According to Hyman Minsky’s Financial Instability Hypothesis, there are three phases that lead to a Minsky Moment. These are three credit lending stages, with risk levels increasing in each subsequent stage that finally ends with a market collapse or bubble burst. The three stages are:
1. Hedge Phase: This is the first stage of financial stability, where borrowers can repay interest and principal out of cash flow. Debt levels are manageable, and the risk of default is low.
2. Speculative Borrowing Phase: As economic conditions improve, debts are repaid and confidence rises. Borrowers begin to speculate on rising asset prices and take on more debt.
3. Ponzi Phase: The third and final phase leading up to the Minsky Moment is named for the iconic fraudster Charles Ponzi. In this phase, borrowers borrow more money than they can repay out of cash flow. They rely on rising asset prices to repay their debts.