Wealth Destruction 1 How bubbles destroy wealth.
Wealth Destruction 1
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- Let's do an example of
- how a housing bubble can lead to wealth destruction.
- And I really just want to hit the point home that
- once wealth is destroyed, all legislation can do is
- redistribute who takes the losses.
- That you can't create wealth, all of a sudden, out of legislation.
- You can maybe create incentives for investment etc, etc,
- but we'll talk about that in a future video.
- So let's say, in year one, I have a neighborhood and
- Toll Brothers goes out and builds a new development
- and they build five houses.
- Let me draw those five houses.
- House 1, house 2, house 3, house 4, and house 5.
- And let's say, that this was a normal home buying environment.
- This could have been 1995.
- Let's just say, for the sake of argument, this is 1995.
- Although, I want this to be an abstract example,
- so we could call that year one.
- But in 1995, these people find five new families
- that go buy the house.
- They pay $100,000 each, for the houses.
- These were conforming loans,
- there wasn't this whole CDO and mortgage-backed security market.
- So essentially, these people have to put 20% down, and
- they had good credit scores, and all the rest. So immediately,
- they have $20,000 equity and an $80,000 loan.
- It's my code, E for equity.
- $80,000 loan. I have to write that down. or $80,000 mortgage.
- They have good credit etc etc.
- Now, we have this whole securitization,
- lending becomes a lot easier, becomes easier and easier every year
- because housing prices go up,
- so people stop taking risk into consideration.
- And let's say, we get to the year 2005.
- This could be an abstract example, it could be year two.
- In 2005, all of a sudden everyone is getting access to funding.
- The people who have houses actually don't want to sell the houses
- because they're convinced that
- their housing prices are going up so fast,
- that it's only a matter of time before they're millionaires
- just with the housing wealth, and then they could maybe retire off of it.
- But there's so much funding and anyone can get a loan.
- And let's say, that these first homeowners,
- maybe they have to move,
- or maybe they just want to move to a cheaper location,
- or maybe their kids have gone to college,
- so they just want to downsize.
- They decide to sell their house.
- And because there's so much demand out there,
- anyone can get a loan, frankly, the person who's going to be able
- to give the highest bid on the house, is a person,
- to some degree, who's most reckless or most prudent.
- And anyway, I won't go into that.
- But let's say, they pay $1 million for the house.
- They have no money down, $1 million loan, subprime,
- negative amortization, they had no credit rating, etc, etc.
- They pay $1 million.
- Now, that was the purchase price of the house.
- And we could just say, that they have zero equity.
- and they have a million loan.
- And of course, this guy's great now.
- He probably did build equity over that 10 years from 1995 to 2005,
- but even if he didn't, even if all he did was
- pay the interest on this $80,000 loan.
- This guy, he had $20,000, now he gets $1,000,000,
- pays off the $80,000, so he essentially, gets $920,000
- plus the $20,000 had before.
- So he moves to Costa Rica with $940,000 and lives like a king.
- Although, I've heard Costa Rica has also become expensive.
- But anyway, what happens now in the neighborhood?
- These people didn't sell their houses.
- They didn't find some subprime individual
- that was willing to bid up the house.
- Nothing happened, no money changes hands,
- but all of a sudden, these people say, well you know what,
- our houses are just as nice as this first house that sold.
- Maybe it's even better.
- So our houses are also worth $1 million.
- So we all have this kind of you could say,
- paper wealth here of $1 million.
- Just from one transaction.
- And actually, this is a five house neighborhood,
- this could happen in a 500 house neighborhood.
- You just to find one person to overpay for a house and then
- everyone in the neighborhood, all of a sudden,
- feels at their house is worth that much.
- And just out of thin air, just by one person getting cheap credit
- and overpaying for something, everyone in the neighborhood thinks
- that they just got $900,000 of wealth, or at least in this example.
- You never see a nine-fold increase in property prices
- but it wasn't crazy to see a twofold increase in a year.
- Well, we have seen nine-fold increases over ten years,
- it's the example here, it's actually not that crazy.
- Anyway, that's all of their notional wealth.
- But all these people don't want to sell.
- One, they like their house, their kids are still there.
- And they say, wow, in ten years my house went
- from $100,000 to $1 million and in another ten years,
- my house is going to go from $1 million to $10 million.
- Why would I sell it; I can then retire off the house.
- They don't think, who could buy a $10 million house in ten years.
- The only people who could-- well anyway,
- I'll do another video on that, I just don't want to run out of time.
- But they can still monetize this.
- They could say, well when I go to my financial planner,
- they said, oh, it's so inefficient for you
- to have all of that equity sitting in your house.
- How much equity do they have?
- They had $20,000 before and even if they didn't build any equity
- while they paid their mortgage, they now have another $900,000 of equity.
- So these people, their financial planner,
- and their siblings, and their friends at work say, oh,
- your balance sheet is so inefficient,
- why don't you take some of that equity and invest it or put it to work.
- So they say, that's a good idea.
- I'll go get a home equity loan.
- So let's say, this person goes to a bank.
- A bank says, OK, sure, I'll give you a $500,000 home equity loan,
- and in exchange, get 8% interest on that loan.
- So this is the bank.
- And the bank thinks it got a great deal.
- Because this $500,000 loan is not an unsecured loan.
- It's not like this person can't pay,
- they just file bankruptcy and
- there's nothing that the bank can get ahold of.
- This home equity loan is secured by the house.
- So the bank says, well if this person doesn't pay that $500,000 loan,
- if they default, for whatever reason, I get their house.
- And their house is worth $1 million.
- And why do I think it's $1 million?
- Because a house in the neighborhood sold for $1 million
- and frankly, that's how, unfortunately, housing was assessed.
- People would just say, oh,
- another house in this neighborhood sold for $1 million,
- this one must be worth $1 million
- because it's a very similar or maybe even a better house.
- So this banker thinks they have a great deal.
- This is better than buying treasuries.
- I'm getting 8%, maybe treasuries are giving me 3% or 4%.
- And if they default on it, I actually get an asset
- that's probably worth more than the loan amount,
- and I can auction that off and easily get my $500,000 back.
- So the risk managers within the bank think they have a great deal.
- And they probably sliced and diced these things and
- sold it to other people and got it rated as triple-A and all of that.
- But what happens next?
- Well let's say, 2005, in our imaginary universe was
- the peak of the credit cycle.
- That was the year that credit was the loosest.
- And as soon as some of these people
- who had no jobs and got these $1 million loans,
- they probably couldn't even pay the mortgage on their loan,
- not to speak of continuing it,
- or even pay the low rate on the original teaser loan.
- So maybe, they start to default, credit starts getting tighter,
- and let's say, this guy actually gets foreclosed.
- And so he gives the house back to the bank.
- The bank auctions it off and let's say,
- when the bank auctions it off, it only gets $300,000 for the house.
- And in the meantime, what did all of these people do with
- the $500,000 that they had?
- Well their intention was to take these home equity loans
- and put that money to work, invest it in some way.
- And they say, well what's a better investment
- than doing home improvements?
- Because we all know a house is the best investment.
- So unfortunately, a lot of that $500,000
- it gets quote-unquote invested in granite countertops,
- two more bathrooms per house, hardwood floors, and you can imagine.
- They wanted to treat themselves too,
- so they did a little vacation.
- So it was invested quote-unquote in their house.
- Because they said, oh well,
- this will increase the value of my house.
- And oh, as a side benefit, I will really look good,
- relative to the neighbors and live it up.
- I can live beyond, essentially, what my income would predict.
- And I've done some videos on investment versus consumption,
- but I'd argue that this wasn't real investment, that $500,000.
- That this was consumption because
- it's not making the world more productive in any way;
- it's not increasing the total economic pie for the world,
- so it's not investment.
- It may be an investment if it somehow makes your asset
- more emotionally appealing to some greater fool to pay more for it.
- You didn't build a factory or you didn't invent some new technology
- that will make all of us richer,
- you just poured some money into something
- that's going to make your lifestyle a little bit better,
- and maybe the next person who buys your house.
- But anyway, this house got foreclosed upon.
- It gets auctioned off for $300,000,
- maybe this is the year 2006.
- Now, all of a sudden, all of these people, probably all of whom
- who took these home equity loans, let's say all of them did it.
- They all say, gee, I'm paying a $500,000 loan.
- Actually, I'm paying $500,000 plus my original $80,000 loan,
- so, I have $580,000 of debt on an asset
- that just sold for $300,000.
- So what do you think they're going to do?
- And I just realized I'm out of time,
- so I will continue this in the next video.
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At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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