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dstars

Enonomic Cluster Bombs And Other Fancies

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Maybe you could post up the unedited version. That would be interesting to see.

Why not? (Seeing as you're so interested, and I can see that from your posts.)

(This is copied from another thread. In-between noticing my high regard for myself he asked that I should post my original, unedited version that was written around three months ago but is still pertinent.)

The Economic Cluster Bomb and other fancies...

By David Stars

You could walk up to a guy with a spider’s web tattooed on his neck and offer an unsolicited critique on his selection of face studs, or you could invest in property; the result will be the same either way.

The world economy is Wile E. Coyote and he’s just chased Road Runner off a cliff; only his disbelief keeps him hovering, defying gravity itself.

After 9/11 US Fed. Chairman, Alan Greenspan flooded the world with money and the UK followed suit. This may have been a decent strategy at a time when the world economy was under threat and they reckoned stuffing loot into our pockets would take our minds off the bogey man; but they forgot to turn off the tap. Almost six years later and our central banks are still pumping vats of cash into our economies. These massive levels of liquidity are laundered via that gargantuan money-creation scheme known as the property/mortgage market.

Of course, I’m completely wrong about all of this. It’s really only me showing my ignorance. Take, for example, the good folks at the recent Great Housing Debate: “House prices look set to continue to rise at an unstoppable rate for the foreseeable future, experts have said.”

That headline on aboutproperty.co.uk put paid to my ropey theories all right.

But, not content with foreseeing the foreseeable future, aboutproperty went on; “At the Great Housing Debate, run by the Wrigglesworth Consultancy, lenders, economists and housing industry experts agreed without major economic decline house prices would keep rising.” (The Wrigglesworth Consultancy is a PR firm.)

Unfortunately, the future is not foreseeable; even if you’re a PR person or a housing expert or an economist. Yet, after apparently nailing both direction and momentum, they elucidated: “‘A serious correction in the housing market traditionally occurs as a result of a sharp economic downturn, which looks extremely unlikely. It would take a reversal in recent increases of income multiples or a considerable tightening in lending criteria by banks, for there to be a serious downturn in prices,’ commented Nigel Terrington, Paragon Mortgages chief executive.”

I love the property market. It never goes down it always goes up forever.

The chaps at The Great Housing Debate even had a proper expert to explain it all. “Our expert, David Miles, Chief economist at Morgan Stanley said ‘Public expectations regarding house price growth is key to the market's stability. Growth would need to fall successively for a number of months before peoples’ expectations, and therefore prices, were seriously impacted.’”

And finally, just in case we didn’t get it, they finished with a bit of voodoo: “…experts also agreed keeping homes affordable would be down to offering mortgages with more income multiples. ‘Focusing on income multiples alone is not helpful – they must be considered instead in the context of affordability,’ said Michael Coogan, director general of the Council of Mortgage Lenders. He added ‘income multiples of six or seven could be a possibility in future.’”

So, price itself has become an irrelevance in the property market as long as the means exists to match it?

Our friend from Morgan Stanley is spot on about one thing: Buyer sentiment, or let’s call it the Coyote effect, is all that’s levitating the property market. There’s no chance at all that legislation will be put in place to curb the enthusiasm of bankers; multiples will continue to rise and lax lending standards will persist until bad debts overtake profits and the whole house of cards is revealed.

When I stare into the sheep’s entrails in front of me I see over a thousand City wags awarding themselves over a million pounds apiece in bonuses for being so clever. I see central banks pumping massive liquidity into a war-torn world where the price of oil can go into the sky and beyond without apparently affecting inflation. I see a media that believes it’s reporting the property market when it provides a daily platform for vested interests to talk it up.

It’s as if all the problems in the world are hidden under a great pile of money. Homeowners are rich! The meek have indeed inherited the earth. Where do I sign?

Because our political and financial betters refuse to let the air out slowly (it’s hard to pull your snout out of the trough when things are good) they will make the market crash, as they always do; for a market in economic equilibrium is hard to make windfall profits out of. Only by whipping markets into a crazed frenzy can exceptional profits be made with relatively little effort.

All of the arguments about houses having more intrinsic value than say for example, tulip bulbs or domain names are true. People need a place to live, bricks and mortar and all that. But when the money supply starts to falter, and it surely will, all hell will break loose and the little people will find that they aren’t rich after all. The money they thought they had will evaporate into last year’s City bonuses and someone else’s villa in Estonia. Some could save themselves by selling-to-rent now; but they won’t.

Every time there’s a crash of any kind in any market the professionals spend a lot of time whining that the amateurs are the ones who are spooked into selling. This is not and has never been true. The little people, unversed in the vagaries of high finance, always try to stick it out. This time it will be the same. Interest rates will continue their uptrend despite the generally-held, and entirely unsubstantiated, ‘view’ that rates will settle back by the third or fourth quarter. Mervyn King, the Bank of England governor said (with the consumer price index (CPI) bursting from its corset at 3.1% and the retail price index (RPI) out of the traps at 4.8% and counting; and both in an uptrend) that he expected inflation to ease back later this year. But he also said, in the Bank of England inflation report published a mere six months ago, that he expected inflation to ‘drop back’ to ‘target rates’ (2%) by mid-2007 (so he’s already out by around 50% on his previous ‘expectation’).

There are only two blunt monetary instruments economies can use to ‘control’ inflation. They can raise interest rates to try to make the currency more attractive to hold or they can plug up or throttle back on the money supply, thereby increasing the perceived value of the money already in circulation. But while the Bank of England has raised interest rates incrementally, the cash is still gushing forth along the river M4. (M4 is the sum of all money in circulation in the UK plus bank and building society accounts: it is our collective wad, if you will.)

And as long as the money supply keeps raging forth a significant subset of the working population, choking on cheap money, will hold onto their Naked Options (interest-only mortgages) to the death in the belief that they’re trying to save their homes. But many never had homes to save in the first place. It was all smoke and mirrors. They borrowed to buy one of the riskiest financial instruments yet conceived in the belief they were actually buying property. They were not but they don’t know that… yet.

You don’t need an expert to tell you, of course, that an interest-only mortgage is a simple loan; it’s not the kind of esoteric financial instrument that, mishandled, could rip through the world economy like a cluster bomb. You go down to the local estate agent or bank or broker or ice cream shop or one of 8,000 or more ‘sources of capital’ who will smile at you like a potential life partner, do a deal and you pay amount X every month for Y years. That’s not an esoteric financial instrument, is it?

But interest-only mortgages are not what they seem. Interest-only mortgages are indeed esoteric derivative instruments. The word ‘mortgage’ is just a disguise; for Interest-only mortgages are options and options are scary.

An interest-only mortgage looks like a Long Call but it has some of the characteristics of a Naked Short Put. It’s a financial chimera; a strange and unnatural hybrid, part Long Call part Short Put. A Call is an option in which the buyer’s (Long position) risk is defined. When you buy a Call you buy the right to buy the underlying instrument (in this case, the house) during a defined period of time. This is broadly what one does when one ‘buys a house’ using an interest-only mortgage. Except that in the case of an interest-only mortgage (as opposed to an actual Long Call) you can define neither the interest-rate risk nor the risk associated with the underlying instrument (the house; but, as we have been earlier informed by the good folks at The Great Housing Debate, as long as the sun shines in the right place prices will not go down).

When you ‘write’ (Short) a Put you are paid a premium for accepting the risk associated with the underlying instrument. If you own the underlying instrument you can write Puts ‘till your heart’s content and the worst thing that can happen is you have to deliver the underlying instrument (which ain’t great but at least you have the Put ‘covered’).

But a Naked Short Put (interest-only mortgage) carries with it the possibility of at least two sources of bad mojo. Both interest rates and the underlying price can potentially bite you in the ass. And the proliferation of such financial devices (providing the ‘context’ in the aforementioned context of affordabilty) means, very broadly, not only could you lose your own shirt writing Naked Options, you could lose everyone else’s as well.

Even if you get an impossibly low interest rate (Rl) and hoochy multiples (Mh) such that you can afford the half million or so for that trendy, ex-council two-bed in Clapham (whoops; Tooting) and even if the universe delivers a low, officially-mandated and traded, interest rate, the chances are that the low interest rate required a low-inflation environment (in which to exist), therefore when looking to exercise (at the strike price/agreed house price) the ‘principle’ (P) will be high in real terms. This means that if your payments remain low the price of the house at the end of the ‘mortgage’ (the time when you actually have to pay for the house for you have only been paying for the right to buy the house, not the house itself) the price will be ‘high’ in real terms.

If, on the other hand, interest rates head on upwards (Ru) (Which apparently can’t happen in a world with China © and America (A) where C (is equivalent to) Insatiable Demand and A = The other reason why oil costs so much and is about to cost even more) while the real value of the principal (at the ‘end’ of the mortgage) will be easier to meet (inflationary erosion and all that) the mortgagee may feel as regretful as a dog when the payments stay in the sky long enough to strip them of… possibly everything? So, in this twisted economic world of mine (kept at bay by sentiment and income multiples and cries of context and affordability!) high is bad and low is bad. But how can that be?

Well, here’s the answer: Go down to the City of London or Wall Street and ask someone in a suit whether borrowing serious multiples of your projected pre-tax income to ‘write’ (Sell/Short) a Naked Put (and ‘service’ it for 25 to 50 years) on a single idea is a viable strategy and they might ask how you escaped from the head-trauma ward.

Pumping vats of liquidity into the world financial system is more like religion than economics. It is the actualization of a theory that believes economic expansion is something we can control by constantly expanding. And we can, if by control we mean keep it going until we can’t keep it going anymore (re: our pals at the Great Housing Debate who reckon that rising income multiples of whatever it takes to provide affordability will inspire buyers to keep shipping-in those naked options because the underlying instrument (the house) is a nap to keep going up, and therefore the ‘speculator’ (prospective house-owner) purchasing those insanely risky options instruments (interest-only mortgages) is sure to be able to exercise ‘in-the-money’ (the house must be worth more than the strike price when you actually pay the principal)).

There is a yawning gulf between the knowledge required to ‘trade’ interest-only mortgages (Naked Options) and the knowledge of actual (primary market) mortgage traders (‘house buyers’). Most people, even if they studied for years, couldn’t care less anyway; which is why they’re easy to sell in the first place. Putting these things in our hands is the equivalent of putting Homer Simpson in charge of a nuclear power station: Mostly, it’ll be okay. We might never see a meltdown at all if our luck holds out; but that would be extremely unlikely. Credit simply cannot expand indefinitely. There’s no need to foresee anything at all to understand that it’s all just a matter of time.

This is not about foreseeing the future; which is not possible, no matter the language within which such claims are couche

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Why not? (Seeing as you're so interested, and I can see that from your posts.)

(This is copied from another thread. In-between noticing my high regard for myself he asked that I should post my original, unedited version that was written around three months ago but is still pertinent.)

The Economic Cluster Bomb and other fancies...

By David Stars

Thanks for the original version. It must be a risk for you to publish articles that most people are not ready to believe.

If you are right (you are), then every other journalist will say they saw it coming too.

If you are wrong, everybody will think you have lost the plot.

VMR.

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Guest DissipatedYouthIsValuable
Blue or Great?

Inside Track BTLers.

Edited by DissipatedYouthIsValuable

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Why not? (Seeing as you're so interested, and I can see that from your posts.)

(This is copied from another thread. In-between noticing my high regard for myself he asked that I should post my original, unedited version that was written around three months ago but is still pertinent.)

Except that in the case of an interest-only mortgage (as opposed to an actual Long Call) you can define neither the interest-rate risk nor the risk associated with the underlying instrument (the house; but, as we have been earlier informed by the good folks at The Great Housing Debate, as long as the sun shines in the right place prices will not go down).

It's questionable whether you can ever define the risk associated with the underlying instrument. Options theoretically price in the risk at a given moment, but that risk changes the second you buy as you've locked in your risk assumptions based upon what's known at that point in time. A Put / Call is always a bet that the underlying instrument will move in the direction you've predicted. And the risk is that it won't.

PS - Still a very provocative and interesting article DStars.

Edited by haggis

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Excellent.

Could do with more tits.

But there's enough violence for an extreme horror flick though.

To the OP, thanks for the enjoyable read.

<Edit: typos>

Edited by williamdb

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And this was posted JULY 2007, before everything kicked off.

Well done and come back DSTARS.

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What makes this an especially thrilling ride is that we now have :-

1/ a probable cyclical bottom in unemployment

2/ a probable cyclical bottom in inflation measures

3/ a probable cyclical bottom in commercial rates (against this specific asset class)

4/ a probable cyclical peak in leverage extended (again, against this specific asset class)

All of which means we're* likely as not going to get a chance real soon now to test this bit...

If, on the other hand, interest rates head on upwards (Ru) (Which apparently can’t happen in a world with China © and America (A) where C (is equivalent to) Insatiable Demand and A = The other reason why oil costs so much and is about to cost even more) while the real value of the principal (at the ‘end’ of the mortgage) will be easier to meet (inflationary erosion and all that) the mortgagee may feel as regretful as a dog when the payments stay in the sky long enough to strip them of… possibly everything?

... we're about to lose control and I think I like it.

(* by which, of course I mean - lenders who have been originating these loans into the market, their share- and bondholders, those donating their savings to such institutional investors, the taxpayer in general, and also any folk unlucky enough to have outbid the "look ma no hands^wbrain^wamortisation" brigade (hi Eric!))

(and DStars - note from your editors - more, and bigger tits next time - circulation's taken a dive since you came on board)

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We should all be aware that Dstars was driven from this forum by a fascist-style burst of moderation that relegated all his EXTREMELY INTERESTING AND RELEVANT TOPICS to the Off-Topic forum. CGNAO's threads have likewise been moved off-topic. Thus we are left with a main forum that consists mostly of anecdotals, gossip, and smut. There are very few threads on the main discussion forum these days that are informative, and/or that provoke discussion. And as soon as any such thread is posted, you can bet your bottom dollar it will be moved off-topic. One wonders whether the moderators of this forum have a suicide wish. Or are they more interested in attracting the Johnny-come-lately sheeple who have flocked to this forum in recent weeks, than keeping the contributors who have been predicting the present housing and economic crisis for years, and whose diligent research and informative posts have been so helpful to many like me.

I would love Dstars to come back and post again, but I can understand his reticence when his posts are relegated to Off-Topic.

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We should all be aware that Dstars was driven from this forum by a fascist-style burst of moderation that relegated all his EXTREMELY INTERESTING AND RELEVANT TOPICS to the Off-Topic forum. CGNAO's threads have likewise been moved off-topic.

The forum has definitely got more laddish and lightweight recently.

I think the cliquey and vicious self appointed moderators are probably worse than the official ones who are merely pedestrian and unimaginative.

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I think the cliquey and vicious self appointed moderators are probably worse than the official ones who are merely pedestrian and unimaginative.

Are you a Psychologist, there appears to be quite a few posting on this Forum now. :)

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