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Housing: A Speculative History

08/12/2005 12:00 am EST


John Bollinger

President and Founder, Bollinger Capital Management

Every now and then I read commentary that helps explain a complex issue in a clearer light. Such is the case with this report from John Bollinger, who looks at the a potential housing bubble within the context of the history of asset speculation.

"Speculation is an elemental force that feeds on liquidity, the greater the liquidity the greater the speculation. Speculation is usually thought of as coming in waves, but it is more useful to think of it as a quantity driven by liquidity. Let's examine the recent record in light of this idea. In the early 90s there was massive speculation in the bond market. The primary focus was on mortgages in their securitized form known as Fannies, Freddies, or Ginnies after the nicknames of the issuing agencies.

"These were then combined into new pools called CMOs, Collateralized Mortgage Obligations, and sliced up in various ways to give a variety of investors bonds with the characteristics they desired. Such bonds are also known as derivatives, as they are derived from other securities, in this case from agency mortgage pools, which are also derivatives as they are derived from the individual mortgages.

"A vast wave of speculation emerged driven by the fact that these bonds offered yield at a time when yield was getting ever harder to come by- interest rates had been falling for 12 years. (You might say that this was a classic case of "reaching for yield," an often fatal practice.) In many cases the characteristics of the bonds such as their responsiveness to interest rate changes was simply ignored, as it was thought that rates would be stable or continue to fall. But these bonds were negatively convex, which meant that as rates rose the maturities lengthened, making them even more sensitive to increases in rates. This is the exact opposite of what a rational investor would want in a bond.

"So, in early '94 when the Federal Reserve started raising interest rates, the prices of these bonds, which had been bid to astronomical heights, started collapsing. They fell slowly at first and then at an ever-quickening pace. In the final panic many bonds simply went without bids; they couldn't be sold at any price. The amount outstanding was massive and the damage was catastrophic. We lost Kidder Peabody, Orange County went bankrupt, many careers were ruined, and a great wailing and gnashing of teeth was heard across the land. So extensive was the damage that even the term derivative became 'streng verboten.'

"I detail this debacle because the common wisdom is that such an event extinguishes speculation, but in this case the decline in the bond market was met with accommodation on the part of the fiscal and monetary authorities and the general level of liquidity remained healthy and even grew. Thus speculation did not cease; it merely moved on, searching for a new target, which turned out to be the ASEAN nations, the "Asian Tigers." This new wave of speculation began slowly at first and then accelerated into a full-blown bubble in 1997 and 1998. This time the palette was wider, a broad selection of countries from Singapore to Thailand and Indonesia were caught up and the speculation involved stocks, bonds, and currencies.

"The overvaluations were extreme as always and the subsequent crash was devastating as usual. This time the big names subsumed in the destruction included Victor Niederhoffer's hedge fund in '97, Long Term Capital in '98, and several sovereign nations. Again, the bursting of the bubble was met with dynamic increases in liquidity and speculation, rather than being quelled simply moved on- this time into the US stock market where the stage was being set for the Internet bubble.

"As the stock market formed a bottom in 1998 in the wake of the Federal Reserve bailout of Long Term Capital, it was becoming "obvious" to everyone that the Internet was "the future" and speculation in a short list of highly capitalized Internet names blossomed into a massive run-up that left the rest of the market behind and culminated in the first quarter of 2000. This time Wall Street firms consumed by greed fanned the flames mercilessly engendering to some of the greatest excesses ever.

"The interesting part of this cycle were the raised ambitions on the part of the public. People quit their jobs to "trade for a living," and expectations were raised such that you were thought a dummy if you weren't making at the very least 20% per year. The bursting of the Internet bubble was also met with massive liquidity infusions and speculation dodged the bullet again, moving on first to the NASD Bulletin Board issues that traded for pennies or less per share before settling on real estate as the next big thing.

"I know that it is wildly unpopular to call the real estate bubble a bubble, but it is, and we must be forthright. Real estate is simply the latest speculative vehicle. At some point this bubble will burst as other bubbles in the past have. The only question that remains is what the bursting of the bubble means for homeowners and speculators. The 'au courant' fashion is to say not much. However, we think that the leverage involved, sometimes 100% or more, suggests that many will be hurt, some substantially.

"Ordinary homeowners with ordinary mortgage loads will likely be relatively unscathed as most are insensitive to changes in the value of their homes. Some homeowners, whom necessity compels to sell, will be hurt. Speculators and highly leveraged situations will likely be gored. We are at a loss to say what it will take to burst this bubble. However, burst it will and we are on the alert."

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