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Current time:0:00Total duration:10:30

Video transcript

let's do an example of how a housing bubble can lead to wealth destruction and I'd really just want to hit the point home that once wealth is destroyed all legislation can do is kind of 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 setter but we'll talk about that in a future video so let's say an year one I have a neighborhood and you know Toll Brothers goes out and builds a new development and they build five houses let me draw those five houses house one house to house three house four and house five and let's say that this was a normal home buying environment this could have been I don't know 1995 actually let's just say let's just for the sake of argument let's say that this is 1995 1995 although I want this to be an abstract example so we could call that year one but in 1995 these people they find you know five new families that go buy the house they pay a hundred thousand each for the house they pay a hundred thousand for the houses each family hundred thousand and 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 twenty thousand dollars of equity and an eighty thousand dollar loan right 20k equity 20k equity that's my code Eve or equity and then eighty thousand loan I don't have to write that down or eighty thousand mortgage right and they had good credit etc etc now we have this whole securitization lending becomes a lot easier it becomes easier and easier every year because the housing prices go up so people stop taking risk into consideration and let's say that where we get to the Year 2005 but this could be an abstract example it could be year two whatever in 2005 all of a sudden everyone has everyone is getting access to funding the people who have houses actually don't want to sell their houses because they're convinced that their housing prices is going up so fast that it's only a matter of time before they are millionaires just with their housing wealth and then they could maybe retire off of it but there's so much funding anyone get alone and let's say that this first home owners 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 a million dollars for the house right they have no money down million-dollar loan subprime negative amortization they had no credit rating etc etc well they pay a million dollars that was a purchase price of the house and we could just say you know they have zero equity and they have a million loan and of course this guy's great now let's just this you know he probably did build equity over that ten years from 1995 to 2005 but even if he didn't even if all he did is he paid the interest on this $80,000 loan this guy he had 20,000 now he gets a million pays off 280 so he essentially gets he essentially gets nine hundred twenty thousand plus than the twenty thousand had before so he you know he moves to Costa Rica or whatever would nine hundred forty thousand dollars 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 some subprime individual that was willing to bid up the house they didn't 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 it sold maybe it's even better so our houses are also worth a million dollars so we all have this kind of you could say paper wealth here for a million dollars just from one transaction and actually this is a five house neighborhood this could happen in a in a 500 house neighborhood you just have to find one person to overpay for a house and then everyone in the neighborhood all of a sudden feels that their house is worth that 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 they or at least in this example you never see a nine-fold increase sorry a nine a nine fold increase in property prices but you have zit wasn't crazy to see a two-fold increase in a year over the last well we have seen nine fold increases over ten years which it's the example here so it's actually not that crazy anyway that's there that's all of their notional wealth but all of these people you know they don't want to sell one they like their house their kids are still there and they say wow you know in ten years my house went from a million from 100k to 1 million in another 10 years my house is gonna go from I don't know a 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 dollar house and in 10 years only people who could well blend we I'll do another video on that I just want to run out of time but they but they can still monetize this they could say well you know when I go to my financial planner they said oh it's it's so inefficient for you to have all of that equity sitting in your house right 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 nine hundred thousand dollars of equity right so these these people they're financial planners say oh and and and they're they're they're siblings and whatever say 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 oh that's a good idea I'll go get a home equity loan so let's say this person they go to a bank a bank says okay sure I'll give you a $500,000 home equity loan five hundred thousand dollar home equity loan and in exchange get I don't know eight percent interest on that loan so this is the bank and the bank thinks it got a great deal because this five hundred thousand dollar loan it's not just it's not an unsecured loan it's not like if this person can't pay they just filed 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 five hundred thousand dollar loan if they default for whatever reason I get their house and their house is worth a million dollars right and why do I think it's a million dollars because a house in the neighborhood sold for a million dollars and frankly that's how unfortunately housing was assessed people would just say oh another house in this neighborhood sold four million this one must be worth a million because it's a very similar or maybe it's even a better house so this banker thinks they have a great deal this is better than lending to buying Treasuries I'm getting 8% maybe Treasuries are giving me 3 to 3 or 4 percent 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 five hundred thousand dollar bank so the risk managers within the bank think they have a great deal and they probably slice and dice these things and sold it to other people and got it ready to dis Triple A and all of that but what happens next well let's say 2005 in our imaginary universe was the peak of of the credit cycle that was a year that credit was the loosest and as soon as some of these people who had no jobs and and and and got this these million dollar loans they probably couldn't even pay pay the the fine it pay the mortgage on their loan not to speak of you know continuing it or they probably could even pay the low rate on the original teaser loan so maybe they start to default credit starts getting tighter and and let's say this guy actually gets foreclosed and so he gives a house back to the bank the bank auctions it off and let's say when the bank auctions it off it only gets I don't know it only gets $300,000 for the house it only gets $300,000 for the house and in the meantime what did all of these people do with their $500,000 that they had well they their intention was to take these home equity loans and put 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 granite countertops two more bathrooms per house more bathrooms hardwood floors are say wood floors and you could imagine you know they want to treat themselves do so they did a little vacation so it was invested quote/unquote invested in their house because they said oh well you know this will increase the value of my house and Oh as a side benefit I will really look good relative to the neighbors and and and live it up and and I can live beyond essentially what my my income would predict 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 an investment it may be this investment if it if it somehow makes your asset more emotionally appealing to some greater fool to pay more for it but it's not in sight 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 on it's now worth it gets auctioned off 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 right they all say gee I'm paying a $500,000 loan actually I'm paying $500,000 plus my original $80,000 won so I have it I am five hundred eighty thousand dollars of debt on an asset that just sold for three hundred thousand dollars so what do you think they're going to do and I just realized I'm out of time so I'll continue this in the next video