Lack of fundamental valuation: A cause for bubble formation and subsequent crash

It is clear that we have entered an unusual economic regime that amplifies the effects of good management on companies, both financial and real. We got here primarily due to bad decision making in all types of companies. In the financial world, securities transactions happened without a fundamental understanding of what they are worth. As we learned from the tech bubble, when fundamental valuation is not present and current price is largely based on yesterday’s transaction (a proxy), bubbles tend to form. Such bubbles can persist and accelerate to some critical level followed by a bust and crash. This understanding from history did not seem to have done any good to the titans of Wall Street – who further exasperated the problem by leveraging the transactions they did not understand. The SEC granted an exception to certain financial companies (for unknown reasons) in 2004 to lever up to levels 2.5 times normal and they immediately obliged by buying securities they did not understand using massive amounts of borrowed money. Complex securities are not a problem – transacting in them without understanding their value is certainly a problem. Many of these securities derive their value from an underlying asset – such as a real estate property and they have options like characteristics. There are many levels of these securities, some deriving their value from pools of other securities. They are complex but they all have some fundamental value that can be derived using established economic principles. Firms that transacted in them without knowing what they are worth were wasting their own money or the money of their clients. By levering up their mistakes they put the entire economy at risk and now they need to be “bailed out.”