Feedback Loops

From the Canadian Globe and Mail, we have Harry Koza pretending to be knowledgable about science: U.S. housing bubble has the potential to blow up real good.

Lenders don't want to keep these high-risk loans on their books, so it is not surprising that the majority of these mortgages are securitized, packaged and sold to investors.

This is scary because, according to a recent study by the Center for Responsible Lending (a U.S. non-profit), one out of every five subprime mortgage loans made in the past two years will go into foreclosure. That would mean 1.1 million houses getting repossessed by banks, vaporizing $74.6-billion in homeowners' equity.

The banks will sell the repossessed properties as quickly as possible, driving house prices lower, triggering more foreclosures, putting more excess properties on the market, driving prices lower and, well, you get the idea -- a negative feedback loop, the mirror image of the one that built the bubble.

Oh, great dumbass! A negative feedback loop is one that regulates itself. You're using "negative" in the English sense as in "not a good thing".

The classic example of "negative feedback" is the thermostat in your refrigerator. As the temperature falls, the thing turns itself off, and then as the temperature rises, it turns itself on. The point is that the feedback is in the opposite direction as the underlying mechanism wherein you get the term "negative" (in the equation, the feedback coefficient has a negative sign.)

What does this have to do with economics?

Well, "negative feedback" is the masturbatory dream of economists of how the market "should" behave. As prices rise, market-makers come in to sell the object causing the price to fall, and as prices fall, market-makers come in to buy the object causing prices to rise.

That's the theory anyway!

Reality, of course, proves to be a little more intransigent.

Human beings are greedy, and if there's one thing that really burns them up inside, eating away at their flesh like carnivorous bacteria is when their neighbors are making money, and they are not. So they pile on to the same investments that have made others money in the past creating the ultimate "positive feedback" loop.

As prices rise, more buyers show up which in turn causes prices to rise further.

Of course, this always ends badly. It always has, and always will. Sooner or later, there are no "greater fools" left, and the market collapses.

Ironically, the collapse creates its own "positive feedback" loop because human beings are also fearful, and prices fall far below what would be considered rational.

In Buffett's words, "What a wise man does at the beginning, the fool does at the end."