Wealth Building Lessons

The past week has seen a dramatic drop in the global stock markets. It first happened in the US and then spread to global markets. It seems to have been started when Bear Stearns announced that 2 of its Asset-backed Hedge Funds where completely worthless.

The two bankrupt funds, the Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd. and the Bear Stearns High-Grad Structured Credit Strategies Enhanced Leverage Master Fund Ltd. had bet heavily on subprime loans. (Funnily enough, these sub-prime Collateralized Debt Obligations or CDOs had received AAA ratings from credit-rating companies like Moodys). Most of the investors had no clue what the Hedge Funds were investing in. In fact, the names are rather complicated and misleading too. (Note that investors broke Warren Buffett’s rule of investing: If you can’t explain what a company does to a six year old, you shouldn’t invest in it).

To make matters worse, American Home Mortgage (AHM) announced that it wouldn’t be able to make payment obligations related to subprime lending and promptly lost 90% of its market cap (after already losing 2/3 in the past six months!).

As if this wasn’t enough of a blow, the market received yet another shock from Bear Stearns. It had stopped redemptions on a third asset-backed Hedge Fund in order to calculate how much it was worth. The last time they did that, the answer was zero or close to zero!

Suddenly, it looks like the market is viewing the credit-rating agencies with increasing mistrust. Not only that, but it seems that investors are suddenly shying away from lending money to businesses for any reason. Cerberus announced that it was having difficulty raising the money to buy Chrysler.And all of a sudden, it looks like there’s a global liquidity crunch.

The UK Times reported that Banks face $8bn credit crunch.

Bankers reckon that in America, there is an estimated $200 billion of debt that banks have already agreed to lend but have not yet syndicated – passed on to other investors. In Europe, the figure is about €60 billion (£40 billion).

One banker said: “The collapse of debt markets has slashed the value of the debt. And we can’t find buyers for it at the moment, which means it could get worse.”

A senior investment banker said: “There is a saturation of debts in the system. Investors, who seemed insatiable, have now taken fright and banks are left holding the baby on deals on which they’ve taken too much risk. Most banks have shut their leveraged finance to new business. The recapitalisation market – which accounts for 40% – is gone. Nobody will underwrite the deal. Also, the secondary buyout market is pretty much gone. It’s not permanent but it’s serious for now.”

Seems like the Leveraged Buyout Party is over too.

Unfortunately, there is a correlation between foreign investors providing capital for the Leveraged-Buyouts and the US Mortgage market. These same investors are inclined from time to time to purchase mortgages, which are wrapped into huge portfolios and sold off as AAA rated products. These portfolios are sliced and diced by financial experts and various derivatives are used to modify the risk profile. They’re given fancy names like ‘tranches’ (which merely means “a slice”, but doesn’t sound sophisticated enough) and the end product is so complicated that no one can really tell what the actual risk is.

Now we have a problem. Due to certain recent events, if no one is willing to step forward and purchase these portfolios (out of concern that they’re not really AAA rated and there’s a good chance of loss of principle), the lending banks cannot get rid of the old loans, and until they do, they cannot originate any new loans.The end result is that getting a mortgage might become increasing more difficult for people like you and me. Underwriting standards will tighten (even more than they already have in the past 3 months) and interest rates will go up because investors demand higher rates in return for the risk. Zero down-payment and low down-payment loans will also disappear.

When its more difficult to get a loan, property prices tend to stagnate, or even decline. Especially in places which were over-built, saw extreme appreciation, and are still largely unaffordable like Southern California, Miami and Las Vegas.

Even though I’m a big fan of real estate investing, right now may not exactly be the optimal time to jump in unless you really know what you’re doing. Real estate can sometimes be very forgiving if you do not buy right. But now is not one of those times.

Related Readings:

1. Value Investing in Real Estate

2. When Genius Failed : The Rise and Fall of Long-Term Capital Management

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