At least one or two of us who watch the markets understand Wall Street is a gambling institution where individuals mostly loose their money, and the big house players, like investment banks, and their friends, mostly take it.
We have been waiting for one in particular to take their fall for a while now. Some of us understand the odds they profited handsomely from the collapse of other banks are off the charts on the high side. Some suspect this whole thing was a great conspiracy, so while we don’t care much about a particular scam, we do care a lot about how much a particular investment bank ratcheted up the price of oil. We do care about what they and their favorite treasury secretary did while peers collapsed. We care, and we want to see a serious investigation. We care, but the case the SEC has brought is not the one we want to see prosecuted. We watch with interest to see if the SEC case shakes out anything relative to, say Bear, Lehman, Wachovia, or the economically destructive speculation on oil.
The run up of the price of oil, the run-up of housing costs, and the collapse of technologies with the associated loss of good salary jobs were the root cause of the mortgage problem. Without any one of these factors the situation would have been perhaps difficult, but in the long term at least manageable.
To understand what exactly happened over the long term one has to look at how business itself is done on location in America. To explore that, we will consider a somewhat hypothetical developing business situation circa 1982.
Let us suppose that certain senior managers of a company in Central New Jersey decide they would like to retire to Central Florida. Let us further suppose their company, in some ongoing state of constant re-organization, puts them in charge of finding a new headquarters for the division. What are they to do? If they pick a site in sunny Orlando, their retirement moving trip south will be picked up by the company. By the way this is not an insignificant expense. So they will perhaps pick a nice new location somewhere in sunny central Florida.
Next lets consider what this means for the employees of this company. First lets consider property values and tax law. In central New Jersey, a fairly metropolitan area within fifty miles of New York City, home prices are only slightly less than on the New York side of the river. So a family selling their home will expect market prices within a couple hundred thousand of half a million dollars. Capital gains tax rules give the home seller eighteen months to re-invest his profits in a new home, before those profits are subject to capital gains taxes. So the family moving to central Florida is packing bucks – even if their New Jersey home is not completely paid off.
Mean while Marvin the Realtor is sitting in his office in Maitland Florida, wondering what he is to do. The average time required to sell a house in Florida is three years. The average sale price is only sixty thousand, and the last time someone built a new home was before time began. His phone rings, it’s a Realtor from central New Jersey. The guy from New Jersey wants to buy land for a business park. In a few weeks Marvin has a huge deal put together with an offer of bucks simply unimaginable in central Florida.
Marvin the Florida Realtor goes to sleep dreaming of dollar signs that night, and a lot of nights afterward. Marvin can’t keep a secret, so before too long every Realtor in central Florida has the same dream. The company in New Jersey makes their big announcement about the time Marvin’s clients business park is finished. This in effect starts a bidding war for homes in Florida, by people with money from New Jersey. Realtors in the south have a big secret they love to keep from their Yankee clients. The secret is you buy property differently in the southern US. In the New York area a seller will collect bids, then pick the best offer. In the south the seller advertises an “asking” price, to which potential buyers respond with perhaps a significantly lower offer.
This clash of home buying culture results immediately in much higher home prices. All it takes is a hand full of Yankee buyers laying down offer letters of twenty percent more than the asking price. Central Florida has a culture of smaller, less expensive, more open homes known as “Florida houses”. Large national builders follow the central New Jersey company to Orlando and immediately start a number of large developments. Within five years everything has doubled twice. Support companies have followed their client south, and the value snow ball has grown significantly, propped up now by loan amounts with home prices far surpassing those of only a few years earlier.
Over the years this scenario is repeated from Raleigh-Durham to Houston, and each time it occurs home prices are driven up significantly. The events driving these transitions often involved software development, engineering, or some other expensive commercial development. Most were driven by a significant number of well paying jobs.
A very big part of this trend was software development. Lots of office space was required, as well as homes for the developers. The Y2K effort exhausted the funds as well as demand for software development for some years. Before the layoffs after Y2K had even gotten started many companies were looking to outsource their software development. This in turn eliminated the need for not only those who wrote the software, but also those who maintained it on a day-too-day basis. Likewise it eliminated the need for a number of large expensive homes. This trend accelerated with the unwinding of the tech economy.
After the dot.com crash, tech companies simply died, whether they were involved in dot.com or not. Investor’s abandoning technologies opted for real estate. To make money on real property you either sell quickly or rent, which is boring. Bundled Mortgage securities were simply a market making activity which allowed investors to escape the realty trap, with their profits mostly intact. These were used to speculate on oil. The speculation on oil drove prices so high families struggling to pay inflated mortgages had no chance after their loans reset. In essence the investor class, private or corporate, did this to themselves, and most of us couldn’t care less if it did not cause so many problems for our families. Since a particular investment bank is the lone survivor of this mess it follows they knew exactly how it worked, which means they are probably the perpetrators.
The investment bank’s role in this sort of thing would have been making market for the investment class to get their money, then in making market once again so investors could escape the realty trap, and once again in commodities. This activity in many ways transcend market making, becoming bubble making activities.