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A Lesson from Las Vegas

p>In the midst of a market cycle, the news tend to reinforce the current trends.  In the following article about the imploding housing market in Las Vegas, you'll see plenty of doom and gloom about how bad the situation is over there and how it's a reflection of the overall US market.

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http://www.economist.com/node/18440791

While the situation is definitely ugly over there, the point is to understand the underlying causes so you can avoid the same fate and maybe even prosper from knowing better what to do.  Earlier last decade, the Federal Reserve decided to stimulate the post-dotcom economy with easy monetary policies.  This led to a massive expansion of credit and a drop in interest rate yields.  As investors responded to the lower yields, they looked to finance real estate as a way to increase their yields.  Buyers found the lower rates made houses very affordable and bought in droves.  Investors were happy with their returns and Wall Street helped juice the system with exotic new capital sourcing instruments like MBS and CLO.

Soon, Freddie Mac and Fannie Mae felt competitive pressure from all the investors out-bidding them on mortgages.  Since historically, housing was a conservative investment with high hurdles for new buyers, these two companies decided that it was in-line with their mandate to increase homeownership to lower their credit standards for borrowers.  Once they did so, all the secondary investors saw that as a signal to accept even lower interest returns and higher risk.

Home builders naturally responded to

the huge credit-fueled demand by building as fast and as cheaply as they could to maximize profits.  Within cities, builders picked up sub-prime locations to build high density homes for all the sub-prime borrowers/buyers.  But the easier growth was away from the city centers and for Las Vegas, that meant going out miles into the desert wilderness.  Land was cheap and all the construction created enough jobs and money for people to feel comfortable paying for the gas to drive ever further to live in a spacious home, a powerful feedback loop.

As the loop cycled, credit standards collapsed to new lows, as anybody or their dog could get a zero-down loan on a house.  The mortgage actuaries believed the value of the house would always be enough to cover the loan, even in the event of foreclosure.  Records from 40 years of history supported their views that home prices would inevitably go up.  But the fall came as much from the increasing defaults of sub-prime borrowers as the loss in confidence of the infallibility of home values.

The reversal came swiftly as our open market economy allowed corrections to occur unobstructed by non-economic government intervention.  Indeed, the Federal government tried a number of incentive programs to slow the fall, but that just delayed the inevitable.  So, here we are, just 4 years away from the market peak and all we hear is doom and gloom.

Since the trend is reversing, here's what to take away:  (1) as credit standards tightens and remains tight, today's qualifying buyers are much less likely to default in the future, so that supply of homes will be more or less permanently off the markets.  (2) shell-shocked home builders are building more selectively, leaving much less good inventory to buy in the near future.  (3) as employment remains difficult, workers continue to move back towards city centers and the high gas prices are just an extra boost.  all the remaining inventory in the outer suburbs will contribute little to future supplies of homes.

Michael Cheng

Michael Cheng