Where My Mind has Wandered

Productivity, Speculation, and Monetary Policy

One of the theories behind U.S. monetary policy is that if we make money easier to get (low taxes and low interest rates) people will invest in activity that drives productivity. Business will expand, new business will open, more jobs and economic growth will follow. The problem with this theory is that it is not absolute. Investment does flow into productivity, but investment also flows into speculation. The technology and real estate bubbles are perfect examples. Speculation drives false productivity, where the value of assets rose based upon perceived value versus actual productivity.

While Alan Greenspan and Ben Bernanke were driving down interest rates to avoid inflation HGTV was airing The Big Flip eight times a week. Funny how the word "flip" showed up in both the tech and housing bubbles. Here is how HGTV promotes the show:

Our renovators, Paul Peic and Kye Husbands, are taking on the challenge of fixing and flipping as many houses as they can in just 12 months. Or lose their minds and shirts trying. Paul and Kye are experienced entrepreneurs who will try anything once, but neither one of them has ever flipped houses before. They say it's not a problem. They're convinced they have what it takes not only to be successful... but really, really rich. The investment, the sweat equity and any ups or downs are all theirs. Can it be done? They think so.

HGTV's peers were all in the game, with competing shows including Flip this House and Flip that House. There is a big difference between a VC that can afford to spend $500 million on 10 start-ups in hopes that one ends up worth $5 billion and people putting all of their savings into real estate and tech stocks. Most venture capital firms aren't investing with their own money. Investing is what a VC does for a living, and the good VCs bring assets to the companies they invest in that make those companies better.

The investor who overextends to invest in properties in Southern Florida is working in a completely different environment. Let's say he put $1.5 million down to buy 20 properties for an average price of $500,000. That gives him $10 million in mortgage liability and $100,000 a month in mortgage payments. He is investing his own money. No one property is going to "make it big" and suddenly be worth $50 million to offset losses elsewhere. And if he can't cover the mortgage payments he has to start selling off property, regardless of the market conditions. The is a real scenario. I rented a house from someone in exactly this situation. The day after we went home from our vacation in Disney World the bank foreclosed on all of his properties.

This kind of speculation happened across the country in both larger and smaller scales. I don't have an answer; the solution is not obvious. I'm all for lowering taxes and trimming government spend. And I am not against low interest rates. I do think that when you use terms like "irrational exuberance" and "froth" to describe market conditions perhaps driving down interest rates, on its own, isn't the best course of action. Once again, I'm not in a position to say where those interest rates should be, but our policy makers need to much smarter at avoiding and/or managing bubbles. 

White Knight Misses Battle

Treasury Secretary Henry Paulson's 218-page regulatory blueprint was released today. Sure, I bet some regulatory tweaking would make a difference, but one can only hope that at least 100 pages suggest some common sense and reading a newspaper once a week.

Even as early speculators were making money hand over foot during the real estate bubble they knew a day of reckoning would come. Everyone can't get rich on the same exact scheme, that isn't how the economy works. Press coverage on the issue started ages ago. Home prices were surging. Home builders were getting bolder and bolder, buying huge tracks of land. Experts questioned the wisdom of ARMs. Well-off people were putting their retirement funds into condos and vacation homes with the overt goal of flipping. Sound familiar? Built to flip? Tech bubble? Come on, seriously, we all knew this was coming.

Perhaps the big financial institutions didn't get burned enough by Enron or the tech bubble. It was their clients, after all, that bore the brunt of all that vaporized stock equity. This time around the implosion of Bear Stearns has taught them a hard lesson.

Yet we never apply lessons learned in one area to our future actions in another. Don't think for a moment that we won't suffer another financial debacle within the next decade. Our economy seems to be programmed this way.

So now Henry Paulson has arrived on the battlefield, a white knight mounted on his war horse. Yet he has missed the battle. All he can do is watch the dying get carried off the field and the dead get buried where they fell.

Sub-prime loans are only part of the real estate story.

The current focus on sub-prime loans (note Google News Reference Volume) makes sense, I suppose, but the real estate bubble is a lot larger than just the sub-prime market. Speculation by investors had a lot to do with the rise in volume of sub prime loans, as did historically low interest rates, as did the desire among low-income families to own homes. However, speculation was hardly limited to the sub prime market.

The developers were selling lots, the builders were selling homes, and the buyers were snapping them up as fast as everyone could secure a loan. Otherwise prudent investors were buying second and third homes, looking for a quick profit. And not the inexpensive vacation homes and cabins of our parent’s generation. A half-million for a house by the water was nothing, and peoples were plowing their savings into $200,000 - $300,000 condos before they were even built. The results are easy to see. Below are some data points from a recent Fortune article by Tom Garnder:

Year over year, building permits are down 28%, building starts are down 16%, and foreclosures are up 35% nationwide. The sentiment indicator of the National Association of Home Builders is at a 26-year low. Shares of one residential construction company after another have fallen at least 40%.

A visit to some resort communities in Florida will reveal plenty of empty lots, unfinished buildings, and for sale signs. The very rich may be riding this one out, but many of the everyday rich are feeling the pinch. Even prudent investors were often hurt by the swift turn in the market.

The speculation impacted buyers who were looking to buy their primary residence as well. The surge in home prices made houses harder to reach, and therefore made variable interest loans with a low initial rate more attractive.  For many people in hot markets, even middle to upper-middle income families, it was an appealing way to stretch into a house that four years earlier might have cost 25 percent less. Even if these families can continue to meet their increased monthly payments as interest rates rise, they will have significantly less disposable income, and that has to impact the U.S. economy.

The signs were there. The articles were abundant. Most people had plenty of warning and simply elected to ignore it. I can’t fathom why, and I am hoping we get a little smarter before the next bubble hits.

My wife and I bought a house four years ago, near the peak of the residential market. Not great timing, but we were ready to move. My father told me that if I planned to live in a house seven years or more the smart play was to put as much as I could muster into the down payment and get a fixed rate, 30-year mortgage. With interest rates at historic lows I thought that was good advice and I took it. The value of my house may not appreciate five to 10 percent a year for the next five years, but it will hold its value until the market recovers and my monthly payments won’t increase.