Saturday, October 6, 2007

Saturday Disconnect on TV

I think I may have figured something out which could shed a little light on the Financial Disconnect that we are seeing as it relates to housing and banking lately. I usually watch the financial block of shows on FOX Saturday mornings (mostly for comedic value). I started to pick out a theme that was repeated by numerous guests. The idea is that the subprime losses are now done, and that banks are having to show those losses from the summer. Going forward these "one time impairments" are fully discounted by the stock market, and it is a great time to buy. Never mind the validity of the thought for now, and try to see how the mainstream financial commentators fundamentally misunderstand the current situation. They are using the usual business cycle filter that they know, and trying to apply it to a radically different asset class. First an example of a (purely hypothetical) typical business problem, the correction process, and then I will contrast it with housing assets.
Example 1 Defective Computer Boards by Microsoft
Suppose Microsoft built and shipped out 1 million new computers over the last 6 months. After about 2 months of normal usage, the mother boards of the computers short out and fail. Microsoft would have to diagnose the problem, and offer a fix for the sold units. They would also have to re manufacture the boards going forwards with the fix in place. The cost of the fix and replacements for the purchased units would show up as a write down or impairment charge for Microsoft. The stock would certainly go down (maybe!) to reflect the new earnings of the company. After all is said and done, the problem is fixed, the boards are replaced and Microsoft goes on with its business. The entire process may take anywhere from 3-8 months at best.

If you see things through the filter like in the example above, you will not be able to understand what is happening to real estate right now. Its that simple. If you the reader are running through the differences in housing to the above example you already know where I am going with this. Some key issues that perhaps the usual suspects on TV are not taking into consideration:
  • Most people do not take out a mortgage (especially a negative amortization ARM) to buy a computer.
  • Not every single mortgage foreclosure that will ever occur happened in August of this year. There were a ton before, and there will be a whole lot more later.
  • Not just one company has nonperforming assets that need to be written off, mortgages, through the wonder of securitization, are spread out amongst banks, hedge funds, pension plans, etc.
  • Houses are highly illiquid assets
  • Real Estate is subject to psychology of buyers more so than other assets classes.

I could list many more, but the point I am trying to make is this:

The current euphoria on Wall Street that the mortgage mess is over after a tough August is lacking in basis in any reality. Home values are dropping, and will continue to drop over the next 3-6 years. This means that mortgage losses are going to come in waves as ARM resets and financially strapped homedebtors lose their homes in record numbers. This is NOT a 1-3 month process but a long drawn out one that will take years to settle out. Absolutely none of these facts are accounted for by the market at this time.

As a reference, please look over information related to the housing bust of the late 1980's that lingered and persisted well into the 1990's. A wonderful chart can be found at the following site:

Very instructive Indeed!


Anonymous said...

All good points, except that microsoft does not make computers. I would not expect 1 million shipped by them to last even one week.

Troll B.

Anonymous said...

Microsoft makes computers.

Their top model is the Xbox 360. They had to announce a $1,000,000,000 charge in order to pay for repair of the repeated defects.

Only thing is, their computer business is more like the housing business. The failure of their defective units is heading higher and higher as time passes; they didn't all break in August, so to speak.

Anonymous said...

Ok, I see what you mean :)

If I were microsoft, I would not have ventured into hardware business given the track record of windows software.

Anonymous said...

Software is more complex than hardware. Hardware is simpler, believe it or not.