Money Management and the Economy

Friday, April 10, 2009

Chicken or Egg

You aren't smarter than the market. It really is that simple.


There have been a few articles recently on the financial meltdown with the same theme. That is that the housing bubble lead to the collapse of the financial markets. The reality is a little different. The financial markets, specifically the creation of derivatives based on real estate loans, created a housing bubble.

Beginning in the late 1990's trillions of dollars poured into the housing market, forcing prices well beyond what people could afford for housing. In most parts of the country, the median price of a home was no longer affordable to someone with a median income. Renting was far cheaper than owning. How did that happen? Where did the money come from.

The answer is that the Wall Street bankers had figured out a way to hedge most of the traditional risk of real estate. Instead of directly investing in real estate themselves, they loaned money to people who were buying a home. Then they took the resulting loans and bundled them into bonds that could be sold as low risk investments. Those "low risk" real estate investments, called Collateralized Debt Obligations (CDO's), produced far better returns than the government or AAA corporate bonds they were competing with. And they produced large profits for the Wall Street banks that created them.

The result was that money poured into the real estate market. As a result prices escalated and the terms of the loans got looser and looser in order to maintain the flow of investment opportunities. And that fed the bubble even more, as people who could not traditionally afford to buy a home entered the market. Thus the real estate bubble was a creation of the Wall Street bankers. Despite the recent collapse, businesses like Goldman Sachs made huge profits in the process and most of those profits were protected when the inevitable collapse came.

While much has been made of the problems created by "toxic assets", the truth is that when the bubble burst, most of the losses were to homeowners, not their lenders. It was the overpriced homes that were the really toxic assets, the bonds were considerably better investments. In effect, much of the risk of real estate investment had been transferred to people who bought a home to live in. Millions of those home owners now owe more than their house is worth.

If you look at the total losses in real estate in the last couple years, the losses to investment banks and lenders pale compared to the total losses to home owners. And all those losses can be traced back to the highly profitable business of taking real estate loans and bundling them into derivatives, shielding investors from the real risks of investing in real estate. And that is what created the financial crisis, not the housing bubble. It was just an unpleasant sid effect.

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