Tuesday, August 14, 2007

Credit Tightens

The big financial story of the past week or so has been the tightening of credit standards, falling stocks, and hedge-fund bail outs. I am no financial expert, but I have been following the housing market pretty closely, and was actually at a hedge fund in 1998, the last time that industry blew up.

Firstly, it's easy to vilify banks for "predatory lending" practices when they sold strange and exotic mortgages to homeowners, but I don't think that's fair. "Predatory lending" kind of makes sense when your interest rate is usuriously high, and the borrower has no other options, but it boggles the mind to use that phrase when the interest rate turns out to be too low. Let me put it another way -- if a car dealer gives you absolutely cut price financing on a new car, are they "preying" on you in any way, or are you "preying" on their desire to make a sale?

When you buy a house you are doing two things: 1) paying rent to yourself instead of someone else (and forgoing the opportunity for someone else to pay that rent to you), and 2) taking a long position in the asset class that is real estate in your local area. The type of mortgage you take out has no bearing on the rent you are "saving" (or forgoing) but it has everything to do with how levered your long position is in the asset class that is real estate. While the details of ARMs, neg-am mortgages, NINJA loans, no-money down deposits etc. are complex, essentially they all add leverage to that position. This is fine when prices are rising, but it also means you will lose all of your money (equity) when prices fall. Historically, home prices have never fallen, but they have never had such leveraged financing either.

And we still have about 6 months until the ARMs start resetting at their higher rate.

Ultimately, I don't think that defaults etc. are all that bad for homeowners. If the value of the house is lower than their mortgage, they will take the credit hit and hand the keys back to the bank. They will have lost whatever equity they had in the house, although that amount was probably quite small given how levered the invest was. As total housing stock has gone up, these individuals will simply rent until they have enough money and credit to purchase real estate again. Renting is not the end of the world.

The hedge fund turmoil is something else. I'll post on this soon.

UPDATE: I don't agree with everything RGE says, but this post on how leverage magnifies gains on the upside and losses on the downside is very good.

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