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Thursday, March 29, 2007
Monday, March 26, 2007
The Chinese problem
Everyone in the investing world needs to have a basic understanding of our trade situation with China. It boils down to this. We buy stuff from Walmart,Target etc who buys their inventory largely from China. So essentially China is sending us stuff and we are sending them dollars. What can a manufacturer in China do with dollars? Well, they can buy US imports, they can buy US financial assets (stocks and bonds or real estate) or they can trade them for Yuan or other currency on the Forex market. As most people know, we have a significant trade deficit with China which means that the Chinese typically do not use their dollars to buy US goods and services. They typically buy US treasury bonds which is essentially saving in the US dollar currency.
This dollar build-up should have a natural brake on itself. Eventually, the excess amount of dollars should cause the dollar to drop (via supply and demand). This makes Chinese goods more expensive to Americans and so should decrease their buying. However, it hasn't exactly worked out that way. The Chinese central banks has been inflating their currency by printing as many Yuan and trading them for dollars as it takes to keep the Yuan from appreciating so that Americans do not stop buying and the Chinese can grow their export-led economy at a very fast pace.
Can this go on forever? Can the Chinese keep growing their factory base at 10% if US consumption only grows at 4%? Not unless the Chinese or someone picks up their consumption. It is unlikely that the Chinese and the rest of the world are going to change that quickly. The Chinese are new to this capitalism thing. They still lack basic property rights, a solid sytem of business law, a strong financial system. Most importantly, the Chinese lack a basic sense of political and economic security. Without this security, they will opt to save rather than consume.
This should lead to dire consequences for China. Eventually they will develop excess capacity. This means they will have too many factories making too many products and not enough Americans or anyone else to buy them. This is the classic economic problem which leads to recession. When the excess is large enough, it leads to a depression. Whether or not this is a mild to medium recession or a more severe depression (like the Great Depression) may depend on the stability of the Chinese financial system. I don't have much knowledge about this but the general concensus is that the Chinese banks are plagued by corruption and nearly insolvent. So you can easily see what could go wrong for the Chinese. They need to support their growing economy with growing consumption but don't seem to be able to do so.
What can the Chinese do to prevent this? I would argue very little. I think it is enevitable that they undergo a recession. They can further inflate their currency which lowers prices for Americans. However this doesn't work out as planned. They still need to buy oil, energy and commodities from outside of China. Cheapening the currency just makes these more expensive. That is, inflation is never a solution. It can add a temporary stimulus but cannot really benefit the real economy.
A better way to look at all of this is without the use of currencies. Currencies can add another layer of complexity that act to obscure the real issues. Basically the real issue is this. As global markets have opened up over the last few decaded, poor people (like the Chinese) have been able to get jobs servicing the people in the more developed nations (like the US). Since they were poor, and had little access to jobs, they were willing to work for less pay. It is just supply and demand. There are lots of skilled but jobless Chinese willing to work all day to pay for their rent and dinners and the global economy has found a way to allow these people to service the richer American people. As long as there are more Chinese people (or in general poor people anywhere) than jobs, their wages will remain low. They simply have no bargaining power to ask for higher wages if their employers (ultimately the rich consumers) can go elsewhere for work.
This will end when we run out of poor unemployed people. Once that happens, they will demand higher wages and they will get them. This will cause higher prices for the rich Americans. In the mean time, the poor will have been saving their money and will be less poor. Ultimately, they will be as rich as the Americans. Overall, this is good for everybody. That is the whole point of the field of Economics. Trade is good for everybody. Isn't this great how trade solves all problems? Well...
This dollar build-up should have a natural brake on itself. Eventually, the excess amount of dollars should cause the dollar to drop (via supply and demand). This makes Chinese goods more expensive to Americans and so should decrease their buying. However, it hasn't exactly worked out that way. The Chinese central banks has been inflating their currency by printing as many Yuan and trading them for dollars as it takes to keep the Yuan from appreciating so that Americans do not stop buying and the Chinese can grow their export-led economy at a very fast pace.
Can this go on forever? Can the Chinese keep growing their factory base at 10% if US consumption only grows at 4%? Not unless the Chinese or someone picks up their consumption. It is unlikely that the Chinese and the rest of the world are going to change that quickly. The Chinese are new to this capitalism thing. They still lack basic property rights, a solid sytem of business law, a strong financial system. Most importantly, the Chinese lack a basic sense of political and economic security. Without this security, they will opt to save rather than consume.
This should lead to dire consequences for China. Eventually they will develop excess capacity. This means they will have too many factories making too many products and not enough Americans or anyone else to buy them. This is the classic economic problem which leads to recession. When the excess is large enough, it leads to a depression. Whether or not this is a mild to medium recession or a more severe depression (like the Great Depression) may depend on the stability of the Chinese financial system. I don't have much knowledge about this but the general concensus is that the Chinese banks are plagued by corruption and nearly insolvent. So you can easily see what could go wrong for the Chinese. They need to support their growing economy with growing consumption but don't seem to be able to do so.
What can the Chinese do to prevent this? I would argue very little. I think it is enevitable that they undergo a recession. They can further inflate their currency which lowers prices for Americans. However this doesn't work out as planned. They still need to buy oil, energy and commodities from outside of China. Cheapening the currency just makes these more expensive. That is, inflation is never a solution. It can add a temporary stimulus but cannot really benefit the real economy.
A better way to look at all of this is without the use of currencies. Currencies can add another layer of complexity that act to obscure the real issues. Basically the real issue is this. As global markets have opened up over the last few decaded, poor people (like the Chinese) have been able to get jobs servicing the people in the more developed nations (like the US). Since they were poor, and had little access to jobs, they were willing to work for less pay. It is just supply and demand. There are lots of skilled but jobless Chinese willing to work all day to pay for their rent and dinners and the global economy has found a way to allow these people to service the richer American people. As long as there are more Chinese people (or in general poor people anywhere) than jobs, their wages will remain low. They simply have no bargaining power to ask for higher wages if their employers (ultimately the rich consumers) can go elsewhere for work.
This will end when we run out of poor unemployed people. Once that happens, they will demand higher wages and they will get them. This will cause higher prices for the rich Americans. In the mean time, the poor will have been saving their money and will be less poor. Ultimately, they will be as rich as the Americans. Overall, this is good for everybody. That is the whole point of the field of Economics. Trade is good for everybody. Isn't this great how trade solves all problems? Well...
Friday, March 23, 2007
Fab Five
Sometimes when we are diligently searching for wonderful ideas, we miss what is right in front of our noses. There are times when the best investment ideas are not found by digging through the 10-Ks of obscure pinksheet companies but rather are found right out in the open among the largest, most prominant companies. This may be one of those times.
Which five Dow stocks have negative returns over the last year as well as the last five years?
All five are considered to be among the highest quality companies in the world (nearly all Dow stocks are). Companies like this are what the financial writer George Goodman (aka "Adam Smith") has termed super-currency. They are more reliable than any currency, resistant to inflation and accepted everywhere as a store of value. When the world is caught up in panic over the next crisis, these kind of stocks hold up the best. JNJ PFE and AIG are practically recession proof and this five stock portfolio is fairly well diversified across a few major industries: health care, retail and insurance/financials.
Their growing dividends are very attractive to income investors (i.e. the massive wave of retiring boomers) and their recognition factor will be attractive to all the new foreign investors (like in Asia) looking for an alternative to their less established stocks and overall turbulent markets. They have little real downside risk from here. All should have a sustainable long term growth rate above 10% (for at least 15 years). All of these are suffering from the fact that they were incredibly over-valued when the 90's bull market came to an end.
What would the expected return be over the next ten years for this five stock portfolio?
Let's assume the average growth rate slows from the 10 year average of 14.4% to G=12.0%. The average dividend yield is 2.42%. We will assume that dividend grows at the same rate as earnings (despite the fact that dividends are growing a lot faster at 20.8%). The annual return will then be R=G+Y = 14.42% assuming that the valuations don't change. That is a pretty good return for no-hastle investing. If the valuation grows from the average PE of 14.1 to 17.0. This might be expected as they become more favored. This is ΔV =20% expansion of valuation. If it comes over ten years that adds another 2% to the annual return. For the mathematically challenged, the annual change is ΔVA = [1+&DeltaV]^(1/N) -1 where N is the number of years it takes to expand.
This gives us a ten-year expected return of R=G + Y + ΔVA = 16.4%. If this valuation expansion happens faster; say in three years (not unrealistic) , then the return is R(3-year) = 21% which would be spectacular. You can fiddle with the numbers and get different results either better or worse. However, It seems almost impossible (short of a depression happening) that this portfolio wouldn't return at least 9% over 5-10 year times scales. Since dividends are growing at 20.8% and these stocks are buying back shares, it would not be surprising for these stocks to return more like 25%.
I own the first three JNJ PFE WMT and may soon buy the other two. I have a few other good investing ideas but feel that there aren't too many good places to invest in this market. In the meantime I will put money into the Fab Five and keep some cash around in case things change.
Which five Dow stocks have negative returns over the last year as well as the last five years?
| Ticker | Full Name | PE | 10-y Ann. Growth | Div. Yield | Div. Growth |
|---|---|---|---|---|---|
| JNJ | Johnson & Johnson | 16.2 | 13% | 2.5% | 16.5 |
| PFE | Pfizer | 10.0 | 9% | 4.5% | 14.4 |
| WMT | Wal-Mart | 17.8 | 17% | 1.8% | 24.6 |
| AIG | AIG | 12.7 | 12% | 1.0% | 24.7 |
| HD | Home Depot | 13.7 | 21% | 2.3% | 23.7 |
| Average | 14.1 | 14.4% | 2.42% | 20.8 |
All five are considered to be among the highest quality companies in the world (nearly all Dow stocks are). Companies like this are what the financial writer George Goodman (aka "Adam Smith") has termed super-currency. They are more reliable than any currency, resistant to inflation and accepted everywhere as a store of value. When the world is caught up in panic over the next crisis, these kind of stocks hold up the best. JNJ PFE and AIG are practically recession proof and this five stock portfolio is fairly well diversified across a few major industries: health care, retail and insurance/financials.
Their growing dividends are very attractive to income investors (i.e. the massive wave of retiring boomers) and their recognition factor will be attractive to all the new foreign investors (like in Asia) looking for an alternative to their less established stocks and overall turbulent markets. They have little real downside risk from here. All should have a sustainable long term growth rate above 10% (for at least 15 years). All of these are suffering from the fact that they were incredibly over-valued when the 90's bull market came to an end.
What would the expected return be over the next ten years for this five stock portfolio?
Let's assume the average growth rate slows from the 10 year average of 14.4% to G=12.0%. The average dividend yield is 2.42%. We will assume that dividend grows at the same rate as earnings (despite the fact that dividends are growing a lot faster at 20.8%). The annual return will then be R=G+Y = 14.42% assuming that the valuations don't change. That is a pretty good return for no-hastle investing. If the valuation grows from the average PE of 14.1 to 17.0. This might be expected as they become more favored. This is ΔV =20% expansion of valuation. If it comes over ten years that adds another 2% to the annual return. For the mathematically challenged, the annual change is ΔVA = [1+&DeltaV]^(1/N) -1 where N is the number of years it takes to expand.
This gives us a ten-year expected return of R=G + Y + ΔVA = 16.4%. If this valuation expansion happens faster; say in three years (not unrealistic) , then the return is R(3-year) = 21% which would be spectacular. You can fiddle with the numbers and get different results either better or worse. However, It seems almost impossible (short of a depression happening) that this portfolio wouldn't return at least 9% over 5-10 year times scales. Since dividends are growing at 20.8% and these stocks are buying back shares, it would not be surprising for these stocks to return more like 25%.
I own the first three JNJ PFE WMT and may soon buy the other two. I have a few other good investing ideas but feel that there aren't too many good places to invest in this market. In the meantime I will put money into the Fab Five and keep some cash around in case things change.
Tuesday, March 20, 2007
Mortgage Insurers
I am completely convinced that we have a housing bubble in the US that will bust and cause havov for the US economy. Still, I would like to keep my cool and invest somewhere at some time in the real estate sector when fear of the crash is overdone. So where to invest? The usual places would be homebuilders, banks, furniture makers, home furnhing like Home Depot etc or title insurance.
Another place is private mortgage insurance (PMI). Mortgage insurance is an interesting business. Basically they insure against banks losses for the top 10-20% or so of loans for people who don't pay a full down payment. Some notable mortgage insurers are (tickers) MTG, RDN, PMI and TGIC. All of these are down somewhat and hovering near book value. These companies have typically grown about 15% over the past decade or so and investors have had good returns despite significant volatility. Buying them at the right time typically gave you a 40% one year return.
The bussiness model is fairly simple. They get paid a premium by the borrower. If they forclose and the bank takes a loss, they pass on this loss to the PMI which either pays the bank or takes over the title. Like any insurance company, it makes sense to talk about the loss ratio (losses over revenue) and expense ratio (operating expenses over revenue) and the sum of the two which is called the combined ratio. When the combined ratio is less than 100%, the PMI makes an underwriting profit. It can also invest the float for investment income. The net operating income is the sum of the underwriting profit (or loss) and the investment income. Most regular insurance companies have a combined ratio near 100%, usually a few points higher. Thus they take a small loss to be able to invest the float at a higher return (mostly in bonds). They make a profit on the spread. A combined ratio of 100% means they are getting an interest free loan which they can invest at say 5% in bonds. There is generally a limit of float-to-equity which is considered safe but they can thus leverage their return on assets by this ratio to make a reasonably high return-on-equity of 12-20% or so for a good insurance company. Generally they grow at about the same rate as ROE.
Mortgage insurance is quite different. In good years the combined ratio is very small. For example MTG (company name is MGIC) has a combined ratio of between 45% and 70% for the past 5 years. Wow! What a bonanza! Even if it just buried their money in the backyard they are making a net profit margin between 30-50% just for signing pieces of paper. Unlike most insurance companies, they make more money from underwriting profits (in good years) than they do from investments.
Figuring out the future of this industry is complicated and requires a good understanding of the whole mortgage industry. (I don't claim to understand it well enough but I am working on it).
For example these companies are at the mercy of :
1) the Federal government which competes with them through the FHA.
2) Fannie Mae and Freddie Mac who make a lot of the rules of what is conforming etc.
3) Strengthening/consolidating lenders who siphoning off premiums through captive reinsurance.
4) Lenders offering piggyback loans and other PMI alternatives.
I won't go into the details of the these issues. Another important things is the shape of the yield curve, the persistenacy of premiums, tax deductability, pricing pressures etc.
What I want to focus on is loss ratios. I have mentioned above that combined ratios over the past 5 years are in the range 45-70%. Expense ratios are typically in the range 20-30% which leaves loss ratios in the range 20-40%. Are these typical numbers? Are there typical numbers? Would we expect losses to increase significantly?
That is difficult for me to estimate. Surely they will rise, but will they rise enough to make combined ratios much above 100% where the PMIs would start reporting losses and decreasing book value? I don't think anybody knows for sure which makes it quite a gamble.
Lets look at the past for examples. First of all there is the Great Depression. There were actually PMI around during the 1920s. None of them survived. All went bankrupt in the collapse of the financial system. MGIC (MTG) started up in 1957 to compete against the FHA which was a "New Deal" program to restart the mortgage market during the Depresssion. You can read about the history of MGIC HERE .
Ok, well you might not want to count the Great Depression. Hopefully that won't happen any time soon. What about more recent history.
Here is a plot that I made of Book Value Per share (BV), Earnings (E), Dividends (D) and Return on Equity (ROE) since 1990.
Another place is private mortgage insurance (PMI). Mortgage insurance is an interesting business. Basically they insure against banks losses for the top 10-20% or so of loans for people who don't pay a full down payment. Some notable mortgage insurers are (tickers) MTG, RDN, PMI and TGIC. All of these are down somewhat and hovering near book value. These companies have typically grown about 15% over the past decade or so and investors have had good returns despite significant volatility. Buying them at the right time typically gave you a 40% one year return.
The bussiness model is fairly simple. They get paid a premium by the borrower. If they forclose and the bank takes a loss, they pass on this loss to the PMI which either pays the bank or takes over the title. Like any insurance company, it makes sense to talk about the loss ratio (losses over revenue) and expense ratio (operating expenses over revenue) and the sum of the two which is called the combined ratio. When the combined ratio is less than 100%, the PMI makes an underwriting profit. It can also invest the float for investment income. The net operating income is the sum of the underwriting profit (or loss) and the investment income. Most regular insurance companies have a combined ratio near 100%, usually a few points higher. Thus they take a small loss to be able to invest the float at a higher return (mostly in bonds). They make a profit on the spread. A combined ratio of 100% means they are getting an interest free loan which they can invest at say 5% in bonds. There is generally a limit of float-to-equity which is considered safe but they can thus leverage their return on assets by this ratio to make a reasonably high return-on-equity of 12-20% or so for a good insurance company. Generally they grow at about the same rate as ROE.
Mortgage insurance is quite different. In good years the combined ratio is very small. For example MTG (company name is MGIC) has a combined ratio of between 45% and 70% for the past 5 years. Wow! What a bonanza! Even if it just buried their money in the backyard they are making a net profit margin between 30-50% just for signing pieces of paper. Unlike most insurance companies, they make more money from underwriting profits (in good years) than they do from investments.
Figuring out the future of this industry is complicated and requires a good understanding of the whole mortgage industry. (I don't claim to understand it well enough but I am working on it).
For example these companies are at the mercy of :
1) the Federal government which competes with them through the FHA.
2) Fannie Mae and Freddie Mac who make a lot of the rules of what is conforming etc.
3) Strengthening/consolidating lenders who siphoning off premiums through captive reinsurance.
4) Lenders offering piggyback loans and other PMI alternatives.
I won't go into the details of the these issues. Another important things is the shape of the yield curve, the persistenacy of premiums, tax deductability, pricing pressures etc.
What I want to focus on is loss ratios. I have mentioned above that combined ratios over the past 5 years are in the range 45-70%. Expense ratios are typically in the range 20-30% which leaves loss ratios in the range 20-40%. Are these typical numbers? Are there typical numbers? Would we expect losses to increase significantly?
That is difficult for me to estimate. Surely they will rise, but will they rise enough to make combined ratios much above 100% where the PMIs would start reporting losses and decreasing book value? I don't think anybody knows for sure which makes it quite a gamble.
Lets look at the past for examples. First of all there is the Great Depression. There were actually PMI around during the 1920s. None of them survived. All went bankrupt in the collapse of the financial system. MGIC (MTG) started up in 1957 to compete against the FHA which was a "New Deal" program to restart the mortgage market during the Depresssion. You can read about the history of MGIC HERE .
Ok, well you might not want to count the Great Depression. Hopefully that won't happen any time soon. What about more recent history.
Here is a plot that I made of Book Value Per share (BV), Earnings (E), Dividends (D) and Return on Equity (ROE) since 1990.
Basically BV has grown at 20% and you can now get a 2% dividend yield. On top of that they are selling for P/B of about 1 which very low. If they continue growing at this rate and get back to P/B of say 1.5 in 3 years, your getting a return of 36% anualized for the next three years, maybe even better. Sounds great right?
I have my doubts. Let look further back into the 80s. The 2002
10-K
for PMI group shows the loss ratios back to 1981.
The bottom line is that loss ratios in the 1980s were terrible. They attributed these to the real estate decline in the oil patch. When inflation was reigned in by Paul Volker's Fed, oil prices collapsed and so did all the business in Texas and other oil patch locations. Loss ratios were in the range 200-265% for contracts written in years 1981 and 1982 and these losses carried on for twenty years for contracts written in those two years. That is PMI was still paying out losses (probably small ones) in 2002 for bad decisions made in 1981. I am not sure how all of this works its ways into yearly earnings. I would like to see a chart of common equity for PMI through all of these years. I am guessing it decreased significantly in the mid 80s but don't know sure since PMI was not a public company then.
How does this relate to today? Surely the oil-patch real estate bust was more acute than todays national/international housing bubble. However todays bubble is more wide spread and I don't see any reason why losses couldn't be worse than the 1980-1983 debaucle. Will these companies even survive? I don't know. Hopefully they are reinsured well enough to handle a national housing crash but I don't have the expertise to figure that out. I have seen a quote in the 10-K of MTG that says that because they are regionally diversified, they don't expect major losses. However that seems to rely on the idea that house prices can't crash everywhere at once. What if they do? Are they still prepared to weather the storm if house prices decline by 20-30% nationally like some bears (i.e. Gary Shilling, Jim Rogers) are predicting?
I don't want to make that bet. I am staying away from investing in these companies until I start seeing them handling severe losses gracefully. Which means I might miss them entirely. That's fine. I will stick to more transparent businesses. I think that if hell gets cut loose on these companies the stock prices will collapse to something like 1/4 of book (see for example the subprime lenders). In that situation you might be getting the right odds to make a bet on these companies. In fact, you might be better off to invest through LEAPS (long term options) since they would either go bankrupt or survive and prosper. If they go bankrupt you lose it all with either common stock or LEAPS but with LEAPS you get more leverage on the upside. I don't think your getting good odds to invest in the common stock now.
Sunday, March 18, 2007
The LA Housing Bubble
This is an example of a house in my neighborhood, the Silverlake neighborhood of Los Angeles. This plot is from Zillow. Can anyone really believe that this rediculous price expansion is not a price asset bubble? In 1997 this was worth $115K. By 2004 it had appeciated to about $200K. That is an 8% annualized price appeciation which is pretty good, about 6% more than the inflation rate of 2%. Then things went crazy. The bubble mentality set in. People decided that prices in this neighborhood were going to accelerate. They were right. Over the next three years the price would increase from $200K to $900K at a 65% annulaized rate. During this time houses became not places to live but things to invest in for short term gains. Failed traders from the dot-com days decided that real estate was the place to be. This house below was traded three times in these three years. The original owner sold in in 2005 for $450K and probably walked away with $350K in profit. It was bought by someone looking for a short term profit. They probably invested no more $10K by buying with an interest only, low or no down payment loan. It would go from $450K to $650K in two months. That is, they multiplied their $10K investment by 20 in two months. That annulized rate of return is over 6 billion percent!!!! By this standard the next owner was down right conservative. This person held it for a whole year and only made a $150K profit. The poor sucker that bought next for $800K may have watched this zillow chart and seen $100K of equity appear about thin air. Unfortunately it is clear to all that this bubble is busting. The poor owner probably has this house sitting on the market at inflated prices and has to bear the horror of watching the prices drop like the hapless NASDAQ in 2000.
Now consider the effects of all of this home equity appearing out of nowhere for millions of people in Los Angeles. How much money was created? Well if there are one million households in LA and if each house recieved $300K of new equity, that is 300 billion dollars. The total amount of new equity created in the US is a few trillion dollars. The effects of a few trillion dollars introduced into the economy can't be ignored. Many of people would pull money out of their homes though a home equity loan. They would use this money for home repairs, new expansions, to buy cars or pay off loans or credit card debt to free up these cards for new purchases. All this new money flooded into the economy. Much of it ended up in bank accounts which helped fuel new lending. As prices rose further and further, houses became unaffordable to most with traditional loans. But banks would not allow the party to stop. New products were dreamed up that allowed anyone to buy a house regardless of credit quality or lack of down payment. These were the interest only loans, the adjustible rate mortgage (ARMs), the negative amortization loans, the option ARM, stated income loans etc. As long as prices were rising, even poor credit buyers could sell at a profit if they couldn't keep up with payments. Banks themselves were not at risk as long as prices rose even if they put their own capital at risk through second mortgages (piggyback loans). Non-bank subprime lenders would originate multitudes of loans to poor credit buyers and sell these loans off to Wall Street banks who would send them along to hedge funds looking for high yield products where they could could make huge profits by buying these with large amounts of leverage, some of which was generated by borrowing yen at near zero rates, selling yen for dollars and buying high yield US mortgage loans. When the bust started, the Wall Street banks stopped providing capital to these risky subprime lenders who collapsed due to this liquidity crisis. This reluctance of banks and non-bank lenders to lend would further add pressure to the collapsing housing market. The end game is now obvious. This housing collapse will be the worst since the 1930s. The bubble is bigger than previous bubbles in the 70s,80s and 90s. The collapse will therefore be worse. Some people still hope that Washington or the Fed can still save housing and save the economy. Unfortunately, the only solution is for prices to come way down. In the meantime this will lead to a miserable economy, higher unemployment and probably a severe banking crisis. The Fed can probably bail out banks if it chooses to to prevent a deflation like the 1930s by lowering rates close to zero which would allow banks to make large enough profits on the spread to cover real estate losses. However it can't make people spend like they did before. It can't restart the boom. It is time finally to face the music and deal with the fact that our economy cannot grow at these unsustainable rates of past years.
Now consider the effects of all of this home equity appearing out of nowhere for millions of people in Los Angeles. How much money was created? Well if there are one million households in LA and if each house recieved $300K of new equity, that is 300 billion dollars. The total amount of new equity created in the US is a few trillion dollars. The effects of a few trillion dollars introduced into the economy can't be ignored. Many of people would pull money out of their homes though a home equity loan. They would use this money for home repairs, new expansions, to buy cars or pay off loans or credit card debt to free up these cards for new purchases. All this new money flooded into the economy. Much of it ended up in bank accounts which helped fuel new lending. As prices rose further and further, houses became unaffordable to most with traditional loans. But banks would not allow the party to stop. New products were dreamed up that allowed anyone to buy a house regardless of credit quality or lack of down payment. These were the interest only loans, the adjustible rate mortgage (ARMs), the negative amortization loans, the option ARM, stated income loans etc. As long as prices were rising, even poor credit buyers could sell at a profit if they couldn't keep up with payments. Banks themselves were not at risk as long as prices rose even if they put their own capital at risk through second mortgages (piggyback loans). Non-bank subprime lenders would originate multitudes of loans to poor credit buyers and sell these loans off to Wall Street banks who would send them along to hedge funds looking for high yield products where they could could make huge profits by buying these with large amounts of leverage, some of which was generated by borrowing yen at near zero rates, selling yen for dollars and buying high yield US mortgage loans. When the bust started, the Wall Street banks stopped providing capital to these risky subprime lenders who collapsed due to this liquidity crisis. This reluctance of banks and non-bank lenders to lend would further add pressure to the collapsing housing market. The end game is now obvious. This housing collapse will be the worst since the 1930s. The bubble is bigger than previous bubbles in the 70s,80s and 90s. The collapse will therefore be worse. Some people still hope that Washington or the Fed can still save housing and save the economy. Unfortunately, the only solution is for prices to come way down. In the meantime this will lead to a miserable economy, higher unemployment and probably a severe banking crisis. The Fed can probably bail out banks if it chooses to to prevent a deflation like the 1930s by lowering rates close to zero which would allow banks to make large enough profits on the spread to cover real estate losses. However it can't make people spend like they did before. It can't restart the boom. It is time finally to face the music and deal with the fact that our economy cannot grow at these unsustainable rates of past years.
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