Skip to main content

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.

Comments

Popular posts from this blog

Self-Directed Real Estate IRA's the New Scam?

You aren't smarter than the market. It really is that simple. You know the marketing folks have been out talking when the New York Times does a fluff story on some new way to make more money with your investments. So watch out for the new scam promoted by the same media advisers who told you a few years ago to buy the most expensive house a lender would finance. Paul Sullivan story is about people'e successful investment of their retirement money in real estate using a self-directed IRA. He provides us with several "success stories".  Of course they are all recent converters to this idea and, not surprising, all but one of the people whose story Sullivan tells are also in real estate sales. The problem isn't really Paul Sullivan. Its that there is no one who makes money by digging out the horror stories from people who invested their retirement funds in real estate at the height of the housing bubble. There aren't any public relations firms devoted to de

The Stock Market hasn't gone up, the Value of the Dollar has Just Gone Down.

You aren't smarter than the market. It really is that simple. The New York Times had an article about the stock market's recent gains. The story noted that while the market had gone up 11% since the election, the dollar had dropped 10% against a basket of foreign currencies during that same period. They described this as "almost a mirror image." Unfortunately it is exactly a mirror image for people who hold those foreign currencies. Lets say they paid a $100 for a share of stock the day of the election and they exchanged 100 units of their own currency for that $100. Now if they sell that stock they will get $111 dollars, but when they exchange that $111 dollars, they will get back 100 units of their own currency. They have earned nothing, in their own local currency's terms the price hasn't changed. In a world investment market, the price of stock is set by what people around the world are willing to pay for it. Most people are still paying the same pr

Who is to blame for this mess?

There seems to be a lot of discussion to who is to blame for the financial crisis. But an awful lot of the media coverage is highly misleading. Here is synopis: 1) The meltdown in the financial market had little to do with people getting mortgages they couldn't afford. The collapse of the mortgage backed CDO's was caused by the collapse in the value of the houses which provided the collateral. It turned the mortgages behind the "collateralized debt obligations" (CDO's) into mostly un-collateralized debts. The result was that they went from AAA rated bonds to junk. 2)So what caused the housing bubble and collapse? Many people blame the fed, but don't have the story right. The fed did play a role. By keeping interest rates on Treasury Bonds low, they provided a market for alternative bonds that would pay a greater return. But the major cause of the housing bubble was the creativity of the investment banks. These are not the retail banks that make home mortgages