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The Real Estate Meltdown

December 11, 2009

Being a student of commerce, economics has always fascinated me. The recent financial scenario has penetrated my mind and captured almost 90% of my thoughts. I am sure this is the case with most individuals. Everyone wants to be abreast of the latest developments as to take necessary actions to safeguard their hard-earned money. Money is dear to everyone, materialism rules the roost. Likewise I have been devouring information on the causes and effects more so out of curiosity and to learn. Literature and articles of economists as well as dinner conversations with my father and grandfather have been my constant guide. Let me present a part of my compilation till now.

 

Economists have dubbed the recent recession as the worst financial crisis since the Great Depression of the 1930s. Unemployment, bankruptcies, dissolution of businesses and thus overall decline of consumer wealth have been the worst effects of this phenomenon.

So what causes such an economic meltdown. I feel ‘Greed’ is the answer. It is human tendency to want more and more without any limits. We’ve never learnt to be satisfied.. Though it there is nothing wrong in being ambitious, infact I believe everyone should be. Working to the best of your ability in order to achieve a fulfilling life for yourself and your next of kin should be the definition of one’s life. However people forget their limitations and the lust for more leads them to take the path of immorality. Being successful at the cost of someone else’s distress is not ethical.

 

 The current economies’ backward trend has been majorly due to the crash of the real estate market. Diagnosis proved that the collapse of the global housing bubble, which peaked in the U.S. in 2006, caused the values of securities tied to housing prices to plummet thereafter, damaging financial institutions globally. Questions regarding bank solvency, declines in credit availability, and damaged investor confidence had an impact on global stock markets, which suffered large losses during 2008.

Real estate has been a separate asset class for millenniums. There is a strange thrill one experiences when one purchases a property. This can be seen way back in the Dark Ages where men dreamt of being landlords and kings. Owning a property symbolises wealth and status in a society. Man has been familiar with the concept of debt and property for a very very long time. It is when the value of property collapses, we end up with a major economic disaster.

Martin A. Armstrong a renowned economist and the former chairman of Princeton Economics International Ltd. has developed a financial prediction model called the “pi-cycle model“. In his publication ‘ The Forecast For Real Estate’ he takes us through history highlighting recurrences of real estate crashes starting from the 1600s. A trend has been seen in each case.

The immediate cause or trigger of the recent crisis was the bursting of the ‘US Housing Bubble’ which peaked in approximately 2005–2006. High default rates on subprime mortgages began to increase quickly thereafter. Attractive loan incentives such as easy initial terms and a long-term trend of rising housing prices by leading financial institutions had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007, refinancing became more difficult. Defaults increased dramatically as easy initial terms expired, home prices failed to go up as anticipated and interest rates started rising. Total losses today, are estimated in the trillions of U.S. dollars globally.

Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds. These institutions assumed significant debt burdens while providing the loans described above and did not have a financial support sufficient to absorb large loan defaults. These losses impacted the ability of financial institutions to lend, slowing down the economy. They became increasingly vulnerable to the collapse of the housing bubble and worsened the ensuing economic downturn. This led to the historical collapse of Lehman Brothers on 15th September, 2008.  The sale of Bear Stearns and Merrill Lynch followed and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. These five institutions reported over $4.1 trillion in debt for fiscal year 2007.

Armstrong blames the mechanical and materialistic tendencies of these institutions that led to their ultimate collapse. He says with reference to his cycle theory, that the pooling of mortgages caused the banks to no longer truly care about the quality of the debtor. They created a securitized market whereby these mortgages were grouped and resold. They were all interested in making a quick buck and never sat down to think what about the consequences if the product failed.

The latest example would be the Dubai real estate crash. Dubai’s property prices have fallen 47 percent in the last year. The fall was recorded since the financial crisis hit the emirate last October. When Dubai announced recently that it was asking banks to allow the state-owned Dubai World to suspend loan repayments on much of its $59 billion of debt for six months, markets crashed everywhere, including in India, on fears that there may be worse to come. The speculation now is whether Dubai is on the verge of bankruptcy?

 

Armstrong’s advice to all is “Be careful with real estate. Stay liquid for in times like the present, cash is king”

Warren Buffet, world’s most successful investor and founder of Berkshire Hathaway Inc. has also been vocal about his concerns, advising banks to reserve minimum downpayments of home mortgages and conduct income verification.

 

I would say that we should be proactive and understand the nature of events. This will allow us to correctly make decisions to be on the other side. A debt crisis affects all sectors including the government. Banks are still functioning as hedge funds and have to speculate to make profits. This is a sign that the worst is yet to come.

 

References:

  1. Martin A. Armstrong’s ‘A Forecast For Real Estate’ dated November 15th, 2009. For more on Armstrong’s publications login to www.martinarmstrong.org
  2. Economic Times and Mint (financial newspapers- India)
  3. Google
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One Comment leave one →
  1. January 11, 2010 11:12 AM

    educational and entertaining. I’ve added your blog to my “reading material.” Keep me updated!

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