Saturday, June 24, 2006

Similarities to previous Bubbles?

If you look at the Tulip Mania in Holland in the 1600's it ruined a lot of people. Demand for bulbs dropped to zero. From then on, if you grew tulip bulbs, you were looking for a second job to support your family.

With the South Sea Bubble of 1720, there was a very fast evaporation of assets. Stockbrokers were looking for that second job.

With the current real estate bubble things should be somewhat different. There is an asset with a rental value. Rental values are pretty constant. At some point, the distressed property owner is going to realize that renting might be cheaper than paying on his present mortgage. The real owner of the property, shares ownership with the note holder. If the owner walks, the note holder is left holding the bag. Notice nothing has really happened, just a change of who is responsible for the asset. At this point the note holder has picked up a very healthy negative interest rate on his investment. No interest payments, property tax accrual, building maintenance and management.

Lets take a $600,000 house. It will take 9 months to foreclose unless they hand you the keys. Figure $27,000 in missed interest payments, $4,000 in property taxes. Now figure that the neighbor sells his for $550,000. Even though prices only dropped $50,000, the note holder has taken a $81,000 bath. In reality, they gave someone an interest free loan for 9 months and then paid their property taxes to boot. If there is Mello Roos, joke gets even worse!

The first thing to go "poof," is the second trust deed. The first trust deed still has some cushion albeit not much.

Second trust deeds would be a hot potato. There would be the urge to sell them. Say you have a $200,000 trust deed at 10% interest and you want to unload it fast. Discount the note so it pays 20% interest and sell it for $100,000 cash. Notice that you salvage 50% of a almost certain loss. What happened to the interest rate on the second trust deed market? it jumped to 20%! At this point, there is still no shortage of money yet, just a shortage of suckers looking for a steal. Raise the discount, you get more "investors." The aspect of risk is returning to the market.

What needs to be realized, is that this is a balancing act. Things can still be in harmony with everything so obviously out of whack. Nothing has really happened to make people want to "Throw in the towel." Something will trigger the fall, something very unexpected; a huge earthquake, a big bankruptcy , something we never dreamed possible.

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