Rule #1: There are no rules.

Let No Good Deed Go Unpunished

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So…the stock markets are soaring today on news that the government has banned naked short selling. Add this to the jumble of other awkward, piecemeal “solutions” they’ve vomited out and what it leads to is disaster.

Banning naked short selling is not a solution, it’s a bandage. No, it’s worse than that; it’s a faustian bargain. Yes, shorting creates bearish pressure, but it’s not the reason we got into this mess, and those reasons seem to have been forgotten behind the backdrop of exciting new pain-avoidance strategies.

Let’s recap:

We’re here because of homeowners who made ridiculous gambles on adjustable rate mortgages in order to buy homes they couldn’t reasonably afford. They thought they’d find easy street, but the market called their bluff as it is wont to do.

Compounding the problem is the other side of the transaction, where banks who sold bum mortgages—which they reasonably should have known would never be paid back considering who they lent to—and recorded this outstanding debt as valuable assets, working under the false assumption that they would one day see this money.

So, both sides made foolish, risky trades for their own benefit and, lo and behold, to varying degrees, both lost. The meaning of risk is thus: sometimes someone gets screwed, and that guy could be you. It’s not complicated.

And that’s perfectly fine. We engage in risk every day (it’s unavoidable), and it’s our job to determine our personal cut-off point in the risk/reward spectrum (really more like regions in a plane, but whatever). E.g., driving a car is very dangerous, but I find the risk acceptable for the benefit of getting around. I could have purchased a sub-prime mortgage and bought myself a nice chunk of suburbia, but I didn’t because it’s less financially risky for me to own an apartment. It doesn’t mean I like living in an apartment, it means I made a conscious determination to scale back the quality of my home so that I wouldn’t be that guy who is now concerned about losing his home. It’s called ‘responsibilitity’.

As all of this was happening, and as the attitude of lenders and borrowers changed from ‘money should be borrowed with care’ to ‘WOOHOO, FREE MONEY FOR EVERYONE!!’, the “U.S. homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 percent” (Wikipedia). And as the windbag politicians prattled on about how ‘owning a home is American’, anyone who was reasonably considering this situation should have seen the writing on the wall: a non-emerging market probably can’t sustain 70% growth. But what do I know? I’m just an un-American apartment renter.

Regarding my comment above about 70% growth, I’m rereading this as of 2009-12-11, and realizing that I obviously made some kind of typo. Frankly, however, I don’t know what I was intending. It’s not 70% growth, it’s about 0.52% per annum ((69.2 - 64) / (2004 - 1994)). My intention is not to mislead, so I apologize for the error persisting so long. Fortunately it was so egregious that likely no one took it seriously.

That said, I still believe the growth rate is rather out of hand and the original point still stands, and I’ll try to back that up with some sane math.

If you take the U.S. Census Bureau’s data, which goes back to 1968 (I’m using the first quarter numbers), the average yearly growth in homeownership is 0.14% per annum (= (68.6 - 63.6) / (2004 - 1968)). Put simply, homeownership grew at a rate almost 4 times as fast during those ten years. This shouldn’t happen in a non-emerging market without some kind of technological miracle.

Then suddenly, rather like someone who just got the ‘deal of a lifetime’ buying a “Rolex” on the streets of NYC, the uber-Americans (homeowners) realized they’d paid too much (I imagine this probably happened around the 7th inning, mid-bite into a slice of apple pie). Though for myself, I’ve oft wondered if anybody thinks paying 15 years of your annual salary for a place to live seems like a reasonable idea.

On the other side, the banks woke up and realized that their speculative “profits” were vaporous, but these debts had already been bundled into commodities which were bought and sold all of the world. And suddenly the world let out a collective, oh, shi—

And somehow nobody saw this coming…? Oh wait, maybe a fewcrackpots” did (but who understands those capitalist guys, anyway?).

Ok, sorry, longest recap ever.

So yes, people shorted. What of it? Those people made the right call. The shorters didn’t take the value out the market; they just profited when everyone else finally realized that there wasn’t much value there to begin with. All of investing is about making the right call and there’s nothing inherently wrong with thinking that call should be in the downward direction. There are some difficult considerations with naked shorting potentially creating a false magnitude of bear pressure, but the fundamentals of American home lending were fundamentally wrong, and naked shortselling alone would never have brought us anywhere near here.

Now that the market has become aware of the problem, it will, unaided, resolve the situation. But of course that solution is not pretty: the dead weight has to come off. Those who made bad financial decisions (on both sides) need to pay the cost. Yes, that means some companies need to go under, and yes that means some homeowners need to lose their homes. It has to happen for recovery. Think of it as sweating the fever off. The magic of capitalism is that it resolves problems like this, and it does so by purging the toxic elements.

What frightens me is how little understanding there seems to be of this very simple concept…or maybe it is understood, but it’s not a politically marketable viewpoint. People losing their homes?! This is terrible. Maybe I’m next! But reallly, folks, listen to these characters you’re going to have to pick from in November yakk about the poor, innocent homeowners:

“We need a more institutional response to create a system that can manage some of the underlying problems with bad mortgages, *help homeowners stay in their homes* […]” —Sen. Barack Obama, Obama would rescue Main St. along with Wall St.

And here’s the other one:

“There is nothing more important than keeping alive the American dream to own your home, and priority number one is to keep well meaning, deserving home owners who are facing foreclosure in their homes” —Sen. John McCain, McCain Refines Plan for Homeowners

I, for one financially-responsible American, don’t feel the need to fund the homeownership of others based on someone’s unfounded, poorly-defined ideal that homeownership is American. * I resent the idea that my hard-earned cash will be ransacked for the sake of those who indulged in luxuries they couldn’t afford* in the form of increased taxation. And meanwhile I don’t get so much as a ‘thank you you being a financially-responsible American who contributes to the stability of this economy.’ No-siree.

The market would find the right price on its own, it just takes time. But every time the government steps in and injects funds, it creates a false sense of security; the illusion that financially inviable entities are viable. Injecting capital doesn’t improve the business models, it doesn’t eliminate the weak, and only serves to create competition for the responsible corporations who would aide in our swiftest recovery if we allowed them to. But injecting funds does create that A-OK appearance so valuable to a pandering politician by making things better in the short term.

It is the very basis of capitalism that the best companies thrive and the worst die: we need to shake off the dead weight.