Thursday, October 16, 2008

Free Markets, Crashes, and Other Parables

“We have now entered the final phase of the boom-bust cycle--the search for villains for past ill deeds and the search for reforms to prevent future calamities. But in the panic to sell shares in U.S. companies, investors are deaf to good news about the resilience and productivity of the American economy just as they were deaf to bad news at the height of the market euphoria.” These words, penned by Laura Tyson in her 2002 article, “After Irrational Exuberance, Irrational Pessimism” are, once again, almost completely relevant to today’s market. Perhaps what’s missing is the good news. Oil going down is apparently something approaching a positive, but that’s it. However, because of the consistency of human deafness to market fundamentals, Ms. Tyson’s article is almost always partially relevant. Here’s the sad little story rife with truths.

From 2003-2005, real estate, like the equity markets of the late 1990’s, had that peculiar reek of impending disaster that emerges from willful ignorance to market forces by those who should know better. A March 2008 REIT Wrecks article commendably explores the death of real estate’s canary: in 2005 rental occupancies fell despite declining rents. The article, “Play Subprime Safely With These Residential REITs” carefully exposes the Spiderman-like tingling those who specialized in rental properties had. They could smell the gas of the broken main. They knew that all that was driving real estate was the money supply. The loan amounts kept increasing as the credit requirements decreased. The only impediment to receiving the cash was having a residential deed to sign.

Interest rates finally began to rise, but they were answered with more easy money. After all, the changing bankruptcy laws of 2005 (making Chapter 7 debt forgiveness more difficult to come by) meant that more foreclosed assets would be available to offset these bad loans. Even more importantly, as far as the speculative eye could see more and more non-standard loans were coming down the pike. Hence, real estate had to continue to rise as the free money bid them well above their actual values. If real estate had to continue to spiral upwards, then even foreclosed properties would be worth more than the original assets. Hence, easy loans were more easily packaged into marketable “securities” that, based on an implied connection between Fannie, Feddie and the Feds, met only the most cavalier inspections. Who’d know? Who’d say anything? The only evidence of this covenant with disaster would be the mushrooming commissions on portfolio mangers’ Christmas bonuses.

However, even the “victims,” those with no credit who took exorbitant interest rates hits, laughed out loud as they signed and swore on a thousand dotted lines. Even they thought they’d hit the Vegas craps. “Why worry?” they thought; they could to sell for a 15% profit in a year. That would be more money in one place than they’d seen in their whole lives! Everyone was doing it… Then oil hit the roof, and the predatory lenders headed for the high grass. Everyone knows the rest.

Just as in the dotcom bubble, those who should have known did know. But why pull the fire alarm and alert the police? Instead, lawless bands of speculators who knew better, weren’t betting on the American dream. No, they were betting they could get out of town before the three alarm conflagration was noised abroad. The parable? Markets don’t need corrections, people do. The moral: unregulated markets will result in great prosperity only in proportion to the sense of responsibility and the recognition of the ethical source of prosperity owned by those that participate.
California, here’s the allegory: As free markets are to ethics, so is a great nation’s government to the truth. As the real estate fundamentals were eroded by senseless monetary expansion, so the credibility of our government will be eroded if we enshrine lies in our laws. Vote “Yes” on Proposition 8.

As depressing as today’s corruption of our markets may be, it has a precedent. As Frank Shostak discusses in his article, “The Prophet of the Great Depression,” two Austrian’s, Friedrich Hayek and Ludwig von Mises, based on their theories of credit expansion, predicted the Roaring 20’s would end calamitously. The Austrians used a cool math based on exchange rates, but the reality is that no wizard-like forecasts are required. Indeed, even the victims of this latest real estate credit bubble knew what they were up against. They knew they were at cross purposes with the basic principles of responsibility, ethics, and, hence, genuine prosperity. We all finally got what all involved already owned.

Individuals cannot live a lie and escape the consequences. Don’t try to tell such people however, for you will be mocked to scorn. Likewise, societies cannot live a lie and long endure. But what if that lie is consecrated by the consensus of one’s fellow creatures, as was the run on equities in the 1920’s and the run on real estate in the twenty-first century? It doesn’t matter; such a nation and such a person cannot prosper. Even if so many thrill with the lie that one might say the lie is “normal,” a lie it is nonetheless, and who are so heedless cannot prosper. Whether it is abandoned at the church door or at the cork of those spirits that cry “you can’t prove it!” discard reason at your peril.

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