SERIOUS MONEY:THE SHEER magnitude of the damage inflicted upon the financial sector by the nation's waning love affair with property became clear last week, as the National Asset Management Agency (Nama) revealed it intended to acquire more than 1,200 individual toxic loans for a consideration equivalent to 47 per cent of nominal value, writes CHARLIE FELL

The recriminations were immediate and the Taoiseach was accused of “economic treason” for the decision to provide the rogue Anglo Irish Bank with a State guarantee in September 2008. A tabloid assigned blame for bringing the country to its knees to two former bankers, and ran the irresponsible front-page headline, “They Deserve to be Shot”.

The truth is the blame extends far and wide, as all levels of the Irish economy engaged in a classic credit-fuelled property bubble that contained all the hallmarks of speculative manias from the past. The late economist Charles Kindleberger provided a history of financial crises in Manias, Panics and Crashes, and identified five distinct stages to an asset bubble, each of which is apparent during Ireland's unsustainable boom.

The first stage – displacement – occurs when there is an exogenous shock to the macroeconomic system that alters the profit opportunities in at least one important sector of the economy and “crowds out” opportunities in other sectors. This stage represents the birth of a boom, and the rises in prices that occur during this period are typically justified by improved fundamentals.

Displacement occurred in an Irish context during the mid-1990s, as housing demand increased in response to the solid income gains fuelled by an emerging export-driven Celtic Tiger, and the lower interest rates attributable to prospective European Monetary Union (EMU) membership. The economic boom from 1994 to 2000 was built on sound fundamentals and the house price rises justified, as the country emerged from a prolonged period of economic stagnation.

The boom from 2002 onwards, however, became increasingly unsustainable as the nation’s fiscal position, labour market gains and overall level of economic output became increasingly dependent on property-related activity that crowded out the tradable sector and led to a serious erosion of competitiveness.

The second stage – credit expansion – is required for a speculative bubble to form. The credit expansion is fuelled not only by existing banks, but also by the entry of new banks, the development of new credit instruments, the expansion of personal credit outside the banking system, and the inflows of foreign capital seeking high potential returns.

The emergence of new players can be traced to the arrival of Bank of Scotland in September 1999, and the introduction of its variable rate mortgage with the promise it would not charge a differential of more than 150 basis points above the European Central Bank. Additional new players entered the market and, at the height, there were 18 providers of residential mortgages – the competitive pressures resulted in a reduction in already-low borrowing costs.

Competitive pressures intensified due to the reckless expansion of both Anglo Irish Bank and Irish Nationwide, but the leading banks were able to protect market share through increased use of short-term foreign capital as a source of funds. Financing requirements were easily satisfied following euro membership, as international banks searched for yield in a low-return world, but the deluge of foreign capital unleashed a lending boom that inevitably proved fatal.

The net external liabilities of the banking system soared by an amount equivalent to 50 per cent of annual GDP during the bubble years, and lending to the non-financial private sector reached 200 per cent of GDP, roughly twice the European average.

The third stage – euphoria – is where irrational exuberance takes hold and speculation gains momentum. Traditional valuation measures are abandoned and the asset class attracts a cult-like following as prices continue to defy gravity. Bubble participants overestimate profit possibilities and leverage their balance sheets excessively. The stage is set for disappointment.

Euphoria was evident across the economy mid-decade. Average new and second-hand house prices in Dublin soared to 10 and 17 times average earnings respectively, but the traditional yardsticks were ignored as mortgages with high loan-to-value (LTV) ratios and extended maturities were introduced. The percentage of mortgages with an LTV of 100 per cent or more jumped from 5 to 12 per cent between 2003 and 2007, while the percentage of loans with maturities of more than 30 years increased from 10 to 35 per cent over the same period.

Meanwhile, members of the political elite dismissed suggestions the boom was fundamentally flawed. The Government pursued a pro-cyclical fiscal policy that stoked the boom, and the cut in personal income taxes meant increases in spending were increasingly funded with windfall property taxes. The fragility of the underlying fiscal position was masked by the property bubble.

The penultimate stage – financial distress – occurs when some event precipitates a change in the market’s overly exuberant psychology. The trigger can simply be the realisation prices are unlikely to go higher and this seems to have been the case in the Irish context, as the number and average size of mortgages approved peaked in the third quarter of 2006, long before the collapse of Lehman Brothers triggered the final stage – revulsion – where panic envelops the financial system.

The lessons of history reveal that Ireland engaged in a classic credit-fuelled bubble, and the warning signs were apparent at every stage. The scale of the losses reminds investors that even a fool can make money in a bull market: the real trick is to keep it in a bear market.