Friday, June 08, 2007

The Disappearing Money Supply

With the housing bubble, one thing that people don’t really comprehend, is that no matter how low prices go, there will always be an owner of every house that is standing. The real hard part of this nut to crack is the perceived evaporation of value. If it was sold at 2 million last year and is sold today for 1 million, there is a real reduction in the money supply. The asset is being marked to market. Whether the owner sells it at a loss, or it is sold after a foreclosure, the loss is real.

Let’s examine the 12 trillion dollar real estate market. If everything got marked down say 50%, there would be a loss of 6 trillion in the money supply; this is people money, not government money. This contraction in asset value will leave people short of cash and further stress the banks for funds. Interest rates will have to rise.

When we finish marking everything to market, there will be people who have nothing left. They were leveraged and it’s all gone. Others with little debt may now have the option to buy assets at fire sale rates.

Just using the real estate market, example from above, the 6 trillion represents a massive contraction of the money supply. But on the brighter side, about 30% of homeowners own their house outright. Here are people who have capital to invest. It’s these people, who will be the new real estate investors, probably at 10 cents on the dollar. It’s going to get real fugly, but the market will be orderly (we hope).

FDR had to close the banks back in 1933, but “it’s different this time.” You can’t really close a mutual fund or investment program. They are going to trade all the way down to absurdity. Historical note: between October 1, 1929 and August 31, 1932, 4,835 American banks failed and that can’t happen with FDIC insurance today.

-----------------------------------Quiz Question-------------------------
Nobody today, keeps their money in a bank they keep it in a ____________ (fill in the blank).

So if your mutual fund is insured and buys shares of Google at $508 and Google drops to $8, it’s a real comfort to know that your fund is insured. You get to keep the $500 dollar loss and management gets $7.99 for management fees. Just think how lucky you are that your fund isn’t buying the China market! Are we rich yet???


Numpty McHoon said...

that can’t happen with FDIC insurance today.

as grandpa used to say "don't worry, your money is backed by the federal government. If there is ever any problem, as long as they have the funds, they'll have to pay up. At a fraction of your principal, but they'll pay up. After all, the entire system is based on confidence. Without confidence, nobody would invest."


I suppose he meant it's all one big game of confidence.

Jim in San Marcos said...

Hi Numpty

Another point often overlooked, back in the last banking crisis. You got your insured deposits back, but it took some time, up to a year from what I have heard. Some senior citizens were upset that they needed the money immediately for medical reasons.