I've seen a lot of stories about what caused the Mortgage Meltdown, the Credit Crunch, and the recession (some are even calling it a depression). On the drive in today, the REAL answer finally came to me.
As in all complex things in life, there wasn't one specific cause. Here's my general thought process on this topic.
People who want to get to the root of any cause always use a root cause analysis to determine the true cause of any issue. One of the practices that process improvement folks use is the fishbone diagram, where if you keep asking "why?" to a question you'll get to the root of it.
But this simple approach often neglects the contributing factors to an issue or a failure. For example, a barn might have caught fire and burned to the ground. The root cause might have been determined to have been a spark from a passing-by freight train.
But the contributing factors were that there was damp hay in the barn, along with kerosene, dry timber, a poorly-maintained exterior, and weeds that had grown rampant over the course of several years.
All of these things led to the fire. Of course, the fire could not have started if not for the spark. But the weeds, hay, timber, etc. allowed the fire to spread at such a rate that the fire crew could not stop it before the entire barn burned down.
Such is the case with the economy. There were many contributing factors: Declining home values, rising bad debt, companies trying to stay afloat cutting staff, phoney financial instruments dreamed up by mathematicians rather than business folks, etc. The list is literally endless.
But what was the root of it all?
As in any mania, it was the madness of crowds. Adam Smith's "invisible hand" and "pursuit of self interest" was the downfall.
Home buyers thought, "If I don't buy this house now, somebody else will."
"Or, if I don't buy this house today, it will cost me $60,000 more to buy this house in 6 months." (By the way, this was the rate of price appreciation for a below-median home price in the Bay Area in California in 2003-2006.)
Lenders said, "If I don't fund this mortgage, somebody else will."
Insurers surmised, "If I don't insure this asset, somebody else will."
If I don't _____ this, somebody else will!
It was all about getting "it" before somebody else got "it." Or, in other words, what I call "relative greed." It wasn't that everybody was greedy, in and of itself. It was more along these lines:
You get a 10 percent pay raise. Your neighbor gets a 15 percent pay raise.
You get a 5 percent pay raise. Your neighbor gets nada.
Do you know which one most people would take? Yeah, #2. It's getting "more" than your neighbor, co-worker, competitor. That's what happened here, in my humble opinion.
It's also "the market" filling in voids. If Bank of America doesn't do this mortgage, Wachovia will. And Wachovia did. And did, and did and did and did.
BofA saw this and said, "We're losing market cap. And we're the biggest and baddest bank around." So, they got into the game, and then some!
People did it, too. If I don't buy a house now, I may never be able to afford one.
"Investors" did it, too. If I don't buy this duplex now and flip it, I may never get another golden opportunity like this.
Do yourself a favor: Read Extraordinary Popular Delusions and the Madness of Crowds.
You only really need to read any one of the stories. They're all the same, really. Market goes up and up, creating self-fulfilling prophecy. Something happens. Market goes down and down, creating self-fulfilling prophecy. What stops it? Who knows?
Money isn't everything. It's the only thing. Wait. That's only for football.
Enjoy life. Spend time with your family.
As the Mortgage Meltdown spills over into the Credit Crunch and recession, most of us who own homes (or at least live in homes where we pay a mortgage) have seen the value of our home decline precipitously. Where prices rose the highest and the fastest, they’ve come down the farthest and the fastest. In some areas, real estate values have dropped by over 50 percent.
Side note: If you can get a loan, start thinking now about buying a home if you don’t already own one. Prices may drop further, but not by much — if, that is, the economy doesn’t go into free fall. If it does, all bets are off.
In trying to cope with falling values, I suggest you look at your house purchase as a two-part purchase, the first being the intrinsic value of the utility a home provides (shelter), the second being the investment value.
I submit to you that in years past (prior to the run-up in house prices), the investment value of your real estate purchase was trivial, whereas the past few years it held the majority component of your purchase.
Let’s use an example. The discussion below assumes you paid cash, for simplicity. Nobody does this anymore, so the leverage is much higher, and your return on investment is considerably higher than this cash method suggests. Keep that in mind.
Say you bought your house in 1990 for $100,000. Back then, in a “normal market” you could expect the value of your house to rise by 2-5 percent (depending on where you lived). I’d estimate, then, that 95% or so of your mortgage was the intrinsic value of the shelter you purchased, and 5% was the investment component. So, if your $5,000 “investment” rose in value to $105,000, you made 100% on your investment.
Not bad. In fact, excellent!
But how much did your “shelter” component rise? Let’s say rents rose by 2% in a year. In a market where rents and mortgages were in line (we’ll call it equilibrium), the value of your shelter, by definition, rose 2%. That is to say, if you could rent out your house, you could rent it out for 2% more this year than last.
So, in fact, the gain on your $105,000 house was $3,000 investment and $2,000 intrinsic value.
Still, a 60% gain on your “investment.” Not bad at all.
Fast forward to 2005.
Your $100,000 house is now $500,000. If you bought it in 2005, I’d estimate that your investment component was around $390,000! In other words, at 2% per year growth in rents, your shelter component is only worth about $110,000!
That leaves a lot of room for investment losses!!!
In fact, if house prices fall by 50%, it is my contention that your shelter component barely moves. If anything, it has risen, simply because rents should be increasing as everyone moves out of “too expensive” homes to apartments — the demand for rentals has risen dramatically through this mortgage debacle.
So, if your house declined in value by 50%, down to $250,000, I am suggesting that all of it was comprised of the investment component.
But, the intrinsic value of your house has risen.
I know, money is money. And you’ve lost a lot. But if you felt that your house was worth $500,000 in 2005, what makes you value it any less today?
Your loss is only on paper. If you truly believed that your home was worth the half a million dollars you paid for it, then it truly has gone up in value since then.
Of course, you cannot realize that gain right now. Or for quite some time for that matter.
Think of your house for a moment as you would the purchase of a stock. There’s the future cash flow (dividends) and the capital appreciation. If the stock does not rise in price, but keeps paying out the same dividends, it’s still worth what it was when you bought it.
It may be worth more to somebody else right now, or it may be worth less (this is all based on price). But to you, it is worth just the same.
If the price falls on the stock, yet the dividend remains the same, then isn’t the stock intrinsically worth more?
That’s what I’m saying about your home.
On paper, you may be suffering a “wealth effect.”
But in real life, your home is providing the same utility today as it did when you bought it. In fact, it may be providing more. Rents have not fallen, they’ve only gone up in the real estate “collapse.” Therefore, the shelter component of your purchase is worth more today than yesterday.
It is only the investment portion of your purchase that has taken a beating. Try to set that aside for a while. In time, you will recoup your investment, and then some.
Especially with the rapid inflation the Fed is building into the system. Don’t be surprised, if in 5-10 years, your investment will be reaping positive returns!
In perhaps the biggest stimulus program EVER considered, Congress is mulling over a plan to spend over $800 Billion, none of which it has. Kinda what got us here in the first place…
“Congressional Democrats are planning a stimulus package with a price tag that could approach $800 billion over two years. It will include a tax cut, aid to state governments and funding in five main areas: traditional infrastructure, school construction, energy efficiency, broadband access and health-information technology. Meanwhile, top Republican lawmakers are positioning themselves as guardians against excessive spending rather than outright opponents of the Democrats’ plan.” (from Scottrade’s “Tomorrow’s News Today”)
I know, we don’t have the money. But it’s in this time where the government has to step in and take the place of private investment (who’s doing NOTHING to help resolve the issue).
Once it’s apparent we’re heading out of the woods, the government then needs to step out of the picture and let private enterprise reap the benefits. That growth will undoubtedly trickle down to the individual level.
Might as well spend some dough on education, alternative energy, and the like. It’s all on the table.
What do you think? Tell me in the comments.
Money isn’t everything. It’s the only thing. Wait. That’s only for football.
Enjoy life. Spend time with your family.
The financial fallout outside the United States from Lehman Brothers‘ bankruptcy has been about $300 billion, the head of Germany’s financial regulator said on Monday (October 13 — I’m a little behind in my reading).
Here’s Robert Reich’s take on the crisis, taken from his blog: Why Wall Street is Melting Down, and What to Do About It
The sub-prime mortgage mess triggered it, but the problem lies much deeper. Financial markets trade in promises — that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting the promises, Wall Street can’t function.
But it’s turned out that many promises like these weren’t worth the paper they were written on.
That’s because, when the market was roaring a few years back, many financial players had no idea what they were buying or selling. Worse, they didn’t care. Derivatives on derivatives, SIVs, credit default swaps (watch this one!), and of course securities backed by home loans. There seemed no limit to the leverage, the off-balance sheet liabilities, and what credit rating agencies would approve by issuers who paid them to.
Two years ago I asked a hedge fund manager to describe the assets in his fund. He laughed and said he had no idea.
Is this crazy or what?