Reader Todd Peterson asks this question:
Dear Genghis Khan,I'm a bit more comfortable answering questions about Asian land campaigns, but I'll see if I can help.
Can you explain what the U.S. subprime mortgage meltdown is all about? And please don't use the term "derivatives."
This goes back to the dot-com bust, the wider stock market sell-offs, and the Enron/Worldcom/Tyco/etc scandals. Enormous amounts of money left the stock markets, as well as the venture capitalist (pre-stock) markets. But money does not sit still. It cannot.
The real-estate professionals went after it. The pitch was nothing new. "Your home is the largest and best investment most people ever make," "Real estate has never had a widespread decline," "There's no substitute for living in your investment" "Invest in what you know, and what can you know better than your house?"
U.S. tax law is believed to encourage home ownership. But it doesn't. It encourages mortgage debt. It encourages you to borrow as much as possible from the banks, and to put your home up as collateral. And since it's the banks business to loan, it's easy to reach an agreement.
How much is "as much as possible?" Well, the banks assign odds to you going bankrupt, and they figure out how much it'll cost them if you do. With money flooding from the stock market into housing, house prices climb fast, and as long as they do, the bank loses little or nothing when you go bankrupt (they get the house). There's a temptation to act as though prices can't go down, and historical evidence that it won't happen. So the bank continues to assign low risk to you going bankrupt, and looks for ways to get you that pricey house.
You see what happens now, right? You get a big loan despite the risk, allowing you to spend more on a home, further pushing up prices, and the cycle continues.
This is always a risk when you make policy based on something having never happened before. The policies based on that assumption may cause that something to finally occur. And that's exactly what happened. Houses stalled in value. Those "creative loans" that the banks found a way to produce started to fail because they assumed ever-rising home values. The cycle reverses.
Now, the banks have been selling these loans all over everywhere, assigning risks based on models that are now proved wrong. Nobody knows what to value these loans at anymore, and they're showing up in places many people never expected, such as their brokerage house. So people are pulling their money back into their own hands, and the models said that wasn't supposed to happen either. It's a mess.
So what should you do? If you can figure out where the money will go next, get their first. Non-U.S. markets isn't a bad bet. I always recommend the Mongolian Stock Exchange. (Full disclosure, Mongolia is mine.)
