SubPrime Scapegoat

Posted by Eric Solis on October 20, 2009 under Housing and Mortgage |

The Sub prime Scapegoat

Written October 2006

Keep in mind that it was not long ago that we read about Fannie Mae and Freddie Mac.  These are the harbingers for bad policy and the hand writing on the wall for what is coming.  The $500,000 tax exemption was the jet fuel that hurled our housing market into debt bubble serfdom. 

When the “dotcom” bubble burst, prices of anything that even looked or smelled like a dotcom company dropped in value 30% almost over night.  Worse, pure play “dot-coms” dropped 70%+ or went out of business.  The driver of this sort of “sell off” is that if a company is connected in anyway shape or form to projections that created the inflated values, then it needed to be “market to the market” through a re-valuation of current business expectations.  This process is to be applauded, because it immediately allowed the market to re-set valuations and investors that took risks in pursuit of above market returns paid the price through a loss of capital.  It is through this process that capitalism works.

Now, let’s look at the real estate market and what has transpired and how it is NOT playing by those rules.  If you have been reading the newspapers you see headlines like “Real Estate Market Drops first time in 15 Years.”  These stories go on to report that the market has dropped 1 to 3%.  This my friends is a joke.  A 3% decline is not even a correction, let alone a bear market.  The stock market moves that much in an hour when major news hits the wire. The fact is that the housing market has experience far more damage than listings or closing prices reflect, but because it is such a slow market, prices take a long time to reflect value adjustments. 

But, rest assure if your house was listed on the NYSE and it could be re-valued in real time on a day to day basis, it would be down substantially more than what the media is quoting.  If we were to take into consideration your mortgage and your ability to pay your mortgage, this may even hurt value further, based on the risk of default that you represent. 

The interesting thing here is that ignorance is not bliss.  Markets are “markets” regardless of how efficient they are and they will have their way.  Look at Eastern European countries, Japan, South America or other economies where markets have not been allowed to fail via control, manipulation or excess financial engineering.  The result has always been the same…economic collapse.  Just because one wishes it were not so, or that one becomes unwilling to accept the reality of a loss, does not change reality.  As the old saying goes “wishing it so does not make it so.”

It is possible that people who are buying houses today thinking that they are getting a good deal, may be in fact paying a huge premium over what the house would be worth if it were market to the market.. When you are buying into a market that is rising prices adjust quickly upward because of the greed factor.  But, when prices are falling they move very slowly because of denial.  This dynamic creates a window for smart money to unload in what can be disguised as a “buyers market”.  In the stock market there is an old adage  “you don’t want to try and catch a falling knife”. 

If you look at the behavior of the real estate market over the past several years, it makes the dotcom bubble look like child’s play.  This debacle to my thinking will become the single most catastrophic economic event in the history of the financial world.  Bigger then the stock market crash of 1929, bigger than World War II (in economic terms), bigger then the oil embargo of the 1970’s, bigger than the 1987 stock market crash and bigger then Enron, Worldcom and all of the other scandals combined.

And it is not just Sub-Prime that is the issue.  This is going to touch every aspect of the housing market.   Valuations have gotten so far out of line with income that it is frightening.  In the same period where the housing market doubled, personal incomes rose single digits.  The mantra that people buy a “mortgage payment” not a house is going to come back to haunt millions of people all across the nation.   The message that the American public was sold was that the price you paid did not matter, so long as you could afford the payment (a strategy borrowed from the auto industry.  “What payment can you afford on this lease?”)  This propaganda is poison to sound decision making and will come with a steep price to pay for society.

Here is something to think about.  When the stock market crashed in 1929, the primary cause was people buying on what is called “margin”.  Buying on margin is the act of buying stock with borrowed money.  For example, let’s assume you could buy $1000 dollars worth of stock and all you would needed to “put down” was $100 dollars.  In this case, if the stock went up 10%, you would make $100 and thereby double your money.  Conversely, if the market dropped 10%, then you would lose 100% of your money.

When the market crashed 1929, it fell 30% within a week.  This wiped out all of the equity for those who were buying on 10% margin.  So, after the crash, all of the bankers and regulators got together and raised the margin requirement to 50%.  This meant that a an investor would have to put up $50 for every $100 dollar of stock they wanted to buy and the stock would have to drop 50% before all of their equity would be lost.

But they DID NOT apply the same rules to the housing market.  Many folks to day have been able t buy a house with zero down.  And a large percentage of home buyers have put 10% or 20% down.  That means that a 20% decline in the housing market could wipe out all of the equity of millions of home owners.