Entries Tagged 'Economics' ↓

This is the calm before the storm of the next housing crash. As the pendulum continues its down swing, expect more fallout across a broader number of housing markets. For the enterprising investor, the upcoming “double dip” presents an unprecedented opportunity to profit.

Zero Hedge presents the case for a second leg to the housing crisis and a lack of government regulation has provided yet another chance for investors to reap tremendous profits. Remember credit default swaps?

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A bookie is an arbitrager. He has no skin in the game; rather, he uses odds (the parallel in finance would be interest rates) to earn money on each bet that is placed (each financial transaction). The odds are always variable unless you are willing to pay a fee to lock it up.

At yesterday’s financial committee hearings, Loyd Blankfein gave a general overview of his firm’s risk management management practices: to paraphrase, risk mitigation is achieved by finding a third party to take the other side of the transaction. Fees from brokering these investments are a significant source of revenue for most investment banks. The research divisions of these same investment banks will also put out opinions on the direction of the market for most of asset classes, fortunately for bank, 50% of their customers will make sound investment decisions.

The issue in late 2008, was that the third party (AIG) in many of these transactions took on way too much risk from numerous investment banks. They put everything on black, and they were wrong. The result was that AIG couldn’t make good on their debts and the government had to come to the rescue. The investment banks had significant exposure to AIG’s credit risk and this is where the domino’s would have begun to fall.

Imagine a bookie in a similar situation. He takes a bet on opposing outcomes from each of two parties; one wins big money and, all because of overextending himself, the loser can’t pay. What’s a bookie to do?

If the financial committee could see the banks in the same light as a bookie operation, it would clear up much of the confusion over how to handle any future regulations. It seems apparent that a transaction tax could be levied or that banks can be required to have more skin in the game.

This brings up accounting issues, but should banks be required to hold some portion of every transaction on their books? How much is enough? Is 8% of risk weighted assets enough? Is there a better way? Let me know in comments.

Advice to President Obama:

.”..we’re going to unclog the arteries. My banking experts have analyzed each of your balance sheets. You will tell us if we’re right. Those of you who are insolvent, we will nationalize and shut down. We will auction off your viable assets and will hold the toxic ones in a government reconstruction fund and sell them later when the market rebounds. Those of you who are weak will be merged. And those of you who are strong will receive added capital for your balance sheets, after you write down all your remaining toxic waste. I am not going to continue rewarding the losers and dimwits amongst you with handouts.”, Thomas Friedman wrote on Sunday.

With another $350 billion to spend, Barack Obama has a critical decision to make. In this mess of an economy, who is the best allocator of capital (how can we get the most bang for our buck)? There are three broad options:

1. Individuals
2. Government
3. Businesses

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Public works projects are well intentioned and should certainly be pursued where appropriate; however, government has largely proven to be an inefficient allocator of capital. The single greatest tool the government has is the ability to incentivise behavior through fiscal policy rather than mandate it through regulation.

In this spirit, if we want America to thrive again, government should focus its efforts and resources on putting Americans back to work. The key to this strategy is to reduce labor costs for employers.

• Obama has it right with his tax credit for businesses hiring new employees, but this does not go far enough. There is a need for a number of other programs which have been tossed around by the new administration and some they haven’t thought of yet.
• The tax credit certainly lowers costs, but it is an upfront savings which effects will be limited by businesses already struggling to keep who they currently have on staff.
• Healthcare is another crippling cost that keeps employers payrolls smaller than they otherwise would be. This is why passing Obama’s healthcare plan will open up resources for hiring a more robust workforce.
• Offer employers further tax benefits for subsidizing the education of new employees and community college students who will commit to working for the company once they graduate. Not only will this be a boon to educational institutions, it will provide a clear path to employment for underprivileged youth.
• A modified section 8 program can close the gap left by a weakened economy, falling wages and a government which is quickly becoming over-stretched. The impact on struggling families and a faltering real estate market would work by encouraging those under threat of foreclosure to make sure they are working, even if their wages were less than desirable.

Much of our strength as a nation comes from the incentive system embedded in a capitalist economy. Rewards come to those who work harder and smarter than the competition; put in place the right incentives, put America to work and we’ll be on the road to recovery sooner rather than later.

Adapting the Section 8 housing subsidy model, government might the answer we are looking for that will abate the cascading housing crisis. At the root of most of our economy’s problems, especially the contraction in our credit markets and financial institutions, are falling home prices nationwide; a phenomenon never before seen in America. Much of this turmoil was caused by misaligned incentives; however, we can use these same lessons to implement innovative solutions which capitalize on our fundamental economic motivation: financial independence.

A program which expands rental subsidies to homes sold that are in danger of (or already through the process of) foreclosure would do two important things to help abate the current crisis: (1) guarantee real estate investors a baseline rental income –effectively allowing them to accurately value a property based on cashflows which are backed by the government– and (2) help individuals in danger of foreclosure by providing them a way to stay in their homes, even though they will no longer own them.

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If 40:1 leverage was responsible for much of the GDP growth over the last decade or so, what does this mean for us going forward?

Here are a couple of questions we should be asking to determine where we are and where we are going (it’s already clear how the housing crises started):

1. Which assets benefited most from this exorbitant leverage environment?
2. What is a “healthy” level of leverage for these assets?
3. Based on the above two answers, what is the legitimate price level for these assets?
4. Did any of the financial engineering of the past decade have a legitimate use in risk reduction, thereby increasing what historical levels of “healthy” leverage are?

To the extent we can answer these questions, one should be able to call a “real” bottom and determine what the true expected returns will be in the long run. I haven’t seen a fair analysis of this anywhere, but if you have, please point to it in the comments below.