Some Real Estate Perspective

It seems almost common knowledge that loose lending practices and the over-extension of credit is the primary cause of what we refer to as a housing bubble.  While these policies certainly exacerbate the problem, I assure you that asset bubbles form quite well under very tight credit standards.  Loose credit and poor lending policies are more to blame for the collapse of a bubble, while an entirely different mechanism altogether is primarily responsible for the inflation of it. That mechanism is fractional reserve banking.  Lets look at some basics, consider 4 banks with varying fractional reserve ratio requirements, all with $10,000 in reserve.

--------------------------------------
Bank     |     Reserve Ratio  |
A                    100%
B                     25%
C                     10%
D                       1%
--------------------------------


Under the fractional reserve requirement, bank A can loan out $10,000.  Bank B can loan out 40,000.  Bank C can loan out $100,000, and Bank D can loan out a whopping 1,000,000 dollars.


Now consider a small society with 10 real estate owners/investors with $10,000 in capital each.  If each got a loan from bank A, the total capital between all of the investors would be $200,000  (each having their initial 10,000 plus a 10,000 bank loan.).  In this situation each investor would be able to bid a maximum 20,000 for a home.  In a society of 10 homes, there is a capital ratio of $20,000 per home.  Expensive homes would be off limits, and home prices would have to fall below 20k for anyone to buy one.


Now consider if just two of ten people with great credit were able to get a loan from bank D.  Now two of the 10 real estate owners have 1,010,000 each to spend on housing.  They easily have the purchasing power to buy homes much more expensive than some of their neighbors.  In a society of 10 homes there is over $200,000 in capital per home if two people get a loan from bank D!  They two real estate investors can create bidding wars on the nicest homes driving the price up significantly.... and still have plenty of capital left over.

but wait.....they are going to have to pay the loan back at some point.... if they overpay for the property and cannot find a seller they could take on serious losses!!!   Yes.  This is true,  but if bank lending policy remains the same and society is large, there exists the opportunity for other people with large amounts of credit to buy the home.  With bank D, more people are able to buy an expensive (say $500,000) home than with bank A, B, or C.  Say one man with a million dollars in capital sells a house he paid 500k for for 700k... now he has $1,200,000 in capital to invest in real estate with!  The free flow of large quantities of credit made this possible.  If the society as a whole was operating with the banking policies of Bank A, it would take forever and be nearly impossible to build or afford a home worth $500,000.... you would have to earn most of that money yourself before you could afford that because only $10,000 exists in credit!!


The naive mind may be thinking that total credit cannot continue to expand after the bank has made their loan.  After all, it would need more reserves to loan more money.  Fortunately for the home owners association, when the money that gets loaned out from a bank gets redeposited somewhere, that bank can then re-loan that money out at the reserve ratio.  For example: Person A sells house for 100k, deposits money into bank.  That deposit is legal basis for the bank to loan out 90k under a 10% reserve ratio requirement.  Each new loan can be re-deposited and re-loaned repeatedly (if unfamiliar with this concept search "fractional reserve banking" on youtube.).  In addition, any interest repaid on these loans can be held as reserves (as opposed to deposits) and can then new loans up to the amount of 1/(reserve ratio) can be created!

As you can see, the quantity of capital in a system is very sensitive to the reserve ratio requirement... more so than changes in lending standards.  Fractional reserve banking creates money at exponential rates.  It my not be hard to see that as long as there is available credit, this process can continue for long long periods of time.    Unfortunately our world is finite, and when the rate of credit does not satisfactorily grow to allow old loans to be re-payed with new.... the music stops...  leaving some without a chair.  Let us pray the music never stops.

A Hayman Capital report

While i'm on a roll posting links, here's another great one brought to us by none other than Kyle Bass:

http://www.scribd.com/fullscreen/113621307?access_key=key-11v6eigpyerwnsdswgqs

Oh Canada

No unique analysis today, just a bunch of links pertaining to the Canadian subprime mortgage bubble.  Looks like shes going to blow soon.

http://www.investopedia.com/stock-analysis/2010/short-the-canadian-housing-bubble-fre-fnm0511.aspx#axzz2NM4MHoO3

http://www.wallstreetoasis.com/blog/the-big-short-2-electric-boogaloo

http://www.europac.net/commentaries/canadian_real_estate_bubble_bubble_toil_trouble?font_size=3

On Hard Assets

Diamonds may be forever and gold may be the money of kings... but frankly silver has better electrical and thermal conductive properties.

Physical vs. Paper

I believe the age is upon us where we will start seeing more and more of the phenomenon charted below:

(img from 0hedge)

The price of precious metals is set by total market demand, of which physical is a small part.  Most price action is in the form of paper: futures and ETFs.  According to CME, approximately 20 million ounces of gold each day are traded in futures, and 2.4 million ounces a day are traded in ETFs.   22.4 million ounces of gold in "paper" traded each day.... but how much of it actually exists?  Here lies the explanation to the above chart.  If all "paper" metal was backed by "physical", demand for physical would correlate well with the price of the metal.  Unfortunately this is not the case...  acute hedge fund managers and the majority of "doomsday" economists have known for a long while about this manipulation in the precious metals market.... but like traditional fractional reserve banking, this fraud won't end in disaster unless a large number of people demand the physical metal backing the ETF or future contract at the same time.  What's worse is that most of largest ETFs and futures contracts do not contain any clause that says you can redeem anything physical for your "paper" metal.  Instead, you typically can find a trustee certificate of some sort, in which a third party (party other than the issuer of the ETF or future) guarantees that the precious metal is stored safely in the vault somewhere and is somehow audited on a regular basis (best case scenario).  However, these audits DON'T HAVE TO CONFIRM WHETHER OR NOT THERE IS ENOUGH PHYSICAL TO BACK EXISTING PAPER CONTRACTS.  Banks/trustees are using physical like the basis for loans in a fractional reserve system: continuously selling the metal in paper form while each time holding a fraction of what they sell in physical reserves.  So what happens?? How does this end??? It ends with physical metal and paper metal being sold at different prices, or with organizations providing paper precious metal securities eating massive losses.  The catalyst for this is the continued difference between paper and physical demand.  If continued demand for physical (instead of paper) precious metals persists, mining companies (who have been getting royally screwed in this entire process) and the physical demand will begin driving the price.  Either way it's going to end up as a shit show, buy yourself some physical silver.