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bkkandrew · 28-04-2008, 04:13 AM

An interesting metaphore I found on the housing market:

The rises in property prices were not real. They do not exist. Houses do not make money. They just sit there, being houses. A couple of years ago, it almost seemed sane for a home-owner to go to work (doing something productive in the economy) and come home having made a few hundred pounds for their efforts, then think to themselves "My house has gone up in value by a few hundred pounds today. It's made more than I have". The idea is, of course, crazy. The house has not added any value to the economy at all in that time. (It's actually gone down in value slightly each day, as it deteriorates slightly, bringing it ever closer to needing increasingly costly structural maintenance/repairs, or necessitating a new structure being built on the piece of land to replace it).

Anyway, the money was not real. All that happened was the amount of debt available steadily increased, meaning there was more money available to spend on houses, meaning the prices went up. This increase in prices was NOT created by the houses themselves (remember, they are all just pretty much sitting there, being houses), but was created out of the increased amounts being leant. And the more people were able to borrow, the more they were able to spend on houses, so the more the prices went up, so the higher the value of the asset that these loans were secured against.

This is infact the folly of secured borrowing as a principle. If you borrow too much money to overpay for absolutely anything, then at the point of the transaction no 'alarm bells' will ever ring. I could lend you £1m to buy an empty Cola bottle from me, and at the point of the transaction your own personal balance sheet would look pretty healthy. Sure you have £1m of debt, but you also have assets (a Cola bottle) worth £1m, so there is nothing to worry about. We know the Cola bottle to be worth £1m, because it is "marked to market" (i.e. the last price it was sold at), and it has just sold for £1m, so it's WORTH £1m. Not only that, but since it only used to be worth about 2p before you bought it, it means that Cola bottles have now gone up in value from 2p to £1m. So at this point - all is well. There is no problem, and even if there was, you have assets that match the value of your debt, so if it all goes bad you could simply sell the empty Cola bottle for it's "market value" (£1m) and clear the massive debt.

So all looks ok for a while... until - you realise that you cannot service a £1m debt, regardless of the fact you own as asset of the same value (it can't pay for itself). So the Cola bottle has to be sold. And guess what, if no-one else can afford to service a £1m debt either, then you sell your empty Cola bottle for the 2p it was actually worth, and lose £999,999.98 in the process.

Now, in my silly example above. Did the £999,999.98 of gains ever really exist? Of course not. The money was never real. It was just an illusion temporarily created by the over-extension of unservicable debt. It would be completely irrational to, at the point the exuberent supply of credit was withdrawn, to even be speculating on whether it was going to affect the gains. The gains weren't real, and as the credit bubble reverses, all the gains simply evapourate.

Exactly the same thing applies with all the gains in property over the past 5-10 years. The credit bubble giveth, the credit bubble taketh away.

28-04-2008, 04:13 AM	#45 (permalink)
bkkandrew Clingin' on... Join Date: Oct 2007 Location: BKK Posts: 4,145	An interesting metaphore I found on the housing market: The rises in property prices were not real. They do not exist. Houses do not make money. They just sit there, being houses. A couple of years ago, it almost seemed sane for a home-owner to go to work (doing something productive in the economy) and come home having made a few hundred pounds for their efforts, then think to themselves "My house has gone up in value by a few hundred pounds today. It's made more than I have". The idea is, of course, crazy. The house has not added any value to the economy at all in that time. (It's actually gone down in value slightly each day, as it deteriorates slightly, bringing it ever closer to needing increasingly costly structural maintenance/repairs, or necessitating a new structure being built on the piece of land to replace it). Anyway, the money was not real. All that happened was the amount of debt available steadily increased, meaning there was more money available to spend on houses, meaning the prices went up. This increase in prices was NOT created by the houses themselves (remember, they are all just pretty much sitting there, being houses), but was created out of the increased amounts being leant. And the more people were able to borrow, the more they were able to spend on houses, so the more the prices went up, so the higher the value of the asset that these loans were secured against. This is infact the folly of secured borrowing as a principle. If you borrow too much money to overpay for absolutely anything, then at the point of the transaction no 'alarm bells' will ever ring. I could lend you £1m to buy an empty Cola bottle from me, and at the point of the transaction your own personal balance sheet would look pretty healthy. Sure you have £1m of debt, but you also have assets (a Cola bottle) worth £1m, so there is nothing to worry about. We know the Cola bottle to be worth £1m, because it is "marked to market" (i.e. the last price it was sold at), and it has just sold for £1m, so it's WORTH £1m. Not only that, but since it only used to be worth about 2p before you bought it, it means that Cola bottles have now gone up in value from 2p to £1m. So at this point - all is well. There is no problem, and even if there was, you have assets that match the value of your debt, so if it all goes bad you could simply sell the empty Cola bottle for it's "market value" (£1m) and clear the massive debt. So all looks ok for a while... until - you realise that you cannot service a £1m debt, regardless of the fact you own as asset of the same value (it can't pay for itself). So the Cola bottle has to be sold. And guess what, if no-one else can afford to service a £1m debt either, then you sell your empty Cola bottle for the 2p it was actually worth, and lose £999,999.98 in the process. Now, in my silly example above. Did the £999,999.98 of gains ever really exist? Of course not. The money was never real. It was just an illusion temporarily created by the over-extension of unservicable debt. It would be completely irrational to, at the point the exuberent supply of credit was withdrawn, to even be speculating on whether it was going to affect the gains. The gains weren't real, and as the credit bubble reverses, all the gains simply evapourate. Exactly the same thing applies with all the gains in property over the past 5-10 years. The credit bubble giveth, the credit bubble taketh away. __________________ The future of TeakDoor: To view links or images in signatures your post count must be 10 or greater. You currently have 0 posts. A funny thing happened today - Ant trolls, stalks, prevokes and generally upsets approximately 15 members of the board, yet Noodles goes to jail. Perhaps it was a dream... To view links or images in signatures your post count must be 10 or greater. You currently have 0 posts.