Socializing Bad Investments

[mike777]

"I think it's quite simple. Contractors buy off market risks associated with fluctuations in raw material markets. That's standard. I just want homeowners to have a similar posibility."

 

Ok let me try one more time. The statement you have above is just not true. :)

 

You can never have no downside risk and keep all of the upside risk.

 

Why would I sell you that product? I am only going to sell you a product where I have a high chance of making a profit. I am not going to sell you a product where I have a high chance to loss money and a low chance to make tiny money. :)

 

However I will sell you a product where you have a chance to lose lots of money and I have a high chance to make a little money. :)

 

Contractors can buy off some of the market risks with fluctuations in raw materials for a short time. :) If they bought off all of the risk it would cost you 100%.

 

Same thing is true in any market including housing. :)

 

Let me try and explain using a farmer of corn. :)

 

Day one I forward sell all of my corn (X bushels of corn) for 100,000$ I lock in my production costs of 90,000$...I got a guaranteed profit of 10,000$ on Day 100 right?

 

Wrong.

 

There is a drought, my corn does not grow. Supply of corn is low, demand is high I have to buy X bushels of corn for 110,000$ and deliver the corn.......now I have a huge loss...OR in real life I have to buy back my contract/hedge/insurance at a loss.

 

Let me put it another way..you can try and hedge away your risk but the cost should be the PV of the loss and carrying costs. I am not going to buy your risk unless I think I can make a profit ..not a loss. :)

 

Or to use your negative future example..it costs the PV plus carrying costs.

 

Or let us use car insurance..what does car insurance cost you?

500$ a year

If your car does not get hit..you lose 100% of your money, 500$ year after year after years yes?

If your car does get hit...it costs you 750$ the next year, yes.

[mike777]

I will try and make some numbers that may be close to real life.

1/01/08 your house is worth 100, 000 euros.

You buy your future to protect your self from market fluctuation for 1000 euros

12/31/08 you sell your house for 100,000 euros.....the market did not change.

 

You lose 1000 euros the cost of the future

But you also lose 7000 euros 7% the standard cost of selling your house. :)

 

In other words it is tough to come out ahead if you hedge away all risk after costs. :) Simple because you do not get rid of all risk/costs. :)

[helene_t]

Yes, your example is what I'm thinking about. It will cost the homeowner money most of the time, and it will cost on average, but it will eliminate the risk of a catastrophic loss (in this case: a catastrophic loss due to overall market fluctuations). Just like an insurance. However, the overhead will be much lower than an insurance because there is no need for individual loss assessment. Futures are exercised by a simple computer program, the process is not more expensive than other routine financial transactions.

 

I think that it, if properly implemented and marketed, could be attractive for many homeowners (not the majority, maybe). Because the option of paying someone for taking the market risk already exists. It's called renting, and some people prefer that to owning. However, by renting you also pay for a lot of other things. Not everybody might want to bundle those things.

[hrothgar]

Ok let me try one more time.  The statement you have above is just not true. :)

 

You can never have no downside risk and keep all of the upside risk.

 

Why would I sell you that product? I am only going to sell you a product where I have a high chance of making a profit. I am not going to sell you a product where I have a high chance to loss money and a low chance to make tiny money.

Mike

 

Why do you keep posting this stuff when you clearly have no idea what you're talking about

 

In this case, you appear to be confusing both

 

1. Expected value and risk

2. Options, collars, and futures contracts

 

Lets consider the following simple case:

 

I own 1,000 bushels of wheat. I want to protect myself against a fall in the price of wheat. I buy a "put" option that gives me the right to sell my wheat for $1 a bushel. I have now effectively shielded myself from any downside risk. If, however, the price of wheat goes up I don't need to exercise the option.

 

Alternatively, I am a major airline. I am worried that the price of jey fuel is going to go up. I decide to buy a series of call options to purchase jet fuel. I am now insulated against an increase in the price of jet fuel. However, I will still benefit from decreases in the price of jet fuel...

 

There are also collars (where you sell a combination of both puts and calls) as well as futures contracts where you guarantee that you will sell an asset at a specified price.

 

By the way... The simply answer to your question regarding why anyone would sell the instrument in question is market asymmetries.

 

1. Different individuals might have different risk profiles

2. Different individuals might have different beliefs

3. Different people might have different information

[kenberg]

Everyone has his numbers, so I have mine. First, let me just give concrete experience. The numbers are from almost 40 years ago so they will seem perhaps strange.

 

In 1970 I bought a townhouse for 28K. I am going to estimate some numbers so let's say 30 K. I sold it a few years later and after realtor's fees and such I had a profit of about 6K. A 20% profit? No, much better. I had put down about 6K to buy it. While I lived in it I paid on the mortgage but after the tax breaks it came to about the same as rent. So really I had a profit of about 100% ( If I sell for 36K and have a mortgage of 30-6=24K I get 12K back, I had invested 6K). The note about the study showing that the stock market beats the housing market needs to take this margin buying (if that is the correct term) into account.

 

Now to look at the current situation. It was, and to a lesser extent still is, possible to buy into a house with much less of a % down payment than when I bought in 1970. If prices go up, the profit percentage thus is even higher than it was back then. Ah yes, but prices might go down. Let's compare stocks and houses.

 

A person thinks stock X is a good investment ant buys 500K of stock. Oops. The price drops to 450K. Few people are cavalier about losing 50K but we are talking of a person that had 500K to invest and still has 450K if he sells. An annoyance, no doubt. Now suppose a person buys a house for 500K, putting down 30K with a mortgage of 470K(I think this was possible a bit back). The price of the house drops to 450K. This is not an annoyance, it's a disaster. He has lost money he doesn't have.

 

 

Now I will get a little out of my depth. As I understand it, this margin buying was a strong contributing cause to the 1929 crash. You could do with stocks what people today do with houses. You thought a stock was going to go up, you bought it by putting down a fraction of the cost. As long as prices kept going up, everyone got rich. This drove people to make ill-considered stock purchases using money that they didn't have, and when things got wobbly panic set in.

 

I realize that there were some good intentions to allow everyone to buy a house.

But there was, in earlier times, some financial sense in requiring some sort of decent down payment. House prices, over time, go up. Over short periods of time, they may go down. If our hypothetical guy above had put down 100K on his 500K home then when it drops to 450K he won't be happy but he also won't be wiped out, He won't panic, there won't be a foreclosure, he won't move out in the middle of the night with no forwarding address, and so on.

 

 

Optimism and good intentions are fine qualities. When dealing with finances, a little realism is also useful. Our banking industry seems to have forgotten that.

[hrothgar]

Let me try and explain using a farmer of corn. :)

 

Day one I forward sell all of my corn (X bushels of corn) for 100,000$ I lock in my production costs of 90,000$...I got a guaranteed profit of 10,000$ on Day 100 right?

 

Wrong.

 

There is a drought, my corn does not grow. Supply of corn is low, demand is high I have to buy X bushels of corn for 110,000$ and deliver the corn.......now I have a huge loss...OR in real life I have to buy back my contract/hedge/insurance at a loss.

Here, once again, you're comparing apples and oranges

 

Futures contracts are used to hedge against fluctuations in pricing

Crop insurance is used to hedge against a bad growing season

 

Different instruments are used to protect against different risks

 

Critiquing a futures contract because it doesn't protect an individual against a bad growing season is equivalent to complaining that a "Married with Children" episode doesn't provide enough information about the crisis in Dafur

[joshs]

Everyone has his numbers, so I have mine. First, let me just give concrete experience. The numbers are from almost 40 years ago so they will seem perhaps strange.

 

In 1970 I bought a townhouse for 28K. I am going to estimate some numbers so let's say 30 K. I sold it a few years later and after realtor's fees and such  I had a profit of about 6K. A 20% profit? No, much better. I had put down about 6K to buy it. While I lived in it I paid on the mortgage but after the tax breaks it came to about the same as rent. So really I had a profit of about 100% ( If I sell for 36K and have a mortgage of 30-6=24K I get 12K back, I had invested 6K). The note about the study showing that the stock market beats the housing market needs to take this margin buying (if that is the correct term) into account.

 

Now to look at the current situation. It was, and to a lesser extent still is, possible to buy into a house with much less of a % down payment than when I bought in 1970. If prices go up, the profit percentage thus is even higher than it was back then. Ah yes, but prices might go down. Let's compare stocks and houses.

 

A person thinks stock X is a good investment ant buys 500K of stock. Oops. The price drops to 450K. Few people are cavalier about losing 50K but we are talking of a person that had 500K to invest and still has 450K if he sells. An annoyance, no doubt. Now suppose a person buys a house for 500K, putting down 30K with a mortgage of 470K(I think this was possible a bit back). The price of the house drops to 450K. This is not an annoyance, it's a disaster.  He has lost money he doesn't have.

 

 

Now I will get a little out of my depth. As I understand it, this margin buying was a strong contributing cause to the 1929 crash. You could do with stocks what people today do with houses. You thought a stock was going to go up, you bought it by putting down a fraction of the cost. As long as prices kept going up, everyone got rich. This drove people to make ill-considered stock purchases using money that they didn't have, and when things got wobbly panic set in.

 

I realize that there were some good intentions to allow everyone to buy a house.

But there was, in earlier times,  some financial sense in requiring some sort of decent down payment. House prices, over time, go up. Over short periods of time, they may go down.  If our hypothetical guy above had put down 100K on his 500K home then when it drops to 450K he won't be happy but he also won't be wiped out, He won't panic, there won't be a foreclosure, he won't move out in the middle of the night with no forwarding address, and so on.

 

 

Optimism and good intentions are fine qualities. When dealing with finances, a little realism is also useful. Our banking industry seems to have forgotten that.

 

 

You can buy stocks on margin also. You just don't get the tax break that reduces the effective interest rate... But if you want to count the returns on your highly leveraged investment, ok but lets compare apples to apples. Also, Transaction costs of buying stocks are much lower (you are not paying 6% commissions...)

 

Ooops, never mind I just read the rest of your post..

[kenberg]

The New York Times is reporting that the Bank of America has proposed to the U.S. Congress a creation of a special government agency to buy troubled debt, thereby eliminating these obligations from the bank balance sheets and transferring the risk of further loss to the taxpayer - a socialization of bad debt.

 

From the NYT (emphasis added)

 

WASHINGTON — Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for “financial innovation.”

 

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

 

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

 

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

 

“We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market,” the financial institution noted.

 

The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.

 

If the government pays too much for the mortgages or the market declines even more than it has already, Washington — read, taxpayers — could be stuck with hundreds of billions of dollars in defaulted loans.

As is the usual case with the U.S.A., we like to do things in a "super" manner. Not satisfied to bailout a single failing lender like the U.K. (Northern Rock), the ideas being proposed in the U.S. are more "Northern Rock on steroids".

 

On which side of this fence do you sit? Bail 'em out or let 'em burn?

Let me try to address the implied question: What should the government do about those who are going to lose their homes. With such questions I find it useful to ask myself: What would I do for a close friend or a family member? Collectively doing more for strangers than I would personally do for a friend strikes me as strange. So would I help? How?

 

Every case is different, but under some circumstances I would loan some money. There are not many circumstances, really probably no circumstances, where I would just give some money. I certainly would not cosign or in any other way take over the loan.

 

So if the government can come up with some plan to help those who can reasonably be expected to first get back on their feet and second pay back the money over a period of time, I would listen and maybe support this. The government has made such a muck of the student loan program that I am not so sure I am prepared to trust them with this, but I would not reject such an idea out of hand. Helping people is an idea with merit, but it doesn't always work out as planned.

 

 

Of course it is reasonable to see B of A's suggestion as watching out for the interest of B of A. But the fact that I am not interested in helping the irresponsible goons who created this mess does not mean I have no interest in helping some families.

 

I'm not so interested though in helping the guy who took out a second mortgage on the inflated value of his home and bought a BMW. I drive an Accord.

[Winstonm]

So if the government can come up with some plan to help those who can reasonably be expected to first get back on their feet and second pay back the money over a period of time, I would listen and maybe support this.

 

Ken, this is the "bill of goods" being sold for the bailout - what terrible, untoward event has caused these people to lose the ability to pay their mortgage payment?

 

Employment has been stable. No national disasters to speak of. During the height of the mania, 2005-2007, inflation was tame so that isn't the blame.

 

People are losing their homes for only one reason - they couldn't afford them in the first place. The majority losing their homes were the last suckers to buy in a Ponzi finance scheme - a game of musical chairs and they were the ones left standing when the music stopped. Everyone thought that home prices would go up forever and they could always sell to the next sucker - no one stopped to think that they may BE the last sucker.

 

And the banks, ratings agencies, appraisers, and investors who bought the paper all played along, making enormous profits along the way.

 

But this game couldn't last forever for one simple reason: solvency.

 

Housing costs simply rose too much compared to wages - it really is that simple.

 

And all the bailouts in the world are designed to do one thing: protect the capitalizations of the lending institutions - while tossing the remaining losses onto the taxpayer.

 

If the idea was really to keep everyone in their homes, you could do the same thing by raising wages to match mortgage payments - but funny, you don't see the banks asking for a national wage pay increase. I wonder why?

[Winstonm]

By EDMUND L. ANDREWS

Published: February 27, 2008

WASHINGTON — President Bush sided with banks and mortgage lenders on Tuesday, threatening to veto a bill being offered by Senate Democrats that would give more bargaining power to homeowners who face foreclosure.

 

[kenberg]

Largely I agree Winston, although not entirely.

 

Around here there are townhouses, very modest, not anything special, that are going for a quarter million and up. How could this happen? Speculation fever, of course, but I think that this creative financing idea had a role to play as well. Go back a few years, not many, when the price for the same place was maybe 150. A careful sensible family could save up 30K for a 20% down payment. You didn't need to be a CEO to accomplish this. But the requirement would sort the careful from the frivolous. Enter creative financing. Any fool with a pen, and the bank will supply the pen, could get a loan. Demand goes up, prices go up, and now the sensible careful guy who was prepared to buy the house for 150 with 30 down finds that the price is 250. Oops.

 

The banking community has always presented itself as careful sensible folks who can be trusted. Probably it was a bit naive to take that at face value but at any rate that is all in the past. Whether they are morons or scoundrels or both, an old quip on skepticism is about to be updated: I'm from the bank and I'm here to help you.

[Winstonm]

Well, Ken, Treasury Secretary Henry Paulson (Former CEO Goldamn/Sachs) had this to say:

 

“I’m seeing a series of ideas suggested involving major government intervention in the housing market, and these things are usually presented or sold as a way of helping homeowners stay in their homes,” Mr. Paulson said. “Then when you look at them more carefully what they really amount to is a bailout for financial institutions or Wall Street.”

 

There is no reason to bail out homeowners who made poor decisions - they relied on being able to refinance or sell - that is risk.

 

The banks lent them too much money on the premise that the buyer could refinance or sell - that is risk.

 

Risk is a two-way street.

Can't afford to play, then don't gamble.

[Winstonm]

Largely I agree Winston, although not entirely.

 

Around here there are townhouses, very modest, not anything special, that are going for a quarter million and up. How could this happen? Speculation fever, of course, but I think that this creative financing idea had a role to play as well. Go back a few years, not many, when the price for the same place was maybe 150. A careful sensible family could save up 30K for a 20% down payment. You didn't need to be a CEO to accomplish this. But the requirement would sort the careful from the frivolous. Enter creative financing. Any fool with a pen, and the bank will supply the pen, could get a loan. Demand goes up, prices go up, and now the sensible careful guy who was prepared to buy the house for 150 with 30 down finds that the price is 250. Oops.

 

The banking community has always presented itself as careful sensible folks who can be trusted. Probably it was a bit naive to take that at face value but at any rate that is all in the past. Whether they are morons or scoundrels or both, an old quip on skepticism is about to be updated: I'm from the bank and I'm here to help you.

Sure, Ken, there were a number of factors that drove prices higher - the entire system engaged in euphoria-driven overoptimism.

 

Everyone involved has a share in the blame, including the buyers of the houses that were unaffordable.

[kenberg]

Thanks for the quote from Paulsen. I thought he might be a good appointment and this seems to support that.

 

 

I hope he speaks to the banking industry in language that they can understand. Seems as if he might be doing just that. Now if he can just get his boss to pay a little attention.

[mike777]

Wow you guys are pretty tough. :D

 

We can only hope in 11 months we get a President who cares about:

1) Helping people not lose their home

2) Helping people not lose their jobs in banking, mortgage/credit bus.

3) Helping anyone who owns banks in their pension or ret fund not lose money.

 

Spending a zillion bucks on Health care/global warming is very important but if millions are losing home, job or their retirement account...........just kill us....:)

[Winstonm]

Wow you guys are pretty tough.  :D

 

We can only hope in 11 months we get a President who cares about:

1) Helping people not lose their home

2) Helping people not lose their jobs in banking, mortgage/credit bus.

3) Helping anyone who owns banks in their  pension or ret fund not lose money.

 

Spending a zillion bucks on Health care/global warming is very important  but if millions are losing home, job or their retirement account...........just kill us....:)

While we are at it, let's not forget all those who cannot afford the cars they bought and are having them reposessed, all the credit-card debtors who have taken on too much debt and can only afford minimum payments that keep rising, developers who borrowed too much to finance overpriced commercial real estate, leveraged buyouts failing because of tight lending standards and overpriced buyouts, the 50% of all banruptcy filings that are caused by health care bills......

 

Hell, let's just socialize everthing and get it over with.

 

Fidel for President.

[mike777]

:D

Wow you guys are pretty tough.  :)

 

We can only hope in 11 months we get a President who cares about:

1) Helping people not lose their home

2) Helping people not lose their jobs in banking, mortgage/credit bus.

3) Helping anyone who owns banks in their  pension or ret fund not lose money.

 

Spending a zillion bucks on Health care/global warming is very important  but if millions are losing home, job or their retirement account...........just kill us....:)

While we are at it, let's not forget all those who cannot afford the cars they bought and are having them reposessed, all the credit-card debtors who have taken on too much debt and can only afford minimum payments that keep rising, developers who borrowed too much to finance overpriced commercial real estate, leveraged buyouts failing because of tight lending standards and overpriced buyouts, the 50% of all banruptcy filings that are caused by health care bills......

 

Hell, let's just socialize everthing and get it over with.

 

Fidel for President.

Well I prefer to vote for whoever is for:

1) Very strong defense

2) Very strong economy

3_ Jobs

4) Cutting taxes!!!!!!!!

5) Fiscal responsibility

6) Helping the sick

7) helping the poor

8) Education

9) Helping the children

10) For human rights ...yes even including women.

11) Stopping pollution and global warming.

12) stopping high gas/heating oil prices

13 For peace not war.

 

 

So far I only see one person to vote for .....

 

If you prefer to be heartless :)

[kenberg]

So far I only see one person to vote for .....

 

Hillary?

[helene_t]

Mike, how can you have so narrow priorities, would you really vote for someone who doesn't guarantee nice weather, winning finesses and 2-2 trump splits? ;)

[PassedOut]

Well I prefer to vote for whoever is for:

1) Very strong defense

2) Very strong economy

3) Jobs

4) Cutting taxes!!!!!!!!

5) Fiscal responsibility

6) Helping the sick

7) helping the poor

8) Education

9) Helping the children

10) For human rights ...yes even including women.

11) Stopping pollution and global warming.

12) stopping high gas/heating oil prices

13 For peace not war.

A nice list, but how are the other items compatible with number 4?

 

We are already running huge deficits.

[kenberg]

Well I prefer to vote for whoever is for:

1) Very strong defense

2) Very strong economy

3) Jobs

4) Cutting taxes!!!!!!!!

5) Fiscal responsibility

6) Helping the sick

7) helping the poor

8) Education

9) Helping the children

10) For human rights ...yes even including women.

11) Stopping pollution and global warming.

12) stopping high gas/heating oil prices

13 For peace not war.

A nice list, but how are the other items compatible with number 4?

 

We are already running huge deficits.

Volume!