From another blog:
In Malcolm Gladwell’s book, The Tipping Point (How Little Things Can Make a Big Difference), the “tipping point” is defined as “the moment of critical mass, the threshold, and the boiling point” to massive change called an epidemic. There is a lesson to be learned here for players in the capital markets.
Gladwell says there are three characteristics of sweeping change:
(1) they are typically unexpected,
(2) the major outcome results from a series of minor causes, and, most importantly,
(3) our recognition of the massive change happens not step by step, but at one dramatic point where the scale is tipped with just the slightest push in the right place.
Gladwell offers three concepts for trying to make sense of epidemics:
(1) The power of effective communication from a few centers of influence
(2) The retention and understanding of “sticky” communications or messages, and
(3) The sensitivity of people to nuances in messages.
The theory here demands a new paradigm in the way we think about our world. We need to look beyond what I call the noise, and focus on a few key specific areas that could tip the scale.
Let me try to put The Tipping Point concept into the context of the today’s capital market.
Clearly, the majority of people “feel” that something big is happening, and they are afraid they will wake up one day and the news will be staring them in the face – and the news might be bad.
There are cross-currents today involving (1) personal wealth that has grown via real estate values, (2) concerns and possible relief that speculation in crude oil contracts is abating, (3) a minor recovery in recent days to declining prices in stocks and bonds, (4) Greenspan talking about the potential for off balance sheet credit derivatives threatening the stability of the financial system, (5) worsening twin deficits, (6) continuous Fed tightening, (7) topping out of the corporate earnings cycle, (8) revaluation of the USD after the Chinese yuan is freed from its peg, and (9) the potential for BOTH inflation and deflation, depending on how certain factors work out.
These are all evolving processes; but what is the ‘tipping point’?
Straight up I’ll give you my take: I think it involves multiple home ownership, and the ability of the equity owner to service debt.
Other than the potential for directly impacting certain sub-industry groups in the equity market, I don’t see this as an equity market problem. At least not one of epidemic proportions.
If PE multiples were more extreme, or if margin debts of the average investor were much higher, or the financial strength of the broker-dealer counter-parties were much weaker, and so forth, then I could say that the equity market could be a serious problem. But, I can’t.
What I can see though is that, when adjusted for inflation, “real” residential home price increases have been unabated for 15 years, and I believe that multiple home owners are going to awake to a shock of the kind that was experienced in 1978-79 and 1989-90.
Interestingly, there were relatively minor equity market shakeouts during those years – not major bear markets. But the financial impact on people was devastating nonetheless.
For those of us old enough to remember, we all have stories to tell.
In my case, in 1979, it was a young neighbor in rural Ontario who had purchased one or more residential condo’s in downtown Toronto for investment purposes. Interest rates skyrocketed, and he could neither meet the debt service or sell, as demand for these properties dried up overnight. He had a new baby and a good job, but rather than face a personal bankruptcy he decided to shoot himself in the head.
In 1989-90, I had a former business partner -- who was incredibly sophisticated in capital markets -- decide he would chase rapidly escalating condo prices in downtown Toronto. He bought many at once. When interest rates jumped, money got tight, and demand dried up, he too could not meet the debt service and was pushed into bankruptcy. He just got on a plane and moved to East Asia.
My parents had a neighbor who ran into the same problem that year. He had just finished building tennis courts, and was ready to put in the heliport, when interest rates zoomed, and demand for real estate dried up overnight. Simultaneously his business encountered problems, which forced him to put the property on the market. He had had it valued at C$1.1 million with a mortgage that exceeded $900,000. He first tried to sell at $950k, then in steps down to $550k. One day he knocked on the door at my parents and offered (quietly) $450k. My Dad put in a “stink bid” of $300k, which the man’s banker immediately accepted. For years the man blamed my parents for “stealing” his place – but that is what happens with what Gladwell calls The Tipping Point.
I suspect that later in this year – 2005 – the owners of multiple residential properties will experience the psychological and emotional downside to the ‘tipping point’ and let me tell you why.
Creative financing – interest-only Adjustable Rate Mortgages – is the driver to pockets of speculation in real estate prices. The percentage of homes in California that have been financed in this way has increased from just 1.4 pct in 2001 to a whopping 47.8 pct in 2004, according to the LA Times. These typically three-year loans have been securitized and sold to investors.
Two things are going to happen: the original homebuyers are going to face the day when they realize they are “still in, but not home free”. Being unable to meet the principal-included rollover debt, they will look to sell and take profits.
But what happens when there are more sellers than buyers? Of course, the price drops. It will drop so fast, and so far, that an epidemic crisis will catch these people, who will walk away from their homes, unable to sell them for what they originally paid.
The buyers of those mortgages will then own real estate, but they will refuse to meet the taxes and other maintenance costs, so they will sell.
Interest rates will skyrocket in the 2-year to 5-year paper. Of that, I am fairly certain. Demand will far outstrip supply.
Right now, right before the epidemic is to strike, cash is king. I think it’s the reason why short-term paper is yielding so low, and why the Fed is having such a problem in raising short rates.
Ultimately, Greenspan knows that the free market will take care of the problem for him. He is concerned, in that event, about stability of the financial system, especially with respect to credit derivatives.
You see, so far, it has been rogue traders who have caused problems for their financial institution employers, but credit quality and investment policies (checks and balances) have so far mitigated serious damage. But what happens in the case of systemic failure?
There are really only a few institutions (dealers of credit derivatives) in this market, and a failure at one would immediately transmit to the others, causing market disruption.
Before that happens, Greenspan is urging Congress to put limits on the operations of Fannie and Freddie. I think it is probably too late, given how slow politicians are to react.
Normally the derivatives market is a balanced market, but disruptions would make it more expensive and less effective for banks and other mortgage lenders to do business.
It should not be underestimated just how important is this market to the growth of the U.S. economy. Following the 2000-01 equity market collapse, Americans are actually now wealthier because of what has happened in the real estate market caused by “creative financing”.
What happens when that financing option just goes away?
I say panic. At the very least, there will be collapsing real estate values in niche U.S. markets along the Pacific, Florida, and mid-Atlantic to New England regions.
What will be the ‘tipping point’ will be the rapidly escalating bond yields in the two to five-year series as everybody wakes up one day and scratches for cash. It won’t be pretty, and I’m afraid it’s going to hit equity prices because paper can become cash overnight.
How much cash is another matter. |
