Written as an email newsletter to our property investors in 2008
Are we witnessing the last days of the American Empire, the death of Capitalism and the end of the free market as we know it?
The biggest mistake that is being made in interpreting the cause of the financial crisis is to confuse the operation of the free market with elaborate fraud, let me explain.
The current story which is being pedalled around is that the de-regulation of financial markets led to unbridled greed within the banking community and this greed produced the highly leveraged toxic derivative financial products which are now killing the world’s financial system.
On the surface this is true but you need to pay attention to get this bit because it is where the political sleight of hand comes in.
We are being told that it is the free market which has allowed this to happen whereas in reality it is the free market that is in the process of purging the system.
Let me illustrate the point. One of the essential features of the free market is that it is open and transparent. In other words, when a free market operates correctly, everyone gets an even chance to succeed and those who do are the best at what they do.
The financial markets have been anything but open and transparent, in reality they have been made overly complicated in an effort to hide the true nature of what has been going on, the plundering of our societies wealth for short term gain, this is not the operation of the free market it is more akin to piracy!
Financial smoke and mirrors
As an example of the way in which financial markets have been manipulated and undermined by the greedy and the short-sighted, let’s take a look at one of the so called sophisticated financial instruments which are being cited as the cause of the instability.
Credit Default Swops
A merchant bank insider was bemoaning his fate recently and complaining that the wicked hedge funds were deliberately manipulating the CDS market in order to scare the market about their shares while they took out short selling positions and made huge amounts of money as the shares plummeted.
All of this meant precisely nothing to me and although I grieved for him like a lost brother, to be honest I didn’t know what he was talking about. So, out of curiosity I made it my business to find out what CDS’s really are.
It seems that at some time in the last few years one of the ‘creative’ merchant bankers came up with credit default swops as a way of enabling them to lend more money than their capital base would normally allow.
In essence, as we all know, banks lend more money than they actually have. The ratios for this lending are strictly regulated and are there to prevent a bank lending irresponsible amounts of money. If a bank does lend too much money, there is an increased risk that any defaults on the loans could eat up the banks capital and make them insolvent.
So a credit default swop was invented to get round these capital ratios while remaining inside the regulations. What happens is that a bank lends money to a borrower and then goes to another bank and buys the equivalent of an insurance policy which means if the borrower defaults then the lending bank can go to the second bank to get the money back.
By doing this the first bank can lend ever more money because it has ‘laid off’ the risk of a default with another bank. The only problem is that the second bank is also doing exactly the same thing only they are using the first bank to insure their loans against default, hence the coy name ‘credit default swops’.
To make matters worse, these ‘cdo’s’ were then classified as tradable instruments in their own right, which meant that other banks and institutions could purchase them on the open market. In this way they became a barometer for the creditworthiness of the issuing bank which is how hedge funds were able to use them to spook the market about a particular bank while they were short selling the banks shares.
In hindsight this might seem a pretty obvious sleight of hand which would have been picked up by the ever vigilant regulators, well it wasn’t and you are left wondering why not.
The Black Swan
This theory was described by Nassim Nicholas Taleb in his 2007 book The Black Swan and it helps to explain how the financial markets pulled off such an enormous confidence trick. In essence, all banks have to calculate risk when adopting any buying, selling or lending strategy. The assessment of risk is important because it is this process which protects the backsides of the executives if things go wrong.
In other words they employ highly qualified scientists, experts in risk assessment to tell them that what they are doing is OK. Of course if any of these brain boxes make the mistake of saying that what is going on is not OK then they are promptly rendered unemployable. It’s a bit like getting an expert witness at a trial, what the witness says very much depends on whether they are being paid by the defence or the prosecution.
The idea of the black swan is based on the simple concept of deductive logic. Deductive logic is really precise and elegant and neat but unfortunately it does not tell us anything we don’t already know and so it is totally useless in predicting the unexpected.
So if we start off with a simple statement called by scientists a ‘hypothesis’ that says ‘All swans are white’ then, if we are presented with a swan, we can say with 100% certainty that ‘this is a swan, therefore it is white’. Of course the problem comes within the terms of the hypothesis itself, it states that all swans are white but it does not say how this conclusion was reached.
The reason for using the example of the black swan is because until the discovery of black swans relatively recently, all observed swans had been white, it was therefore very reasonable to assume if presented with a swan that it would be white but the process of coming to this conclusion is not based on certainty, rather it is based on probability, two very different things.
It therefore follows that if the boffins who create the value at risk models depended upon by banks use deductive logic in their hypotheses to try and bypass the unknown, then all their complex workings will be worthless in the face of just one black swan.
Not the free Market
So this type of behaviour is not the operation of the free market, it is actually the antithesis of the free market (the exact opposite). Given time it is only the operation of the free market that will provide the catharsis needed to heal and restore order to the system.
Better Start Learning Chinese
The fundamental cause of the crisis was the irresponsible use of leverage. There is however yet another black swan out there to take into consideration.
Just as the out of control credit bubble had to burst eventually, so the flow of cheap goods from China to the western economies will also exact a high price. Just as our stock markets have crashed the Chinese find their coffers filled with our currency and as we don’t produce anything they want what can they do with the money?
Oh yes, there is one thing they might quite like, how about all our major companies. Yes, that’s right, now our company’s values have fallen so low, the Chinese can come in and give us back some of our currency in return for becoming our economic masters.
Never fear though, our leaders will save us, won’t they? Well probably not, the more disturbing likelihood is that they were all in on the whole scam in the first place. Their argument that no-one could have foreseen this situation is patent rubbish, Warren Buffet saw it, I saw it and countless others saw it too, it was just ‘an inconvenient truth’.
So it’s financial Armageddon then? Which means that property along with everything else will become and remain worthless forever, we don’t think so.
You see just as those pesky Black swans come out of nowhere to spoil the party and suddenly all swans are black, there will also be a white swan which will come out of nowhere and a new party will begin.
What does this mean for property investment?
The reason we think all this stuff is relevant is to demonstrate how fickle and untrustworthy the alternatives to property investment have proven. The price of the financial turmoil will be paid by the tax payer in the form of higher taxes and lower benefits. What this means is that relying on a pension or the state to look after you in retirement is going to be even more foolhardy than it was before.
Buying property as an investment remains the only way that most people can insure themselves against poverty in old age and now, for a short time at least, we have been presented with a great time to get started. The reason prices have been falling so fast is nothing to do with an oversupply of property, the reverse is true. On our website we receive about 65000 new visitors per month and in the past year we have seen enquiries from tenants increase fivefold. The demand for property has merely leaked into the rented sector and as a result rents are rising and as prices have fallen, this means yields of 7-8% are possible once more and at these yields it is possible to make a profit from the rent, a profit which will grow as interest rates fall. What this translates to is the real possibility of a 20% return on your deposit putting aside long term capital growth prospects.
The catch is that these favourable buying conditions could end sooner, rather than later, all it would take is the re-introduction of the 100% mortgage and the market would be off and running again.
Stop Press: ‘Government insists newly nationalised banks restore lending to 2007 levels’
In the mean time builders are de-stocking at an ever faster rate. The new property discounts are now real and relate to yield, not some invented valuation. The catch here is that builders have stopped building so once they have de-stocked there will be nothing else new available in volume for some time.
As private individual investors this is the time to be bold and get your portfolio off the ground. If you don’t act now then housing associations will step in and mop up this stock before you get a look in. With our help you can buy property at the same fire sale prices that are being paid by bulk buyers. This applies to second hand part exchanges as well as completed and partially completed new property.
As a company Choices Acquisitions has retained its credibility and integrity as an advisor by refusing to put our clients into overhyped, overpriced off plan development at the height of the boom. For this reason you should take us seriously when we say that now is the time to start buying in earnest while the current climate of fear persists.
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