Month: January 2009

More than 20% of all US mortgages are under water. If you owe more on your mortgage than the current market price of your house is, what are your incentives to keep it? In this real estate market environment, it would be financially more logical to walk out and rent a similar property for smaller monthly payment. Lower housing prices lead to more defaults on mortgages, more people walking away and more houses offered to sell. In an environment of gradual decline of housing prices, there are not enough quality buyers, who would step up to become owners. Those, who will qualify for a low interest mortgage, already have a house and are not interested into entering the low liquid, low return house lending business. Many of those, who are willing to purchase a house, are not qualified for a low interest loans. Why banks would lend to low income people at 5% if housing prices are expected to continue to fall another 15% this year. In a year, those same people will have negative equity on their house and the same problem will worsen.

George Soros claims that the only exit out of the situation is to ask all banks to reduce the principles of people’ mortgages to 80% of its current market price. In this case, even if prices slide another 10%, people will still have an incentive to stay. The condition, under which this could be done, is owning only one house, living in it and an obligation not to sell it within the next 5 years.  The government will use taxpayers’ money to offset part of this principles’ reducing, but it won’t be able to cover all of it. Banks will have to take part of the losses, which will send many of them into oblivion. The government will try to save some of them by buying bank shares, which will wipe out all current shareholders and will kill incentives for private money to enter old financial names.

An alternative solution of the housing problem would be to provide regulatory and financial incentives to foreigners to invest directly in the US housing market. Politically this might be unacceptable for many locals, but don’t forget that foreign money has been covering the deficit for the past 20 years anyway. Turn your creditors into your shareholders. Personally, I believe this would stop the decline in the housing market, even faster than many expect.

To conclude: If nothing is done, more people will default and banks will lose more money. If principles are reduced, banks will lose money. If the government starts buying shares from the banks, the current shareholders will be wiped out. This is why I believe that in 2009 we will see another 30% decline in stock prices of major financial institutions. Some regional entities will have to close doors. The system will clean out and there will be fewer, but stronger players left on the field.

Concentration of power in several entities is potentially very dangerous since a possible failure of one will have much more dire consequences on the economy as a whole. I hope the government will give fiscal and regulatory incentives to many entrepreneurial people to create new banking institutions with solid balance sheets and to work for decentralization of the financial industry.  

George Soros theory of reflexivity explains very clearly why investment crowds have the habit to create bubbles. Investors make their bets based on expectations for the future. Those expectations often turn into self-fulfilling prophecies. Why do people invest in stocks? For one very simple reason – to make money. For example, people start to buy  stock (or asset class) “YYY” on expectations for huge future earnings’ growth.  How they have reached to this conclusion is not entirely clear and this is not the point. The underlying reason might be recent acceleration in earnings’ growth or/and involvement in breakthrough technology that might revolutionize the way people live. We don’t know and we don’t have to know.  All we know is that YYY is rising, fast and substantially.  As investors buy, the price of the stock continues to climb and climb. Higher stock price is easily transferable into:

–          easier access to big amounts of low interest credit, which can be used to acquire a major competitor or to buy the best equipment available, which will reduce operating costs significantly;

–          higher rewards for employees, which will attract the brightest and the smartest from all over the world;   

In the majority of cases, those expectations for the future growth never come true and this is why the majority of bubbles don’t last long, but along the way, they had made rich many disciplined investors. In some cases, all those changes might lead to what investors have expected at first place – a significant earnings’ growth.

Those, who decide to not participate in the bubble, will sit on the side, watching how others are getting filthy rich. They are convinced that it is a bubble, but don’t know when it will burst.  After a month or two, they will also decide to enter the bubble by making it even bigger. As long as the fundamentals keep up with the expectations, the process will remain sustainable and the bubble won’t burst. The point is that the expectations never keep up with the fundamentals. If fundamentals are moving with the speed of the sound, the expectations will move with the speed of the light. As the time passes, the gap between the two will widen. Many short sellers will try to stop the insanity and will get burned along the way, adding fuel to the flames as most bubbles tend to reach extremes not expected by anyone. Negative yield on the 30-year treasuries, anyone?  People’s greed (expectations) is like a car without breaks. It doesn’t stop until the car falls of a cliff and bursts in flames. At one point the price will reach levels that are immensely unsustainable for the underlying fundamentals and a first wave of investors will leave. Suddenly, more and more people will be obsessed of fear that they might lose and will try to exit. Have you ever witnessed what happens when hundreds of people try to exit through one small door simultaneously? In the real world, people are getting stomped. In the financial world, liquidity suddenly dries out and exit is possible several levels down the drain, if you are lucky.

Now imagine that shorting was prohibited. In this case a bubble will reach far bigger size, since there won’t be a chance for short sellers to take some of the steam off that is moving the bubble train. Market makers will quickly realize that it is not profitable to take the other side of a trade in what is about to become or it is a big bubble. The liquidity will fall drastically and the prices will go parabolic. When the bubble bursts,( and it will, but no one knows when), the crash will be much more severe and faster. There won’t be any short sellers to cover their positions and to offer liquidity for those, who want to exit.