Alan Greenspan suggested home prices could not fall; Ben Bernanke suggested the subprime mortgage market problems were contained; and Janet Yellen argues complacency in the market is not a problem. The current Federal Reserve chair, just like her predecessors, might well live to regret those words.
Complacency is the absence of fear; in the markets it is reflected in low volatility. When asset prices rise on the backdrop of unusually low volatility, investors unaware of dormant risks are lured into the markets. And because there is such low perceived risk, investors are tempted to gear themselves up, ie borrow money to invest. However, at the first sign of volatility flaring back up, which could come from any number of reasons, those investors might sell out of their positions in a heartbeat screaming, “I didn’t know this was risky!”.
In the years leading up to the financial crisis, investors had geared themselves up given what appeared to be a “goldilocks” economy. As complacency yielded to fear, it was only rational for investors to reduce their leverage. Disruptions arose when large investors were forced to sell anything liquid to meet margin calls.