Tuesday, May 5, 2009

Credit Crisis Severity

Why do some asset booms end so much worse than other asset booms? Why did the housing boom end so much worse than the tech boom for example? The answer is amount, debt, and expectations.

The amount most have invested in equities is much less than they have invested in real estate, partially due to less leverage, partially due to the necessity of shelter, and substantially due to real estate coming in such large units.

Consider an asset that rises from price p to price 2p before falling back to p. Anyone that held it for the duration would be no better or worse off. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. In total, there is no gain or loss, only a transfer from the buyer to seller. It is zero sum to first order. Any losses leave no debt behind. Wealth was not created or destroyed overall, only redistributed.

Now consider the same situation where the asset is acquired with borrowed money. Since these asset prices are afforded by incomes which change little over a boom, they will often vary roughly inversely with interest rates, with rates falling by half before rebounding. Anyone that held it for the duration and did not refinance would be no better or worse off. Anyone that refinanced the same amount to a lower fixed rate at the peak would be better off, while anyone that refinanced to the full amount at the peak may or may not be worse off depending on the terms of the loan, but may be much worse off than they expected if they did not anticipate the decline. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. The lender will also have problem if the owner cannot make the payments, must sell the asset, or even is no longer willing to pay, as the asset no longer provides sufficient collateral for the loan. This is not something the lender expected. Though this is also zero sum to first order, expectations make the result worse. Some will have consumed temporary gains leaving themselves more indebted. Some will have lost any equity they may have had. Some won't be able to afford it. Some won't be able to repay the loan if they have to sell. Some won't want to pay for something that has lost so much. The lender will suffer unexpected losses. Losses often leave debt behind, debt being the residual of crushed expectations. Wealth was not created but it very often is destroyed by being consumed during the boom leaving only the debt afterwards.

So what makes equity markets so much different from real estate markets? Equities amount to much less then real estate in most instances. Equities are much more liquid in most cases. Equity markets offer much lower leverage to retail investors, a factor of 2 (50%) compared to 10 (90%) or more for real estate. Equity markets are callable and marked to market daily, limiting losses, while real estate is at the option of the owner and marked to market only on sale. Equities are volatile, fast, and changes are expected, while real estate has low volatility and changes slowly with considerable inertia and momentum.

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