Wednesday, March 04, 2009


Here's my hypotheses regarding the financial crisis:

1. The fallacy. The fallacy underlying the current financial mess is that the amount of realestate in the United States is relatively fixed, but the population continues to grow; thus real estate is always going to appreciate over time. Thought eh general principle is true, the fallacy is that it will continue to appreciate over ANY period of time.

2. The anomaly. The anomaly in the situation occurred because of efforts to intervene in the market mechanics of real estate pricing, to the effect that the appreciation in realestate outpaced income growth. This inflated the housing bubble and would inevitably lead to a bust.

3. The confounder. The usual balancing mechanisms that operate in fair markets were skewed by artificial devices that obscured where value was being created and disappeared. These were the "derivatives" which supposedly added liquidity to real estate investments. What actually happened however was that the derivatives became divorced from the intrinsic value of the underlying mortgages and asumed the nature of wagers. Thus, money invested in these derivatives did not go to increasing value, but merely shifted it between the people who bet correctly and those who did so poorly.

4. The vortex. Because of the proliferation of derivatives, and because of the synergistic effect of ineffective government oversight on one hand and inappropriate meddling on the other, money that should have gone to maintaining equilibrium in the credit market, and maintaining liquidity of the system the old fashioned way, i.e. by having debtors pay off their obligations, the underlying assets became "toxic" and the artificial value of realestate collapsed.

5. The upshot. Foolishness in the housing market shook the credit and investment sectors of the economy, but the underlying premise is still sound. Even though real estate and housing are subject to bubbles, i.e can have artificially high valuations, over the long term, real estate values will appreciate. My bet is that the safest investments right now for liquidity appreciation and safety is real estate investment trusts.

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