Saturday, October 30, 2010

Housing And Leverage

A while back, FLG decided that leverage was what we needed to tackle to mitigate future financial crises.  And by a while back, FLG means the Fall of '08.  And FLG repeated it numerous times, including this post in January of this year.  Everything else, besides focusing on leverage, is just people beating their own personal hobby horses or their financial and economic ignorance coming to the fore. 

(Don't get FLG wrong. He's not saying that limiting and regulating leverage is easy or that he knows how to do it, but that should be the core concern. This other stuff about consumer protection and even Glass-Steagall address leverage indirectly, but also distract from the core issue.)

Today, Matt Yglesias asks an interesting question -- Is Housing Inherently Bubbly? However, he asks this riffing of a part of a post by Mike Konczal, the Rortybomb guy:
In my personal opinion, in the same way middle-class people turned amateur stock analysts was the sign of a tech bubble, or middle-class people turned amateur realtors was the sign of a housing bubble, middle-class people turned amateur credit risk analysts and credit channel intermediaries was the surest sign of a credit bubble.

FLG calls this the shoeshine rule from when Joe Kennedy got out of the market before the '29 crash, but Matt takes it up like this:
Adam Ozimek calls this the Beware of Amateurs rule. It strikes me as a particular problem with real estate. Most of the time the vast majority of stock trading is being done by professionals. And you can imagine a world in which average middle class people all wise up and have their money in index funds or we revive defined benefit pensions or the like. But housing, as currently done in the United States, is more or less necessarily a market of amateur investors.

He then describes the housing market like this:
you’re looking at tons and tons and tons of amateurs making highly leveraged investments. It strikes me as an inherently dicey situation.

FLG gets Matt's desire to see the problem as amateurism. Amateurism can be defined as the lack of expertise. And faith in expertise undergirds a lot of Matt's political preferences. But the truth is that for every loan to amateur investors, there's at least one person paid by a bank on the other side. Given that this person is paid by a bank to do this, then presumably they are supposed to be an expert.

Now, there are a variety of problems with this story. And FLG is sympathetic to the idea that large numbers of amateurs getting involved in a market means it is a bubble. In fact, as soon as FLG see a late-nite infomercial on how to make money in something he assumes it's probably a good idea to start shorting it. But the issue, what ultimately causes all the adverse consequences, is leverage.

Without leverage people invest money they already have in things like tulip bulbs. If they loose that money, yes, it sucks. But it isn't usually bankruptcy causing. The systematic issue arises when people borrow a whole bunch of money to buy tulip bulbs.

Again, almost all financial crises start in real estate markets. Some, like the Asian financial crisis, began in commercial real estate markets, which somewhat undermines the amateur theory. The systematic problem is leverage. Everything else is a distraction.

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