The real problem is that the underlying assets are sharply overvalued due to liberal bank credit schemes from the 2001-2007 real estate bubble. People with no savings, bad credit, and low income could buy $250K to $500K homes. If banks are unable to finance the crazy prices that people pay for homes, then home prices have to come down equally sharply. Paulson may be able to save banks from some of their stupidity by loaning them $700 billion, but the reality is that this is a $7 to $10 trillion problem, if not greater. How is a 10% bailout going to help anything or anyone? Is it not slowing down the inevitable for a six month soft landing at the taxpayer's expense? If banks can't continue to lend in the crazy format of years past, how can home prices not deteriorate exponentially? If housing prices continue to drop, banks will not be able to continue to lend due to rational reserve requirements. How will banks with no lending capability dump the foreclosed assets that they hold in mass, keeping in mind that houses deteriorate quickly without maintenance? If they sell these foreclosed homes to the government, won't the government dump them for pennies on the dollar and tank the housing market
Thankfully, and somewhat to my surprise, people actually seem to have figured this out and the plan is going to be dead, or amended. As a gambit though it was classic disaster capitalism. Create a crisis and then act like we have to do something right now that gives massive power and money to the people responsible. As they say, it's not a bug in the system, it's a feature. It's the point, it's how this philosophy works.
But returning to the above it's not just a $7 to $10 trillion dollar problem. It's much bigger than that even, by far. It's not just mortgages, the total value of credit default swaps is well over $50 trillion dollars (yes, as much as five times the entire US GDP) and as far as I can tell -- and I'm far from a complex securities expert -- many of these were traded/exchanged with no regard to the counterparties ability to pay. So it appears there are companies "insuring" perhaps $100 billion in default risk, when they have nothing like that kind of money if there in fact is a default. It's madness, again it's hard to believe it really happened this way. But here we are.
But again, it's interesting to read the discussions of how this all relates to the real estate market as I still think it represents a classic fallacy, which loosely translates to the idea that 1) The problem is primarily based on home prices, and 2) The lack of liquidity and a newfound unwillingness to lend is a main culprit.
I think it's actually pretty instructive to put this in the context of another bubble we can all understand and remember from the not too distant past, the dot com bubble. Stock prices and home prices have some similarities. Much like the price of Pets.com stock was based on the idea that someone else would be willing to pay more in the future for the stock, the same was true of a lot of marginal real estate. When capital dried up -- and it did -- I'm sure we all remember CEO's saying that the business was on track to be successful but recent developments in the market have made it impossible to continue. Remember all those homepages that had a note to that effect?
BubbleTech.com is sad to announce we are ceasing operations, even though we had a great product and lots of users the current climate has made it impossible to finance continued growth, so sorry to everyone.
Ummm... sure. But the reason Pets.com had problems at root was not that it lost access to capital. To channel my friend, the brilliantly blunt Phil Kaplan for a minute the reason was that nobody wanted to buy kitty litter over the internet via UPS delivery at a price that could make a profit. The underlying model was, in the parlance of the time, f*cked. Completely.
What does that have to do with houses? They're pretty similar actually. Sure, problems with lending are an issue. Just like in technology, where in late 2000 there were undoubtedly actual good -- meaning potentially profitable -- ideas that could not get funded. Right now there are no doubt people with willingness and ability to pay who are having trouble getting a mortgage.
But as a rule, housing values relate to income and perceived value (demand) and availability and quantity of housing (supply). Some things don't really ever change much. When housing prices got so out of kilter with income and rent equivalency then they were inevitably bound for a crash. That's just the way it is. Just like when dot coms spent $1 to get $0.50 back they were f*cked. Period.
But in housing, like all markets, at root there are market clearing prices. In fact probably quite a few of these mortgage backed securities have value. Because of the way they structured them (ie first loss provisions and tranches) many of them, literally, are valueless. But some will have value. Many of these foreclosed houses have some value.
But the banking crisis involves a lot more than just residential real estate and mortgage backed securities. The debt insurance market dwarfs this problem. The reality is that the losses have already been made. People essentially spent on borrowed money, through HELOC abuse and equity withdrawals and the like. It propped up the economy for awhile, but that's over.
But to reference a phrase that was going around quite a bit this week - the fundamentals of our banking system are weak. I think there might be a chance that a good treasury plan will involve recapitalizing the banks (by giving the funds but taking equity in return, which is mandatory and insane that it was not part of the original plan). That kind of capital infusion could indeed work just fine. It could make the banks solvent, and return the economy and sector to some sense of rationality.
But housing prices got too high when they were decoupled from rent equivalence and incomes. Just like dot com stock got insane when it was decoupled with standard notions of profitability and return on investment and revenue. And to keep the metaphor going many people made money in technology during that time. And there will be much money to be made now in real estate for smart people. But the sector will contract and housing prices will continue to fall (in real terms -- the idea of inflating our way out of this is another issue, and another 2000 word post). But that aside there's no other way for things to go.
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