We Need A Crash To Sort The Wheat From The Chaff

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Once the phantom collateral vanishes, there’s no foundation to support additional debt and leverage.

When a speculator bought a new particle-board-and-paint McMansion in the middle of nowhere in 2007 with nothing down and a $500,000 mortgage, the lender and the buyer both considered the house as $500,000 of collateral. The lender counted the house as a $500,000 asset, and the speculator considered it his lottery ticket in the housing bubble sweepstakes: when (not if) the house leaped to $600,000, the speculator could sell, pay the commission and closing costs and skim the balance as low-risk profit.

But was the house really worth $500,000? That’s the trouble with assets bubbles inflated by central-bank/central-state intervention: when inefficient companies and inflated assets are never allowed to fall/fail, it’s impossible to tell the difference between real collateral and phantom collateral.

The implosion of the housing bubble led to an initial spike of price discovery. The speculator jingle-mailed the ownership of the poorly constructed McMansion to the lender, who ended up selling the home to another speculator who reckoned a 50% discount made the house cheap for $250,000.

But what was the enterprise value of the property, that is, how much revenue, cash flow and net income could the property generate in the open market as a rental? Comparables are worthless in terms of assessing collateral, because assets are mostly phantom collateral at bubble tops.

Let’s assume the enterprise value based on market rents was $150,000. The speculator who bought the house for $250,000 sold for a loss, and at the bottom of the cycle the house finally sold for its true value of $150,000.

Leveraged 20-to-1, the lender’s loss of $250,000 in collateral/capital unhinged $5 million of the lender’s portfolio as the capital supporting those loans vanished.

The first speculator who put nothing down suffered a loss of creditworthiness, and the second speculator lost $100,000 plus commissions when he dumped the property for a loss.

The only reliable metric of valuation is revenue, cash flow and net income, not at the top but in recession. One of the best ways to get burned/go broke is buying assets at the top of the speculative cycle and valuing them on projections of never-ending increases in revenues, cash flow and net income.

Then when recession crushes demand (as it inevitably does), revenues, cash flow and net income all plummet, and the buyer can no longer cover operating costs and interest payments.

In a highly leveraged financial system such as ours, when the phantom collateral vanishes, so does the illusion of solvency. Losses are forced down somebody’s throat– either the lender or the owner, or both.

When that happens, the ability of lenders and speculators to leverage debt on collateral is impaired: once the phantom collateral vanishes, there’s no foundation to support additional debt and leverage.

And once the ability to pile on more debt and leverage goes away, the entire debt-dependent financial system does what this building in China did: collapse.

Analysis of the Collapse Of 13-Story Building in China

Shanghai building collapse (Telegraph, UK)

The only way to sort the wheat (real collateral based on enterprise value) from the chaff (phantom collateral created by central banks’ speculative bubbles) is for a crash to force price discovery and the cramdown of losses.

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Back in PA Mike
Back in PA Mike

The flaw in the author’s thinking is that rent value changes as well, it is not a fixed variable.

NickelthroweR
NickelthroweR

Greetings,

When I was but a young lad, my father was an avid stamp collector. He had books full of first edition this or very rare this or that stamp. This, of course, was during a time before the internet and all he had to go on for valuation were these books that listed the stamp and gave an approximate value based upon condition.

Because the real market for these stamps was hidden, it wasn’t possible for my father to actually find out what these stamps were actually worth. The dealer selling the stamp could point to his book and say this stamp is worth $545 and who could say otherwise? It wasn’t until my sister was ready for college and my father prepared to sell one of his many collections that he discovered that his stamps were actually worth very little – perhaps 1/10th of what he thought they were.

That event taught me a valuable lesson. Something is only worth what you can get for it under the worst of conditions.

ottomatik
ottomatik

Nickel-“That event taught me a valuable lesson. Something is only worth what you can get for it under the worst of conditions.”

For planning this might be a good generalization, specifically though, something is worth what you can get for it when you sell/trade it.
Buy low
Sell High
or don’t

DC Sunsets

Illiquid items are difficult to price accurately.

Given “mark to fantasy” FASB accounting now, the moment solvency comes into question, liquidity (and continuous markets) may put everything into the category of “difficult to price accurately.”

Econman

Crashes, depressions, & recessions are like wild fires clearing dead brush. They are a natural clearing of the system.

Dumb governments, politicians, bankers, & the idiot rich that got rich not producing anything of value hate capitalism. Central banks are a part of a communist system & have no lace in capitalism. Central banks tend to destroy & crowd out capital.

Econman

…have no place, not lace. Stupid autocorrect.

robert h siddell jr

Closer to home, what is gold/silver worth after the SHTF: a fortune or peanuts depending on TPTB’s success at controlling buying/selling.. What is farmland or livestock worth if Obamanistas decide to shoot the Kulaks or clear out all the stores without using their SNAP and EBT cards? What is a car worth if you can’t drive a block without getting hijacked? What is a White woman worth if Obama’s son’s complete their takeover?

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