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Posts Tagged ‘Real Estate’

It seems like such an easy question: how much is my house worth? The problem is that this is not an easy question – and that fact that that is a problem is the real problem.  Let me explain…

A long time ago, when Tricky Dick Nixon was President of the United States, our country was running up a huge bill trying to pay for the Vietnam war.  There was only so much money coming in from taxes so we had to borrow money by selling treasury securities to other countries and Americans too.  Treasuries were a pretty safe bet – as good as the dollar, which in those days had its value fixed in relationship to gold.  At one time you could redeem your paper dollar for its equivalent in gold. Later, the paper dollar could be redeemed in silver, if you felt like carrying around bags of silver with you. The point was that a dollar was nothing more than a proxy for your ownership of some precious metals that were stored at Fort Knox or somewhere else.  Nixon’s problem was that there was only so much gold and silver in our vaults – so we could only print so much money.

At some point Nixon or his advisers came up with the perfect solution, disconnect the dollar from any relationship at all to any precious metal – in fact detach it from anything physical. The dollar became a Federal Reserve Note, not redeemable for anything.  This allowed Dick Nixon to print as many dollars as he liked so when it came time for people to cash in their Treasury securities they would be paid back in dollars that were worth much less than if they had been backed by a certain amount of gold. The value of the dollar had dropped – or, another way of looking at it is that the value of gold went up a whole lot.

Which brings us to houses – almost anyway.  There is little doubt that the increase in house prices and lots of other stuff since Dick Nixon inflated his way out of Vietnam War debts was not the same thing as an increase in value. The value of things didn’t change much, just the price because the dollar was losing its purchasing power. OK. So that’s it? No. Not exactly.

If we are talking about the value of a house, and not the price – which we can now see is not the same thing – how do we actually determine its value?  Well, the common sense way of determining the value of something ought to take into account the value of the things that went into it, like wood, stone, paint, drywall, and so forth.  Then there is the cost of labor – a bunch of carpenters, electricians, plumbers and so forth had to be paid for the value of their labor. So we have to figure in that value too. Then there is the value of the land.  How large is the lot? Is it swampland? Is it next to a superhighway? Is it level? Is it cleared?  Some of these items are easy to value, for example, if the lot isn’t level we need to pay for a bulldozer to level it.  And so forth. On the other hand, there are some items that are sort of intangibles, like the proximity to a superhighway.  How do you value that?  This is where things get a little difficult.

The issue we are faced with is trying to place a value on something that has no intrinsic value. It doesn’t cost anything more to build a house next to a superhighway than it does to build it far away.  However, it does make it less desirable.  So, we enter the world of supply and demand, where the value of things is not related to tangible things but to emotional things like desire.  This is where the trouble begins too.

Several years ago we entered a fantasy world of house prices.  The price of houses was going up because…because…well, because the price of houses was going up.  It was a fabulous game anyone could play.  Buy a house, flip it, and make a lot of money.  Except there was nothing tangible supporting the price of houses.  Sort of like the Emperor’s New Clothes, only with houses.  For the past couple of years house prices have been in a near free fall in some parts of the country and they are expected to continue falling. So how far will they go?

Now that the balloon has popped it seems that house prices will have to fall until the “irrational exuberance” of home buyers and the equally exuberant lending banks is completely dead. House prices have to fall to the point where they reflect the actual construction costs of the house, i.e. materials, labor, and land, plus some sort of adjustment for the desirability of its location as determined by the local market.  But all the price inflation due to the irrational exuberance of flipping houses has to go.

Oh. There is one other thing. The dollar isn’t what it used to be either. You need to account for the inflation of the dollar since you bought your house. Figure somewhere between 5% and 10% per year – roughly. It’s a cumulative effect so you need to calculate each year of ownership separately – a computer program might help a lot.  Then there is depreciation. Things wear out. Houses get old and start to fall apart, so unless everything is fixed up like new you need to deduct the loss in value from normal wear and tear, plus the natural aging and decay of things.

All things considered, your house is probably worth a lot less than you think it is – unless you happen to live in one of those parts of the country that, for some reason or other, never got caught up in all the irrational exuberance. For those areas out west like California and Arizona and in the east like Florida, homeowners face more pain to come in the great housing value reality check.

House values are a bit difficult to figure at anytime because of all the ingredients that go into their value like materials, labor, loss of value of the dollar, and so forth.  Irrational exuberance is not part of this equation. It doesn’t add value; it only increases the price.  The problem is that as the irrational exuberance of home buyers fades, so does the price.  Eventually, houses will return to their real value, but it looks like a lot of formerly exuberant, but many ordinary American citizens will continue to have an extremely painful reintroduction to reality.

Thank God the banks are OK.

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A hour ago Bernard Madoff pled guilty to what has been described as the largest Ponzi scheme in history.  Is seems that Mr. Madoff bilked quite a few people out of billions of dollars by telling them that he had a secret way of beating the market.  He always paid dividends that were much higher than the return other investors were making on their investments. He was a miracle worker, or so it seemed.  In actuality he was simply using new investor’s money to pay old investors: a classic Ponzi scheme.  It worked well for a long time – all he had to do was to keep finding new investment dollars. The collapse of global economy sort of put an end to new investments in Bernie’s scheme and that, ultimately, proved to be very inconvenient for him and somewhat more inconvenient for his investors who had gotten used to making remarkable earnings on their investments.  Bernie will be sentenced, probably to life in prison, in a few months or so.  His investors? Probably out of luck – their money is just gone.

As massive as the Madoff Ponzi scheme was, it pales in comparison to the Worldwide Real Estate Ponzi scheme that is responsible for the global loss of somewhere between $30 and $50 trillion of wealth (yes, trillion).  Just thinking about that number for a moment puts Obama’s $800 billion stimulus into perspective, doesn’t it?  One thing to note is that there is not enough money in the U.S. Treasury and probably not even enough money printing capability in the U.S. to provide refunds to everyone who lost part or all of their wealth.  It’s just gone.

The question now is: what should happen to the people who perpetrated this truly massive Ponzi scheme on the world? What should be done with all those whose complicity in this insane scheme directly led to the loss of millions of people’s 401k and 529 fund values?  What should be done to those who created Liar Loans?  What should be done to those who misrepresented the value of property in order to get a mortgage approved?  What should be done to those who rated toxic mortgages as AAA-rated?  What should be done to the bankers who sliced and diced the toxic mortgages and flipped them as fast as they could to the entire world?  What should be done to those who sold mortgage insurance on these toxic mortgages, called credit default swaps, knowing full well that their company couldn’t begin to cover the losses if these mortgages weren’t paid?  What should be done to the Wall Street bankers who took TARP bailout money, taxpayer funds meant to keep their banks from dissolving into a slimy, black pool of toxic sludge, and handed out multimillion dollar bonuses to the very people who created this gigantic Ponzi scheme?

Pretty good questions, huh?  Well, it turns out I’m not the only one who’s asking.  David Segal reports in today’s New York Times that federal investigators are starting to ask, more or less, the same questions.  It’s about time.  Isn’t it sort of surprising that Bernie Madoff rips off a fairly small number of very wealthy investors and before you can say “Free Market Capitalism” he’s hauled off to court and pleads guilty to an historic crime.  Meanwhile, as literally billions of people suffer from the greedy antics of our completely-out-of-control financial industry, we are just getting around to sort of starting to begin to think about maybe checking to see if anyone can be found who might possibly be responsible for the Worldwide Real Estate Ripoff.

So what do we do? What if it turns out that all the leaders of our financial industry are culpable?  What if every last one of our big time bankers is a crook?  Do we throw them all in jail? No, of course not. We need them – remember? Our banks are too big to fail.  Our bankers must also be too big to replace, right?  That’s why we can’t nationalize the banks: all the knowledge of the financial industry resides with these people. Who would run our financial industry if all the crooks were all in jail? The sad reality is this: we can’t throw them all in jail. The solution: find some scapegoats. Find a few of the top dogs, maybe 0.00 1% of the financial industry who probably can’t duck or hide from some massive financial fraud charges and haul them off to court and throw them in jail. Maybe they can get a cell next to Bernie.

Then we declare ourselves to be cleansed of the toxic infection and we take a few moments to mourn over the billions of people who lost their fortunes.  Everyone will feel a lot better and then we will turn our attention to rebuilding our economy.  Then we turn over the task of creating a new financial industry, with built in safeguards against any more Worldwide Real Estate Ponzi schemes, of course, to the same people who got us into this mess.

And then we start all over again.

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Now that we have the job stimulus bill about to be signed, I expect our attention will soon turn to some sort of bank stimulus. Wait a minute, didn’t we already bailout the banks? Indeed we did. The problem is that, even though they received billions of dollars and even though the bankers all gave themselves fat bonuses, it’s still really hard for the average citizen to get credit, i.e. a mortgage or a car loan.  The question of course is why? Why won’t these recently replenished banks lend money? They answer they give is that they are lending, but their ability to lend money for mortgages is limited because of a lack of interest in the secondary mortgage market.

The secondary market? What’s that? Well, if we take a step back in time, you recall that when the economy was surging full speed ahead and the Real Estate Ponzi Scheme was in full swing the big U.S. banks had developed a strategy of dealing with high risk mortgages (now called toxic assets). The strategy can be succinctly referred to as “flipping”, mortgages that is.  The banks sold these hot potatoes to investors after telling them that they were AAA rated by their buddies in the securities rating game. Of course they should have been  ZZZ rated, but that’s just a little detail we can overlook. Right?

Well, these ZZZ mortgages were sliced and diced and sold off by the banks who made up the primary mortgage market to the “savvy” investors who made up what is called the secondary mortgage market.  By selling (dumping) these toxic assets immediately, the banks were able to replenish their money supplies and then turn right around and give out some more mortgages!  Isn’t that fabulous?  The whole economic miracle of the housing boom could go on forever and the original banks had almost no liability!

Then, you may recall, everybody stopped paying their mortgages because they were only planning on flipping their houses anyway. So who got burned? It was the guys holding the ZZZ rated mortgages – the secondary mortgage market. They had their own game going of buying and selling ZZZ securities too. Of course they insured themselves with credit default swaps, but that was a scam because the companies that issued them, like AIG, couldn’t cover the losses if they all defaulted at once.  So people got burned, really bad. Sure the big banks took a hit, because they always had some ZZZ rated stuff on their books that they hadn’t unloaded yet, but the secondary guys, the guys we never hear about, our ghost banking system, really took the brunt of the loss – along with the insurance guys who issued the credit default swaps, of course.

So, just who are these people who buy mortgages on the secondary market? Ultimately, they are individual investors and pension funds and so forth who bought Real Estate Investment Trust (REIT) funds and other derivatives.  The people who were buying this stuff were ultimately just us!  We were scamming the banks by buying houses we couldn’t afford and then the banks were scamming us by selling our own mortgages back to us as AAA rated securities that were actually our own toxic mortgages!  That’s called a real estate-based economy.

So, anyway, now we have a problem. The banks have been bailed out by former Secretary Paulson, and they say they want to lend money, but the secondary mortgage market has dried up. They can’t flip any new mortgages and they are not foolish enough to hang onto any mortgages they provides these days, so they’re just not providing mortgages.  The solution from Secretary Geithner seems to be that the government will help buy up these “securities”, which is a way of saying that you and I will be paying for our own mortgages again (by our taxes) via the secondary mortgage market.  This, of course, is in addition to us making our regular mortgage payments anyway.

The heart of the problem is that our banks don’t hold mortgages any more.  They flip them to a ghost banking system that is riddled with misrepresentation and speculation.  Ultimately, the ghost banking system is just us, you and me, either via our 401k plans, other investments, or our taxes.  We essentially wind up buying our own mortgages! Meanwhile, the big banks make huge profits by being nothing but middlemen!  This secondary mortgage market ghost banking system provided the circular linkage that created our worldwide real estate Ponzi scheme. The way to remedy this is simple: make sure the primary banks are well capitalized and then forbid them from reselling mortgages on the secondary market. A bank should be content with making its money from the interest and up front fees it charges for a mortgage and not be allowed to go for quick profits by flipping toxic assets.

Meanwhile, we need to either completely eliminate or very strictly regulate our ghost banking system.

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As economists now start talking about the U.S. entering a Depression rather than a Recession, the discussion still centers on the effects of our overly exuberant Real Estate Bubble.  It was a bubble that sucked in the entire world as other countries either emulated the U.S. policy of giving mortgages to people who really couldn’t afford them, or they invested in U.S. toxic mortgages, or both.  In retrospect, the popping of such a ludicrous bubble was inevitable – so why didn’t we all see it coming? Why weren’t the governments of the world raising the alarm in 2003 or 2004?  It’s probably because most of us don’tbb recognize bubbles until they pop; and then we say, “Oh yeah, it was a bubble all right.”

If we care to look a little more carefully at our economy – if we dare – we would probably find that we have been the beneficiaries of other simultaneous bubbles.  For example the War Bubble.  After the 9/11 attacks, the U.S., which already was spending enormous amounts of money on defense, geared up for the War on Terror, the War on Afghanistan,  and the War on Iraq.  The Defense Department budget grew, we created a separate line item in the budget for the Global War on Terror, and we created the Department of Homeland Security with its own huge budget.

The 2009 U.S. budget calls for a Department of Defense budget of $651 billion. The 2009 budget also calls for a Homeland Security budget of about $38 billion.  Combining these we have total planned expenditures for war, in some way or other, of about $700 billion.  It is interesting to note that some economists predict that the total cost for the Iraq War alone could eventually reach $4 trillion. Now were talking real money!

According to Nouriel Roubini, the NYU economist who predicted our current economic meltdown, the total amount of losses in the financial sector, due to bad real estate loans and bad business loans will be about $3.6 trillion.  So what does this have to do with defense spending? The similarity is this: the frantic economic activity during the Real Estate Bubble: borrowing, buying, and selling, injected trillions of dollars into the economy that trickled down and trickled up to all levels.  In the case of the War Bubble a very similar thing is happening. The U.S. government has borrowed a lot of money from China to finance the Iraq War. However, this cost has not been obvious to the American public because a vast amount of this money was spent either in the U.S. or paid to U.S. contractors involved in the war efforts in Iraq and Afghanistan.  For many Americans, employees of Raytheon, Northrop Grumman, Halliburton, and many, many others, their weekly paychecks have come, either directly or indirectly from the War Bubble.  In short, we have been living on two bubbles: a Real Estate Bubble and a War Bubble. Now, we are about to pop the War Bubble.

As the U.S. pulls out of Iraq and the Obama administration scales back much of our defense spending to more rational levels it seems inevitable that we will all feel the impact as defense contractors scale back.  Defense and war related jobs will be lost.  Hundreds of billions of dollars per year that had been flowing into the economy and trickling up and trickling down will stop flowing.  If the Real Estate Bubble doesn’t send us into Depression, the ending of the War Bubble – combined with the popping of the Real Estate Bubble certainly will.

Unless, of course, the Obama administration takes preemptive action and pumps a lot of money into the economy right away.  The Obama administration’s current plans are to pump about $825 billion into the economy to create new jobs.  The question is this: is that enough? Is this really enough to compensate for the double bubble economy that has been driving our economy throughout the Bush administration? I don’t think so.  He’ll need to put in more money – lots more.  Our economy is now in a screaming nose dive.  Now is not the time to be stingy. Obama should be thinking trillions, not billions.

Even more important, Obama needs to think about creating a stable economy, and a stimulus that builds roads and bridges is nothing more than a temporary fix, a finger in the dike, because it doesn’t create long term, self-sustaining businesses. It’s called a stimulus, but what is it that is being stimulated? There is not an infinite, unending consumer market for roads and bridges.

We also need a science and technology stimulus because that is where we have a chance to find and create the next generation high tech industries that can be the foundation of a 21st Century, self sustaining economy.  This is the best opportunity to get the U.S. away from a bubble economy.  So far, I don’t see much evidence of such a concept, and while the roads and bridges stimulus thing will help in the short term, we need to recognize that ultimately it’s only a Roads and Bridges Bubble.

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