A Minsky Moment is a sudden collapse of the market following a long period of unsustainable speculative activity involving high debt amounts taken by investors. The term is frequently used to discuss past and/or probable future financial crises.
It is named after an American economist, Hyman Minsky, who claimed that markets are susceptible to being unstable and long periods of good markets eventually end in larger crises.
A Minsky Moment is the point in time that precedes a complete market crash. Minsky Moments occur when investors engage in aggressive speculative activity and increase credit risks during extended prosperous times.
Hyman Minsky argued that the markets are intrinsically unstable and swing between stability and instability periods.
There are three phases of credit lending that lead to a Minsky Moment– hedge, speculative borrowing, and the Ponzi phase.
When Does a Minsky Moment Happen
When markets are good for an extended period of time, investors tend to keep borrowing and adding on risk in their portfolio. Investors continue taking on risk, speculating that the price of the asset will continue to increase.
However, when prices cease to rise, the investors have borrowed so much to obtain the assets that they do not have enough cash to pay off their debts. Lenders then call in the loan repayment, and therefore, investors start selling their assets. It can trigger a sudden collapse in the price of the assets, and the market witnesses a Minsky Moment.
Catalysts and Effects of a Minsky Moment
Investors engage in aggressive speculations during bull markets and borrow to capitalize on the market sentiments. The longer the bullish periods, the more debt owed by investors, and hence, more risk.
Assets acquired by investors generate cash, which is used to pay off the debt taken to acquire them. There comes a point when cash is not enough to compensate for the debt due to the decreasing value of leveraged assets. It happens because a slight retracement of the market, which is normal behavior, results in a decrease in the valuation of leveraged assets.
Consequently, debt issuers start to call in loans demanding repayments. As it is difficult to sell speculative assets, the investors are required to sell less speculative ones. It creates a market spiral, a sharp decline in liquidity, and an intensive cash demand in the market, which may require central banks to intervene.
The rapid decrease in credit volume leads to the inevitable collapse of the market. The market experiences a Minsky Moment at this point and can be followed by an extended period of market instability.
Phases Leading to a Minsky Moment
According to Hyman Minsky, an economy experiences three credit lending stages with risk levels increasing in each subsequent stage, which ultimately leads to a market crash:
1. Hedge Phase
The hedge phase is the most stable phase, where borrowers have enough cash flow from investments to cover both the principal and interest payments. In the hedge phase, lending standards continue to be high.
2. Speculative Borrowing Phase
In the speculative borrowing phase, cash flows from investments cover only the borrower’s interest payments, not the principal. Investors are speculating that the value of their investments will continue to increase, and the interest rates will not rise.
3. Ponzi Phase
The Ponzi phase is the riskiest in the cycle. The borrowers’ cash flows from their investments are not enough to cover the interest and principal payments. Investors borrow, believing that the rising asset value will allow them to sell the assets at higher prices, enabling them to pay off or refinance their debt.
The Ponzi phase is characterized by a high valuation of assets. Currently, the non-financial corporate debt of the U.S., when measured as a percentage of GDP, is higher than it was before the last financial crisis.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: