Friday, October 14, 2011

Seeing The Future By Understanding Credit

I sold real estate in one of the most bubblicious cities in America, Washington D.C, between late 2005 through late 2007.  I feel that my insatiable desire to learn about markets and market history is due to being on the front lines of the most recent financial calamity.  I remember home owners receiving mortgages that would take their total monthly debt payments to $6,000, and only making $3,500 per month.

The greatest lesson that I learned during the process was the impact of debt, or leverage, on the price of an asset.  This was magnified to its highest degree in real estate, an asset that is usually purchased using at least 80% debt.  During the mania, the amount of debt used to purchase real estate rose to 100%. Then closing costs were removed.  Then real estate was even financed at 125% of the purchase price. 

The lowering of lending restrictions allowed more buyers to enter the market.  Greater supply of buyers lead to higher prices.  Then it reached the maximum lending capacity and the levers began to move in reverse.  Lending restrictions began to tighten, lowering the amount of new buyers that could enter the market.  Lower supply lead to lower prices.

It seems so simple today looking back, yet so few people could understand while it was happening. (Including myself until I read a lot of books by people far more intelligent than I)

Now that I have learned this lesson, I try to apply it to future applications.  I ask myself; where could credit be removed from next that could negatively impact the price of the underlying asset it is funding.

The answer lies in the sovereign debt crisis taking place before us around the world.  Government debt now funds a vast majority of the global economy's primary exchanges, and government debt is now slowly being removed, just as subprime mortgage debt was removed in late 2007.

Before we get to the real fun stuff, let's start with Greece because it is easier to apply due to Greece's government spending currently in the process of shutting down.  As the European Union and IMF extend loans to Greece to keep them alive they simultaneously enforce government spending cuts.

So let's say that Greece has $1 billion to spend this year, and it has now been reduced to $700 million in 2012.  The key question as an investor to ask is where you anticipate those spending cuts coming. 

What if it Greece spent $100 million per year providing student loans and that now had to be reduced to $20 million?  What would happen to the price of college education in that country? 

It would collapse.  Less students capable of receiving loans means lower supply of students at the current prices.  Colleges would be forced to lower prices drastically.

What if Greece spent $100 million per year on providing auto loans and that now had to be reduced to $10 million.  What would happen to the price of cars in Greece?

They would collapse.  Do you see how this correlates? 

Now let's take it one step further.  What if you were considering purchasing an apartment building in a college town in Greece?  If the number of students attending the school was about to shrink considerably, what would happen to the monthly rent you could charge?  If an apartment building's value was based on the income a building receives, what would happen to the value of that building?

It would simultaneously collapse.  As would a retail building in that town. 

Now apply this concept to a town in Greece where 60% of workers are government workers.  If 50% of those jobs are removed and the remaining 50% had to take pay cuts, what would happen to the value of real estate in that town?

This is taking place as we speak in Greece.  This is not a hypothetical analysis, but I have one for you.

Close your eyes now and imagine you are in the United States, not Greece.  Imagine that the United States could not run $2 trillion budget deficits annually and we were forced to cut spending to only what we could pay for.  Imagine where the $2 trillion in cuts will come from.

The United States currently pays for:

1. All mortgages in America
2. Financing for apartment buildings
3. Car loans through General Motors
4. Student Loans
5. Defense
6. Medicare
7. Medicaid
8. Social Security
9. Unemployment Insurance
10. Food Stamps

Where will the cuts come from first in that group?  What will the majority of voters ask for when our government spending must contract?  How you answer that question should be a major determinant for how you invest your money today.

I personally believe that the cuts will come from 1, 2, 3, 4, and a large chunk of 5.  I believe that the American people would rather have a social security check, food, and medicine over higher housing, student loan, and car payments.  In fact if you re-read that statement you can see that the government removing themselves from 1-4 will benefit consumers, not harm them. 

This reality is coming to America.  It is math, not science. Our country will not end, but you have to think about how credit will impact the price of assets in the future when someone tells you today is a great time to purchase a home or a retail building.

I'll leave you with a simple example.

What if our government reduced the amount of funding it provided to apartment buildings and reduced the amount of money it provided to student loans?  What would happen to the value of an apartment building at a college campus?

Do you know any publicly traded companies that invest exclusively in student housing? 

I do.

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