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Why was there a dot com or housing bubble? Is the market not efficient enough to see through it? The idea that securities prices reflect informed estimates of value has always coexisted uneasily with a view that sees stock prices disconnected from economic reality. Recent events such as the dot com and housing bubble have fed skepticism as they have been completely unexpected events. A market is efficient when prices always fully reflect the available information to the investors and investors make rational decisions based on that information. The concept of market efficiency can also be understood as an implication about the speed with which prices respond to the change in information and that securities prices reflect the best possible estimates of future risks and returns. In the 1980's the market efficiency had become a mantra not only of finance economists, but also of securities scholars, regulators, and even judges and practicing lawyers. As Ronald Gilson and Reinier Kraakman observed in 1984, in their comprehensive law review article on the subject, "[o]f all recent developments in financial economics, the efficient capital markets hypothesis ("ECMH") has achieved the widest acceptance by the legal culture , the ECMH is now the context in which serious discussion of the regulation of financial markets takes place". After the dot com and the recent housing bubble, this notion has changed considerably, and has put serious doubt to the theory of market efficiency. In our opinion the dot.com and the housing bubble took place because the market is not efficient and was not able to see through it. We interviewed two different professionals in the related field, a financial planner and a mortgage broker to get information about our problem in the real world. The financial planner came to the conclusion that markets are only efficient if stock prices respond to available information not quickly but accurately, and in the real world, not all information is accurate because of information asymmetry and because of agency-principle problems. Also, not all information is available to everyone because of the same problems which is the main reason of the technology bubble. Moreover, he explained that in the real people do not, in fact, share identical views of the intrinsic economic worth of particular securities which leads to the problem of how each security price may be set in a world where investors hold disagreeing opinions about the same security. If they did, it is hard to explain why so many shares of the same company change hands, thus this also makes the market inefficient. The mortgage broker also came to the conclusion that markets are not efficient as the prices of the securities or the houses reflect the trading activities of the investors, if some investors are optimistic and invest heavily in the market, that could create a price pressure and drive the price up when accordingly to the market conditions and the information the price should be high, thus this makes the market inefficient. Moreover, he concluded that not all information is available to everyone because information is costly to acquire, process, and verify and there are always arbitrageurs in the market who sometimes get superior information and hope to profit if the rest of the market eventually becomes aware of what the arbitrageurs already know through short and long selling.
The dot.com bubble or housing bubble is a financial situation in which trading volume and securities are traded above their original value. The occurrence of such a situation is difficult to be predicted by an average investor with limited information. The trade of securities at price above their original value is due to the expectations of investors about increase in value in the future. An increase in the value of securities makes the investors to expect persistent increase in the value, hence prompt them to actively trade securities. The positive aura amongst investors cause increase in trade activities, thus high value of securities appear. The discrepancy in the price could be long term or short term.
One of the possible reasons of emergence of an economic bubble is lack of predictive value in financial statement. Also, investors make their own predictions about future. Thus, the quality of information and expectations of investors contribute to market inefficiency that appears in different forms such as economic bubble. Factors such as uncertainty and rationality are not the prime propeller of economic bubbles. Instead investors make errors and often misinterpret the financial statements that form the basis of market inefficiency.
According to a mortgage broker in Toronto, housing bubble appears because of economic conditions at national level- monetary policy. He believes that lenient borrowing conditions and lower interest rates attract a huge number of investors to purchase properties. Majority of investors want to purchase property in metropolitan cities, thus the demand increase and supply decrease. He believes that this is usually a short phase where there is more than unusual number of investors, consequently the price of properties increase beyond its original value. He also reckons that housing bubble usually is more influential in larger cities compare to small cities where the prices tend to stay stable.
The repercussions of economic bubbles are deleterious to the economy as resources are distributed inequitably. The effects of such type of situation could be long term or short term, but they are inevitably unfavorable. According to a mortgage broker, the prices do not dramatically decrease to the normal but instead the prices stabilize after insignificant decrease, which makes it hard for the investors to invest. It is also unfavorable because the investors who invest during economic bubble feel plundered and get discouraged to invest again in future, hence stifling the economy.
In order to control economic bubbles, the bank of Canada can play a vital role by controlling the price appreciation. Some measures can be taken by the bank of canada such as controlling the interest rate and applying stringent conditions when lending money.
As there are a number of factors that can cause bubbles, one is that excessive money are lended by financial institutions to investors with very lenient lending conditions. Consequently, increase in the number of investors and supply of money appear that eventually cause appreciation. The cause of the recent housing bubble is a combination of both, lower interest rates and generous lending of money to investors. In this situation, investors tend to borrow money from banks at lower cost and expect to make more profits by investing in supposedly growing economy.
It is clear that increased supply of money with limited assets to invest in cause economic bubbles, which cause appreciation in the value of the assets beyond their original value. Once the bubble fades away, the investors find themselves in shackles, which also damage the confidence of the investors in the market. Usually, the bank of Canada changes their policy by increasing interest rates and by applying stringent lending conditions. This deter the investors to borrow money as the cost of borrowing become exorbitant.
Inflation is also considered a reason for economic bubble as the prices increase on yearly basis; investors tend to purchase commodities to avail expected appreciation in the prices. Much of the investors' interest is developed because of their own intuition and expectation. When expectations about future value appreciations become pervasive, more investors tend to invest, hence creating economic bubble.
An economic bubble cause immense demand and supply of money which is generally temporary. When bubble start to unravel, a contraction take place to reduce the excess, which decrease the prices and investors suffer losses. The recent housing bubble also showed such signs, where investors heavily invested in houses causing the prices to increase, followed by depreciation in prices. A number of investors filed for bankruptcy, causing the market to collapse.
The inception of dot-com was revolutionary to the securities market, where information was readily available to an average investor. The availability of information to investors on the internet attracted many to invest. The ease with which securities could be traded compelled many people to invest in the market. Prices soared up as people considered internet as a new way of doing business. The dot-com proliferation, forced companies to connect with people through internet. This increase in investors and availability of information online became the primary reason of bubble, where supply of money was excessive and there were limited securities to invest in. The internet companies projected to make high returns in the future. Although billions of dollars were processed through this period, the companies could not fulfill the investor's expectation and the bubble started to fade away.The repercussion of the bubble had profound effects, the investors lost their money and internet companies started to collapse. The reason for this economic bubble was that investors overvalued the cash flows of internet companies.
As many start-up dot-coms made their way into the new-economy, the speculation that the Internet was revolutionizing the way to do business started to gain strength encouraging many more companies to go on-line. The companies who took the initiative to publize their policies and to share financial information online gained strength, which positively affected their stock prices.
In the same manner, housing bubble also underwent dramatic increase in value of real property. People expected persistent increase in the future value of real property and due to low interest rate and lenient borrowing conditions, a number of people invested in real property. However, the outcomes were against investor's expectation and they lost their investment.
Housing bubbles may occur in local or global real estate markets. The recent housing bubble also incepted mortgage crisis. The major reason of housing bubble being low interest rates and lenient borrowing conditions, the financial institutions are now suffering deficits and collections problems. During the economic bubble, when prices were increasing financial institutions dispensed excessive money without examining credit history, which allowed even the non-eligible to borrow money and invest in the market. However, when the bubble started to contract, investors could not get the expected return to pay back their lenders, thus the market collapsed.
As the bubble matures appreciation in prices continue because of increase in the number of investors and also the demand. Housing bubble followed by decrease in home prices deeply affected the investors as they paid more than original value of the asset and their debt is more than equity. The major causes of the housing bubble are low interest rates, lenient lending standards, and speculations about high returns.