason to believe the mortgage borrowing binge was sustainable…

[I]t is useful to step back and consider why it is that analysts get it wrong in every cycle. The problem lies in what economists call a fallacy of composition, which means that analysis valid at one level does not necessarily hold at another level. When the ratings analysts are assessing the quality of a loan, or the equity analysts are assessing the condition of a company’s balance sheet, or the mortgage broker is assessing the safety of a mortgage, they evaluate each individual loan against the prevailing market prices for the loan’s corresponding assets. In this procedure the tacit assumption is that the asset in question can be sold to repay the loan. At the micro level this is always a reasonable assumption. However, at the macro level this is almost never a reasonable assumption: one house can be sold to repay its mortgage, but if one million houses are sold at the same time prices will crash and the entire housing market will become under-collateralised…

The careful analysis of balance sheets is intended to improve the quality of lending and investment decisions. At the micro level of the individual household or company this works. At the macro level of the entire economy balance sheet, analysis actually becomes a destabilising force, leading to excessive lending and financial instability.

Balance sheet variables, therefore, do not just fail to inform investors of impending economic problems, they may actively mislead them into believing conditions are safer than they really are. In predominantly debt-financed asset markets asset prices cannot be considered an independent metric of sustainable debt levels, nor can debt levels be considered an objective external variable with which to measure asset prices.