Sunday, December 16, 2007

Don't Blame the Financial Risk-Takers

16 December 2007

I was moved to address the present topic after visiting some of the “Flippers in Trouble” websites based here in the southwestern United States, where Susan and I have been staying for a 6-week period.

Let me offer two as an example for you.

Phoenix Flippers in Trouble is fairly objective, documenting the plight of those who unwisely bought into the Phoenix real estate market at the “top” of its recent bubble.

As you know, bubbles collapse quickly, and this has been the case here in Scottsdale/Phoenix. Therefore, individuals who made their purchases at the bubble’s peak (2005 through early 2007) are now listing their homes for sale at discounts as high as

It’s not that bad for all of these purchasers (who are now re-sellers), but significant losses, onsetting rapidly, appear to be indicated. And properties are sitting unsold for months even at drastically reduced prices.

I found, however, that the
Marin Réal Estate Bubble site tends to take a particularly uncharitable view towards the unfortunate “flippers,” referring to the victims of the crisis as “fools” and whiners.”

How in fact did these real estate investors get into trouble?

There is not a single narrative that unites all of the situations.

Certainly some “flippers” were speculators who hoped to buy in a rising market that was gaining say 20% per year, and then to resell at a later date, possibly very soon, in order to capture quick and substantial profits. Many such speculators would then plow the gains into purchases of additional properties, thus over-extending themselves when the flow of easy money ground to an abrupt halt this summer.

Others facing significant losses are long-term homeowners who borrowed too much money against their homes when money was easy, and then faced the double whammy of personal financial setbacks combined with a declining real estate market.

Another scenario is one in which a mainstream family takes advantage of low interest rates to upgrade to a larger home that, in the case of unanticipated adversity, they cannot afford.

Finally, some buyers, hoping to see gains on resale, chose more expensive homes, hoping to capture a larger net increase in home value by applying the growth percentage to a larger initial number (say purchasing an $800,000 home instead of a $400,000 home).

A uniting theme is that these nominal homeowners (many in fact no longer hold any equity in their homes) are financially underwater. That is, what they owe on their homes (or real estate speculations) is either greater than the current market value of the home or greater than the amount they can currently pay on their monthly mortgage account. It is apparently not unusual to find individuals who are $100,000 or more underwater.

In this case, these individuals cannot properly be called “homeowners” at all. They are merely “debt servicers.”

In fact, the mortgage holder is the full owner of the home in many such cases. Further, the mortgage holders are often large investment funds (or participants in such funds) which bought “sliced and diced” mortgage-backed securities from faceless loan originators who essentially sold the mortgage products quickly to unqualified buyers in order to unload them for quick profits and fees to unwary investors seeking enhanced interest income.

Strikingly, these low quality products (“collateralized debt obligations,” often called “garbage” securities) have ended up in a broad spectrum of “money market” funds held by mainstream, even conservative, investors, who in many cases did not know that such questionable products were “spicing up” their (anticipated) interest income – by promising to pay higher interest rates than bonds, but in fact offering little reasonable expectation that the higher rates would ever be paid at all. (Bear in mind that Mr. Paulson, the US Treasury Secretary, is now promising to freeze the rates on such products – assuring that the money market funds will certainly not produce the returns they have promised.)

As we all know, financial bubbles entice the unwary, robbing multitudes of mainstream investors of their hard-won life savings.

Unfortunately, that has happened again to many hundreds of thousands if not millions of American real estate investors (Paul Kasriel of Northern Trust reports that 2 million US homes are now unoccupied, up from 1/4 that number as recently as 1978; he reports that Americans' liabilities have tripled against their assets since 1950).

Obviously, many of these persons were engaging in behaviour they knew to be risky with their eyes wide open. Others were simply caught unaware when fortune turned against them, as the following story from the Marin Bubble blog indicates:

Wealthy Marin not immune to foreclosure crisis

"Ian Minto isn't exactly homeless, but he sure doesn't have his home. The 58-year-old former banker lost his job and, last fall, began falling behind on mortgage payments on the Mill Valley house he grew up in on East Manor Drive. Desperate, he sold the home - appraised at $1.2 million - for about $300,000 less than it was worth. "(I felt) like I wanted to kill somebody or jump off the bridge," said Minto, who just took a job at Radio Shack to help cover the cost of a $600-a-month windowless room he is moving into on Fourth Street in San Rafael…."

The author of the blog adopts a very blaming attitude towards Mr. Minto, presumably because he appears to have extracted excessive equity from his family home when times were good, leaving him in desperate straits with the loss of his job.

Mr. Minto is hardly a flipper. He may have made unwise financial choices, but he is clearly not the sort of real estate “speculator” that is currently being blamed for driving up the current housing bubble.

Why are investors around the world engaging in higher and higher risk behaviour? Are people simply growing more and more irresponsible, or is some other causative factor at work?

Let me assert here that in blaming the home equity extractors, the flippers and the over-reachers, we are misunderstanding the fundamental problem.

As I have discussed many times previously on this blog, the fundamental financial wrong driving United States and much of global monetary policy is “easy money” (that is, excessively low interest rates and accommodative central bank policy, in fact a misnomer, but we'll get to that).

How do people behave in a healthy economic environment?

First of all, and most importantly, in a healthy economic scenario, growth is driven by business investment and gradually growing consumer spending deriving from accumulating savings and return on invested savings.

In our present scenario, the investment community pays only lip service to business and consumer spending. All eyes are in fact fixed on the Federal Reserve, which, by providing injections of liquidity (increasing the money supply through creating new “federal funds” literally out of thin air), has now become far and away the most important driver of global economic growth. This is fundamentally and deeply wrong.

One need not read very far in the current financial literature to see references to central banks “increasing economic growth” by “assuring liquidity” (read: printing money out of thin air).

And, what is everyone in the investment community waiting on tenterhooks to hear? Not that business is growing and investing in productivity, which has become a concern of the past, but that the “Fed” is lowering interest rates to “stimulate economic growth.”

The notion that lower interest rates will drive so-called “economic growth” has now won such widespread acceptance that it is hardly questioned in the mainstream financial media.

But this unquestioned certainty is fundamentally erroneous.

Low interest rates punish savers, plain and simple – and punishing savers is no way whatsoever to “create economic growth.”

In fact, by punishing savers (and retired citizens) with low interest rates, our government authorities (read big-spending governments at all levels) and our central banks (the printers of the “make believe” money) are directly not only encouraging but forcing citizens to engage in incrementally riskier and riskier behaviours.

When saving is rewarded, citizens rein in risk and invest for meaningful gains in bank deposits, bonds and dividend-paying stocks.

When saving is punished – and it has never been so roundly punished as it is today – citizens seek out higher returns by investing in risky ventures to compensate for excessively low interest rates.

What I am asserting is that irresponsible government policy makers and central bankers are literally forcing citizens to engage in high risk financial behaviours, and that the entirely foreseeable and inevitable outcome of irresponsible low interest rate policies will be financial ruin for many citizens – and not economic growth whatsoever.

There is a better way, which I have discussed here many times before.

Allow interest rates to seek a natural (market-driven, and from here, certainly higher) level, and give the economy back to savers and business investors, who, much more slowly and gradually (without dramatic economic booms and busts) will create a more stable but also a more steadily-growing economic environment for us all.

In fact, let’s take the central banks, particularly the United States Federal Reserve – out of the business of running the economy altogether (let alone playing the role of the economy’s primary driver).

Let’s then make the financial news about business again, and no longer about central bank liquidity injections.

And let’s place the responsibility for the real estate bubble, including the entire spectrum of fruitless speculation in that bubble, where it truly belongs. It is government policy-makers and central bankers who have created this bubble and forced citizens to raise the bar on risk in order to compensate for chronically low interest rates in an economy driven by liquidity rather than by citizen savings and business growth.

Speculators have not driven the real estate bubble, but have merely responded to the long-term government and central bank policy of punishing savings and attendant normal investment practices.

The speculators are not the guilty party in the present situation. But the central bankers and the big-spending government policy-makers are very much at fault in creating a climate which forces people to speculate in increasingly risky and dangerous ways.

Hopefully the above exposition has set the record straight on the question of real estate speculation here and now and once and for all.

No comments:

Post a Comment