Archive for the 'What is a bubble?' Category

Date: October 23rd, 2006, Filed under What is a bubble?

CHICAGO, IL

By L.S.
A.B. Dada is out of town due to a family member having surgery.
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Someone I worked with years ago is feeling pretty lucky about the house they’re trying to sell. They feel good because they don’t really understand the math involved in the process of what they’re losing. I feel bad for them, but after a few hours total of repeated explanations I gave, they still can’t see that 1 does not always equal 1 when it comes to price changes.

I believe they bought their house for US$400,000 in 2004 — quite shy of the peak value of the property which was supposed to be about US$480,000 in mid-2006. This is a 20% upswing, a gain in value in pure dollars. In terms of real value gained, it is hard to say — how much value had the dollar lost in 1 year in terms of what they bought and their lifestyle?

I know they took out a HELOC (home equity line of credit) in early 2005 and extracted some amount from it — a vacation and some nice household items were added. I’m not sure what amount they extracted, but I’m guessing around US$40,000. I do know they closed on the loan with only 5% down, and there was definitely PMI included in their mortgage cost. Luckily, they had refinanced with a fixed rate loan.

Their house went on the market for US$500,000 a few months ago, but hasn’t budget at all. They told me they don’t mind, they know their house gained 20% in value in just 16 months. If they have to sell for US$450,000, it’s only a 10% loss from what they were asking. 10% versus 20% — sounds like a fairly close number, doesn’t it?

My explanation to them is that a US$100,000 house that appreciated to US$200,000 goes up 100% in dollar-value. If that same US$200,000 house drops to US$100,000, it is a 50% loss in dollar-value. The actual price in dollars moved the same — US$100,000 up, and US$100,000 down. The percentage, though, was 100% up, and 50% down. You can’t compare percentages in upward and downward motion!

Gaining 20% in dollar-value and losing 10% in dollar-value is NOT the same thing. Once you factor in the HELOC extraction (the vacation has zero resale value now, and the home items probably depreciated 50% the day of purchase), the maintenance and tax costs of living in that nice neighborhood, and the realtor fees of 5% or so that they’ll have to pay on closing, the numbers don’t add up. They didn’t get any offers at US$500,000. I don’t believe they had even one interested party at the open houses. The 20 or so people who showed up without realtors were likely neighbors who wanted to see what they had going on in the walls.

What will happen if they have to sell at US$400,000 or US$350,000? That’s a loss, no matter how you look at it. Sure, everyone pays property taxes, some pay home owner’s association fees (they did), and everyone pays the realtor, but the loss is significant, especially if you walk away having to pay the bank beyond the check you get from the buyer. In this case, selling the home for US$350,000 after paying the realtor nets you about $332,500, or a total loss of about $67,500 in that time period — NOT including taxes, maintenance, upgrades, and association fees. Ouch.

We have to stop looking at percentages when it comes to valuation of what we buy and sell. We have to stop comparing dollars in one year to dollars in another — with each family and market having different costs of living and different real inflation figures, it is even harder to know what you made or lost. People who walked away with a 10% profit over 3 years may be lucky to break even, but considering many are selling houses that are decades old, even breaking even is an amazing thing.

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Date: October 16th, 2006, Filed under What is a bubble?

ARLINGTON HEIGHTS, IL,

By A.B. Dada
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I was looking at a pint glass of Diet 7UP a few weeks ago, staring at the formation of bubbles near the bottom and watched them as they rose. It made me think about the current housing “bubble” — the news media is ablaze with articles about the so-called “soft landing” or the possible “popping” of the bubble. My mind imagined bubbles in that glass that didn’t really exist — economic bubbles.

Every economy is like a bubble of CO2 in a glass of 7UP: the CO2 is the equivalent of the cash available in a given market. Where the bubbles are in the glass is the equivalent of the supply of the item or service that is sold in the market: bubbles near the bottom signify low supply of the item or service. Bubbles near the top signify a high supply of the item in the market.

I pictured these bubbles of money slowly combining: money that was used in one market might be spent in another. As money changes hands, bubbles become bigger: more money runs into the market. As the bubble increases, companies create more products or services in order to meet that growing source of funds. If houses are cheap and money shifts into that economy, the additional funds chasing the same number of houses means prices tend to go up. If no one wants a house, the house’s value is near zero (except to the owner). If ten people want the same house, the price goes up almost like an auction. The more money that is in a market, the higher prices tend to go. This is inflation — not always bad inflation, just market-specific inflation. As prices go up, people see the opportunity for making a profit: more houses are built to try to capture that profit.

As items are built or services are added, the bubble tends to float upwards: more supply. Usually as supply is added, prices stabilize. Demand is up for the item, but the amount of items is up because of added supply. Prices tend to return back to where they were before items were scarce. The problem comes in seeing that no one really knows how many others are creating new items or services: the chance that too many items or services might be created is out there, but people are short-sighted. They saw the profits increasing for a few years, and they believe it will always last. The problem is that there is only a limited supply of NEED for certain items. Eventually, as the bubble grows to a huge size and gets closer to the top of the glass, it starts moving even quicker upwards: more and more people starting providing for the item or service. These are usually last minute speculators who are convinced that they can’t lose, and they don’t want to miss the chance to make money that everyone else seems to be making.

The worst part of the bubble economy is that the government throws a wrench into the system: politicians love seeing people THINK they are making a profit, so they work to make it easy to put more money into a growing economy. They create this money out of selling future income (called debt) to foreigners and investors: this creates new money that can be used now, and just needs to be paid off in the future. If the money is to be paid off at a lower cost than the short term profit of making and selling an item or service now, people will use arbitrage to borrow from the future to make quick money in the short term. The inflation of the money base by government makes bubbles more attractive: people who should never put their money into a market do so only because a market seems to have made more profit in recent years than ever.

Eventually, the bubble hits the top of the glass and seems to pop: there are so many items and services available the market that they outnumber the demand for the items and services by those who actually need them. Too many houses are built versus the true number of homeowners. Usually it has to do with late-coming speculators: they build and buy and fix up, and then they hope that they’ll make the numbers that people made a few years ago. When that bubble is big and moving upwards at a fast pace, it usually means that the top of the glass is near.

But when the bubble hits the top (supply far outstrips demand), it doesn’t really pop. What happens is that the bubble really gets squeezed: the money that used to be in the market leaves. People who made a profit a few years earlier realize the risk is too high, so they take their profits out of the market. For the run-up years, though, many who made a profit reinvested in more homes or bigger homes to make more money. Now, the money in the bubble leaves. Yet the number of homes is still high, maybe even higher, so the bubble sits near the top of the glass, waiting to jump out.

The bubble doesn’t pop — the money just left the market. The bubble shrinks, and the CO2 (money) from that bubble flows towards the bottom of the glass to become part of another market. This happened during the tech boom: government created money (debt instruments) to be paid back later, initial tech investors put their old money into the market, and that bubble slowly grew bigger (from new debt money and old earned money) and moved towards the top of the glass. Soon, everyone was starting a dotcom and going IPO: even though they was already an excess of service-industries and item-makers. The bubble didn’t pop: those who profited moved their money out of the market, and the bubble deflated. Eventually, companies went out of business, so the tech bubble, smaller as it was, was able to move down the glass (lower supply) until it reached a temporary equilibrium.

All that money from the large tech bubble moved down in a hidden fashion to sit and wait for the next profit to be made. That CO2 gas in my Diet 7UP joined up to the housing market: and government propelled it upwards by providing more easy money.

Now the housing bubble is huge — it was moving at breakneck speeds last year in terms of prices going up and people creating more homes to catch those upward prices. It seems to be beyond the hope of any additional profits — supply is huge, demand is tiny, and the people who profited are keeping their profits out. Yet all that government-created money is still out there — it is just slowly sliding to the bottom of the glass. Eventually, it will connect with another small bubble that is sitting near the bottom, or even near the middle of the glass. We’re seeing that in the stock market again — money is coming from somewhere to create a newer bubble in the stock market.

The housing bubble won’t pop — it will only lose size to see that bubble’s gas flowing into another future bubble. This is the problem with government helping create all that gas to be used today: it has to be paid back tomorrow. The U.S. government never pays its debts, so it has a lot of gas today — yet someday, the real owners of the gas will come back to collect. Until that happens, we can expect more bubbles to become larger, move up the glass faster, and then find themselves without gas being lost to whatever new bubble is created. I feel sorry for those people who decided to try to make the bubble a little bigger and end up being the ones who see the bubble shrink: their gas is now gone, and the future does not look bright.

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