Thursday, December 18, 2008


A Crisis Of Competence

What public officials didn’t tell you about the recession – or refuse to admit.

One of the objectives of this blog, the Real Estate Chronicle, has been to share with readers throughout the time principles of economics and to lay the foundations for sound investment decisions. Although the focus of the Chronicle primarily reflects my chosen profession – real estate sales and investments – many of the economic principles enunciated herein are valid and applicable to other fields as well. In this respect and judging from the number of e-mails, comments and at times even criticism I have received over the years, I think I can affirm I have been successful at contributing my fair share to make people “know before they act”, at least those who have been steadily reading these electronic pages.

It is therefore with a great deal of apprehension that I now must bring forward to the attention of anyone willing to pay heed, the fact that it is becoming more and more evident we are living through a historical period of virulent incompetence in pretty much all levels of public administration, as well as among those who are at the helm of some of the largest and more powerful private and public enterprises. This is turning to be an epoch of errors of mastodontic proportions on the part of our government and business leaders, of wrong and at times unethical decisions and practices – whether made neglectfully or wilfully – and of self-serving application of economic and financial principles. All these, in turn, have caused and are causing a dramatic erosion of investors’ confidence, which is at the root of the present problems.

We all share some collective blame for allowing sub-prime lending practices to get out of hand, for continuing to consume far more than was responsible or reasonable, for not demanding that our elected officials ask tough questions and for embracing easy money. But I submit that we have done all this with the tacit consent of those in charge, who knew or ought to have known better, who had both a moral duty to warn the public about the consequences and a legal responsibility not to inflate expectations, who have elevated unsustainable consumption to the standing of moral value and preached that the more we spent the stronger our economies would become and, consequently, the better patriots we were. Politicians and business leaders alike encouraged the spending spree and absurd consumption on the rationale that “the merrier the people, the merrier the voters and the merrier the customers”. Likewise, the recovery plan involving massive spending they are now proposing, dubbed by some ‘The New Deal Redux’ , falls well short of its aimed objectives. It is at its best an economic exercise in futility, at its worst incompetence to the highest degree.

In the United States, the Federal Government has acted in a tradition of unwarranted market interference with "ad hoc" cash infusions which, far away from being well thought out, seem to have been drawn out of the hat. Take for instance the Bear Sterns merger with JP Morgan done with a helpline from Uncle Sam to the tune of USD 29 billion; or the AIG situation where the Feds have poured way over USD 100 billion. Then, of course, there is the ongoing Fannie Mae and Freddie Mac situation, which has led right into the core of the banking industry beginning with Bank of America, that walked into Merrill Lynch with the help of a USD 50 billion federal subsidy, the Well Fargo - Wachovia Bank USD 20 billion deal, the multi-billion dollar Washington Mutual rescue, all the way to Citigroup receiving a USD 306 billion bailout package. Not to mention the new 'rescue package' presently being worked out for the three automakers, which will be certainly followed through by the new Administration. All this has created and will continue to create the worst investment environment America has seen in recent years.

How many times does the Dow Jones need to be saved?

Banking analysts and public officials alike are quick to point out to the real estate bubble as the primary cause of all the economic turmoil. But in doing so, they conveniently omit the fact that they have been the very instigators of such bubble, by promoting and encouraging speculation in real estate, which ultimately caused prices to increase, thus producing more speculation and subsequent price increases until housing prices became so absurdly high that consumers either refused or could not afford to purchase, thus sending demand tumbling down. What’s more, officials of all political colors omit to point out that the present situation is a direct consequence of the biggest asset bubble in history: the stock market, the place where speculation is the norm. And that the economic decline began in the stock market well before it affected real estate. In fact, and contrary to what we all consistently hear, it is the stock market that has dragged down real estate and not the other way around.

A couple of years ago when both Alan Greenspan, the former Chairman of the Federal Reserve and David Dodge, the then Governor of the Bank of Canada were talking about "froth" in real estate, rather than putting pressure on lenders to tighten their credit standards, governments actually encouraged banks to lower the qualifications bar, on the political ground that ownership was a 'right' owed to and bestowed as upon each and every American, and as upon each and every Canadian. After all, so the rationale went, the higher the number of property owners the higher the number of property tax contributors. And banks, of course, merrily went along on the ground that the higher the number of mortgagees, the higher the interest income they received which, in turn, looked good in the balance sheets for when they traded their shares in the stock market. Not to mention the fact banks could go out and sell mortgages in packages to the highest bidder, thus furthering their profits even more. A course of action this first devised in Wall Street but more than happily followed by banks throughout Canada just as well.

I did raise the red flag several times in the past, to the extent that speculation was not synonym of investment. And in an article I authored, which is entitled “Speculation v. Investment” first appeared in this blog all the way back in December, 2005 when all outlooks were rosy and when nobody even remotely thought of economic slowdowns of any kind – much less of recessions – and which article nowadays can be found pretty much everywhere in the Internet, I did spell out that speculative ravages ultimately reveal themselves detrimental for the entire economy, especially when they involve large ticket items such as real capital assets. This is so, I stated, because the role of speculators in a free market economy is to absorb risk and add very little liquidity to the market place. Speculators, I contended, in fact reduce market liquidity by inflating prices which, particularly in the short run, reduce the pool of buyers thus hampering demand and reducing prices even further. Put differently, wealth dependence on speculation as opposed to production and investment, creates the illusion of prosperity.

In the last three months, it has finally become apparent that the economy has serious problems more than originally thought. Households both in the U.S. and now in Canada are indebted, the economy is stagnating, growth is forecasted in the red, and unemployment is edging up. Yet governments in North America, thanks in large part to the Obamania that is pervading the continent – if not the world - are proposing to spend with both hands in the months to come.

The truth - and this is what public officials from the right and especially those from the left won’t tell you - is simply that we are going to have to take it on the chin. There is no easy fix, no return to the days of plucking credit cards and of mortgages growing on trees, no Obamas out there to rectify the situation with the single stroke of a magic wand. Canada in particular is not “immune to the recession” like politicians and banking conglomerates here wanted people to believe, merely because we have all sorts of natural resources. If there are no buyers, we can ditch our resources. And buyers out there are dwindling. Here too people will lose their jobs, like it has already happened to countless individuals across the West. Obama cannot and will not help Canadians – the man has got his hands chockfull with Americans! Besides, I am not entirely convinced that the rooseveltian government spending propositions he is entertaining are the solution, nor am I convinced he’s got the money to carry them out.

Housing in Canada was and still is grotesquely overpriced, though prices are slumping. And albeit real estate is a localized business and varies from place to place, here in my hometown of Vancouver, British Columbia prices will continue to fall not “until June” like Premier Campbell wants you to believe (he’ll have to call elections within six months), but for the whole 2009 and maybe beyond. In time they will reach a level at which it will make sense for consumers to buy a home. These are painful and necessary realignments. However, when the market reaches equilibrium once again - and it will at some point in the future, given enough time to correct itself - then real estate will become once again the traditional, solid, no-frills investment the way it has been for decades before the onset of the new millennium.

When this happens, think twice before plunging your hard-earned money into the stock market once more. Given the choice between the purchase of a piece of paper representing the share into a far-away company over which there is no control, and the purchase of four walls and a ceiling that can be seen, touched and painted, be prudent and conservative and take the low-flying choice by going with real estate. Not to mention the fact that in times of financial straits real capital assets always hold at the very least a residual (land) value, as opposed to stocks that are not worth the paper they are written on.

I know, Donald Trump may not agree with all this, but then again I would not want to take at face value the expertise of someone who owes USD 390 million to Deutsche Bank by year's end - and who doesn't have it.

Luigi Frascati

Real Estate Chronicle


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