BobK

We keep hearing about the “housing bubble,” and how rampant speculation has caused turmoil on Wall Street. But was the housing bubble a result of excess speculation, or an excess aversion to speculation?

Remember the economic environment in 2002-2003. We had just seen the bursting of the Internet bubble. Dot-com stocks went from stratospheric valuations to worthless in a matter of months. The Dow and S&P indices had been halved. It had been a classic speculative “greater fool” bubble, and even large-cap S&P stocks had been bid up to P/E ratios of nearly 30. The crash was painful, and wiped out many. And in the aftermath of the burst stock market bubble, we endured 9/11, a recession, and the Iraq war.

In response, Alan Greenspan and the Federal Reserve cut interest rates to historic lows. Of course, this remains a controversial policy decision. Regardless of the wisdom of the policy, though, lower interest rates make investments more profitable, compared to leaving one’s money in a safer place like a bank or money market account. But in 2002-2003, despite the inducements of low interest rates, Americans had no stomach for risky investments. At the time, Apple looked like a risky investment at $10 a share.

So we started buying houses. Houses aren’t investments, they’re savings, right? Well, that’s the conventional wisdom, and in truth, if you buy a house and stay in it for a decade or more, it’s almost certain to increase in value.

But houses, like any other asset, are an investment. They’re a relatively safe investment, but they’re an investment nevertheless. On top of that, they’re a leveraged investment. Huh?

If you buy a house with a 20% down payment, you’ve borrowed the other 80%. You’re leveraged four to one. If the house goes up 5% in value, the return on your down payment is 20%. Likewise, if the value declines 5%, then that represents 20% of your down payment.

In the era of low interest rates and rapidly-appreciating home prices, many lenders required smaller down payments. Ten percent down became common. If somebody buys a house with 10% down, they’re leveraged nine to one. If the house goes down in value by 15%, then they’ve lost their money and they’re in the hole. It become more profitable to default on the mortgage than to pay it off.

Of course, people buying homes rarely think in those terms, and it’s hard to fault people for investing in homes rather than in stocks. But what was overlooked was the amount of leverage that was quietly being built into the economy. And that’s before the banks got hold of it.

In the aftermath of the Internet bubble, institutional investors and hedge funds liekwise experienced some risk aversion of their own, and rather than piling into stocks, they started buying… more and more mortgages. Since mortgages by their nature normally pay a small but steady return, the various bankers and investors leveraged themselves up… they’d put up one million, borrow 19 million at a low interest rate, then buy 20 million dollars worth of mortgages, and profit from the higher interest rates paid by the mortgages. Nothing could be safer… or so it seemed. It’s been a common practice on Wall Street for decades. But in this housing bubble, too many people made the same bet at the same time, and there was nobody to pay it off.

Eventually, of course, we experienced a housing downturn, many folks started defaulting, investors started asking for their money back, and suddenly everybody tried to sell the toxic mortgages to each other (remember, they had to dispose of several million dollars’ worth of mortgages for each million that investors withdrew). And there were no buyers, only sellers. And that’s been the basic problem plaguing the fixed-income markets over the last year or so. The bubble wasn’t caused by speculative excess in the way we normally think of it, but by a large accumulation of very small risks… combined with somewhat invisible leverage. It’s great on the way up, but when it comes time to unwind that leverage, it’s a messy business.