Roger Marolt: Roger this
September 19, 2008
“The future ain’t what it used to be.” Was it Yogi Berra or a recently busy “Price Reduced” sign maker in Aspen who said it? Whoever it was, it’s true.
The economy’s bright future has passed. The storm has arrived. How do I know? It’s because an old friend doesn’t stop by my office anymore.
Not long ago, he came by about every other week to boast. He was killing commissions from real estate sales as easily as they used to down buffalo from train car windows on the frontier. He swore that one day he showed up to work and there was a check for $60,000 dollars sitting on his desk and he didn’t even know what piddling sale it came from.
With money this loose, he decided that the thing to do was to plow it all back into real estate. By putting 20 percent down and borrowing the rest, he amassed an impressive portfolio of property throughout the valley. He bragged that his monthly interest expense exceeded $40,000 which, by the way, was easily manageable on a million dollar annual paycheck. I told him that I thought that leveraging to this degree was risky, even in the Roaring Fork Valley. He asked, “If you’re so smart, why aren’t you rich?”
It was a harbinger that passed for logic: If you were rich, you were smart. Prevailing wisdom was to extend yourself greatly to prove it.
The smartest people were hedge fund managers. If you needed proof, all you had to do was look at their annual compensation packages. In 2006, the top 25 hedge fund managers raked in a total of $14 billion. As that is roughly enough to pay the salaries of 100,000 school teachers for three years, you can see for yourself how smart they must have been.
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But, these geniuses engineered the meltdown of the financial sector of the greatest economy in the world that now threatens to wreak angst unknown since the Great Depression. They encouraged lenders to make risky loans by buying them and bundling them into packages (the hedge) and then convinced credit rating firms to confer the AAA, “risk-free,” blessing on these “investments.” They reasoned that the loans were secured by real estate that was appreciating so rapidly that there was no peril of default. So the logic was thus: They bought risky loans because the underlying real estate was appreciating rapidly, and the real estate was appreciating rapidly because they were buying the risky loans on it. Smart, huh?
As ridiculous as this now appears, the mess had its genesis in 2001 in lower Manhattan. First the implosion of the technology stock bubble on Wall Street and then the terrorist attacks on the World Trade Center pushed a nervous country into an exaggerated assessment of imminent danger. Our government overreacted and soon had grandmothers shuffling through airport security checks in their stocking feet and interest rates near all-time lows. The government bailed us out and effectively purged our national perception of risk, which turned out to be the fatal mistake.
Although in reality nothing had fundamentally changed, the result was that emboldened families once again began planning Disneyland vacations and spooked day traders started gobbling up real estate as if there was no downside. Housing prices skyrocketed and, since real estate appreciation is not considered in calculating the Consumer Price Index, inflation appeared to be in check. Damned be common sense, and since there was no data to justify the Federal Reserve Board raising interest rates to cool down a hyper-inflated housing market, rates remained unnaturally low. People were borrowing at 3.5 percent and their houses were appreciating at 12 percent per year. Cash-out refinancing on homes was the rage. It was easy, “risk-free” money, and consumers spent it freely. The economy hummed.
Then, a funny thing happened on the way to the bank late in 2007. Millions of adjustable rate mortgages, the initially low interest “ARM” loans that should have appeared too good to be true from the beginning, adjusted after what amounted to a three- to five-year grace period on house payments. Monthly mortgage payments shot up, but only the people who we all knew shouldn’t have been borrowing money in the first place were effected. No sweat, the rest of us had nothing to worry about.
What we didn’t consider, though, is that the investors who encouraged all of these high-risk loans, because of the valuable underlying real estate collateral, didn’t actually want to own houses that borrowers were now walking away from. They sold them as quickly as possible in foreclosure. Soon, neighbors felt the squeeze. Their houses dropped in value because of the fire-sale pricing next door.
Even for a person with a decent job and good credit history, it is painful to be paying off a $400,000 mortgage on a house valued at $325,000. Many homeowners facing this bleak reality walked away from the “investments over their heads” when they realized they really were in over their heads. Instead of moving up to the next dream house, people began dropping out of the market. The spiral inverted.
So, layer by layer, the housing market pyramid collapsed. First the lowest-priced housing fell in value. Then the next layer flopped. With pricing at each level holding up the prices of the next, once the support began to crumble, the unthinkable eventually occurred: Values of luxury homes have dropped. Nobody is buying, not even in Aspen.
Where we stand now is that investors, the people who ultimately put up money for loans, have experienced the downside of risk. They have less money to invest and are reluctant to get burned again. As a result, banks and other lenders have less money to lend because they can no longer sell their existing loans to generate new lending capital. Interest rates have risen, and it is much more difficult for consumers to borrow. The home equity ATM is closed, and consumers have nothing left to spend. This is the credit crisis exploding.
Our government is once again stepping in to assuage the painful realities of taking risks by shoring up giant financial institutions that took too many. Should they really be sticking our money into companies that investors are fleeing from? Policy makers are seeing the future the way it looked back in 2001. But, the future truly is different than it used to be. With the cloud of risk swirling directly overhead, the sky looks darker. Government intervention at this point is like an umbrella in a typhoon. We should have endured a sprinkle in 2001. Because we didn’t, now we are going to get soaked.
Roger Marolt hedges his bet every Friday in The Aspen Times. You can send him e-mail at email@example.com.
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