Friday, March 07, 2008

Unrestricted Free-Market Capitalism

from Mish's Global Economic Trend Analysis

... let's not be too gloomy here.

Other than overleverage, bad debts, sinking home prices, no jobs, shrinking wages, cash strapped US consumers, rising oil prices, a sinking US dollar, $500 trillion in derivatives not marked to market, rampant overcapacity, underfunded pension plans, looming boomer retirements, no funding for Medicaid, no funding for Medicare, and no Social Security trust fund, everything is just fine.

And even though the Fed, central bankers in general, and governments combined to create this problem, the irony is nearly everyone is begging for them to fix the problem by encouraging still more speculation in housing, commercial real estate, and the markets.

Sorry folks, it's the end of the line and payback time for the world's most reckless financial experiment in history. The deflation genie can't be put back in the bottle until leverage everywhere is unwound.

The rest after the click ...

My comment:

Think of it as the invisible hand of the market giving you the finger.

A wise and savvy real estate agent attended a gathering at our house a couple of months ago. Over a beer he waxed on about how this sub-prime crisis was, in his opinion, a tempest in a teapot and that it would go away as soon as everyone realized that it was less significant than they thought at first blush. After all, how can real estate, representing only 2% of the overall economy have that big an effect.

The answer is "It's the leverage, stupid!"

According to Wikipedia leverage is: In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.

When you put down 15% on a house and mortgage the balance, you're leveraging 85% of the value of the house with 15% of the value in cash. That what the rules used to be. However, for the last several years, using creative first and second mortgage loans, lenders have created a situation that allowed home buyers to effectively leverage 100% of the housing purchase. A second mortgage at a relatively high rate provides the cash for a down payment and the first mortgage is extended as if the second mortgage didn't exist. Sub-prime and Alt-A mortgages didn't require verification of assets or income and borrowers were encouraged by lenders to fill in the blanks with numbers that would balance the books ... regardless of the truth of the numbers.

Leverage is a way of multiplying your buying power by assuming debt. It's a great idea when everything is going well. The problem is that when things go south, leverage also multiplies the down side. So, even though real estate may make up only 2% of the economy overall ... the debt associated with that 2% magnifies its impact.

Another way of looking it at might be to think of a bowling ball as representing the mass of that 2% of the economy. It's one thing if I toss it to you gently from across the ally. It's quite another thing if I leverage the same bowling ball by using a cannon pointed in your direction. Same bowling ball ... different leverage.

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