Daily Reckoning

It's really that simple.

In eras of easy credit, both creditworthy and marginal borrowers are suddenly able to borrow more. This flood of new cash seeking a return fuels red-hot demand for conventional assets considered "safe investments" (real estate, blue chip stocks and bonds), demand of which given the limited supply of "safe" assets pushes valuations of these assets to the moon.

In the euphoric atmosphere generated by easy credit and a soaring asset valuations, some of the easy credit sloshes into marginal investments (farmland that is only briefly productive if it rains enough, for example), high-risk speculative ventures based on sizzle rather than actual steak and outright frauds passed off as legitimate "sure-fire opportunities."

The price people are willing to pay for all these assets soars as the demand created by easy credit increases. And why does credit continue increasing? The assets rising in value create more collateral, which then supports more credit.

This self-reinforcing feedback appears highly virtuous in the expansion phase: The grazing land bought to put under the plow just doubled in value, so the owners can borrow more and use the cash to expand their purchase of more grazing land.

The same mechanism is at work in every asset: homes, commercial real estate, stocks and bonds. The more the asset gains in value, the more collateral becomes available to support more credit.

The Illusion of Safety

Since there’s plenty of collateral to back up the new loans, both borrowers and lenders see the profitable expansion of credit as “safe.”

This safety is illusory, as it’s resting on an unstable pile of sand: bubble valuations driven by easy credit. We all know that price is set by what somebody will pay for the asset. What attracts less attention is price is also set by how much somebody can borrow to buy the asset.