Real Estate
Bailout Blunder and Plunder Palooza
By Dan Smith

Bailout Blunder and Plunder Palooza

First, let me say how much I have appreciated the feedback I have received recently from you, the readers. I have had several calls of support, but I have equally appreciated the dissenters’ opinions. I believe it is healthy and essential that we all get to the truth of the matter as soon as possible, if we want any chance of fixing this mess in the long run. So let me backtrack a bit and explain what facts have led to so many of my conclusions.

Derivatives are contracts or financial instruments that are traded like securities. They are “derived” from an overlying security or asset. The value of a derivative is based upon the value of something else—a barrel of crude oil, a share of stock, an interest rate, the value of a particular currency, etc. And a single asset, like oil, can and has generated numerous derivative “plays.” So, why is it important to understand derivatives and the effect they can—and already have—had?

Well, the entire derivatives market worldwide is estimated at $600 trillion. I say “estimated” because derivatives, unlike stock, are traded in an almost clandestine manner and not on any international market or exchange. Meanwhile, the entire amount of assets worldwide (stocks, bonds, our bank deposits, real estate, etc.) is pegged at approximately $170 trillion. We could almost stop right there, as many of you can intuitively see the overwhelming issue facing us. What you really need to understand is that derivatives have the potential to greatly exaggerate the gains or losses that occur in their associated overlying asset.

Speaking of greatly exaggerating the losses on an overlying asset, this brings us to “credit” derivatives. Credit derivatives are approximately 10 percent of the entire derivatives market, or $60 trillion currently. As the name implies, these derivatives relate to a class of overlying security—in this case, credit instruments like mortgages, car loans, and credit card debt. And it is this category of derivatives that we find at the heart of the current financial crisis.

A “credit default swap” (CDS) is a specific type of credit derivative wherein the buyer seeks insurance from a pool of debt instruments defaulting, in exchange for a fee paid to the seller. The issue, as I alluded to in a previous article, is that the math underlying a large portion of these credit default swaps multiplies the risk to the seller 30-fold or more. At the time they were sold, those multipliers allowed the sellers to charge enormous (multiplied) fees for this type of insurance. I called this arrangement “fraudulent” because the sellers, as we have since discovered, did not have the capital to make good on these insurance policies the day they accepted the fees. Oh and did I mention that car loans and credit card debt may also have these toxic CDSs associated with them? In fact, much of the current argument for saving GM is to prevent GMAC (its financing arm) from failing. Recent estimates are that GMAC holds up to $1 trillion in credit default swaps. Meanwhile, the parent company GM has a current market cap of less than $2.5 billion. Hmm, let’s guess where the next round of bailouts will be going …

So where are we now? Well, some have suggested that the government should buy or rehabilitate the overlying assets to solve this derivatives problem. For instance, much has been made of the FDIC plan to renegotiate and modify the mortgage terms in order to make the defaulting loans more affordable for the current homeowners. However, statistics show this method is rapidly becoming another huge waste of money. Of the mortgages modified in this quarter alone, 36 percent have already re-defaulted. Further, of all mortgage modifications made since the beginning of this debacle, 58 percent consistently re-default within the first eight months. Talk about throwing good money after bad! The only bright side is that 40 percent of the homes in foreclosure are vacant and they can’t find the former borrowers. Can you say, “Thank God”? Even though some of these rates were renegotiated to 3.5 percent 30-year fixed rates (something more than 96 percent of the rest of us not in foreclosure couldn’t imagine), politicians once again appear shocked to learn that someone with a 520 credit score just doesn’t pay their debt as agreed.

So, if it wasn’t apparent in my earlier columns, let me tell you exactly what I think of all these bailouts. In the end, I fear we will have spent enormous amounts of money and mitigated nothing. My suspicion is that we will have made the recession much deeper and longer than it would have been—and more importantly, we may have possibly destroyed our own currency in the process. (See Japan’s response to their banking crisis in the ‘90s. Their banks are still worthless!)

I am beginning to wonder if we have been collectively fed a fairytale. The fairytale says that we would all lose “confidence” if a series of big banks failed, all of whom created this highly leveraged nonsense to begin with. If we all lose confidence, then consumer spending (70 percent of the economy) would fall off a cliff and we would have a colossal recession with massive unemployment. Instead, the government tells us that, for our own good, we should prop up these bankrupt financial institutions with our money. We should also save bankrupt car manufacturers who can’t make a decent product and aren’t ever likely to do so. And above all, we should let the same geniuses who brought this debacle upon us handle the disbursement of what is so far $8.5 trillion in bailout commitments.

And what will we get for this $8.5 trillion? They promise us a colossal recession bordering on another Great Depression with massive unemployment—but just not as bad as it would have been. The icing on the cake is, of course, that we will all be able to join a government road crew when our jobs are gone. That isn’t actually the change I had hoped for. How about you?

What should you do then? I would suggest you preserve capital in tangible assets that will, in the long run, reflect the massive inflation which is the only logical result of these policies. Things like gold and real estate come to mind. Real estate here will be some of the first to recover in the country. The Urban Land Institute ranks us in the top 10 real estate markets to watch next year, and our inventory has been steadily declining over the last year.

By the time you read this, rates for 30-year mortgages will likely be under 5 percent. So buy or refinance now with these historically low rates and home prices, and pay back the debt with devalued dollars over time. I know, this sounds suspiciously self-serving. But, it is my honest opinion. And, more importantly, I can at least say that I have taken my own advice. Meanwhile, my financial advisor scolded me when I pulled out of stock market (the DOW was at 10,300 at the time). I found out later she was heavily invested in bonds. In our final conversation, I suggested she should think about a career in politics.