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The Fallacy of Homeownership

The Fallacy of Homeownership.

Many people have a weird obsession with homeownership.

When it comes to buying a house, they are willing to overlook, or even completely throw out, a bunch of financial values and principles they claim to hold dear.

The unfortunate truth is, for many middle-class folks, buying a house is often a very silly financial decision, especially if they are young (in their 20s or early 30s), or have a low net worth.

A well diversified portfolio

The most mind-boggling thing I’ve come across is that most people who punt the importance and wisdom of home ownership, will also tell you they believe you should have a well diversified investment portfolio.

You know…

“Spread your investments over many asset classes.”

“Don’t put all your eggs in one basket.”

And so on.

Well, for the average middle-class-30-year-old Joe, buying a house is akin to gathering up all his eggs, borrowing another 9 times as many, and putting them all together into one basket.

Not only is the the average middle-class-30-year-old-home-owner Joe way over-invested in exactly one asset class (residential property), he is also completely undiversified within that asset class, since he owns exactly one property, in exactly one area, based in exactly one town, located in exactly one country.

In short, it’s just about the most undiversified investment portfolio a person could dream up and manage to get himself into.

Leverage

Leverage basically comes down to borrowing money to invest in something.

If you invest R1,000,000 in something, but you borrow R900,000 and only use R100,000 of your own money, then you have an investment in which you are leveraged 10:1.

That 10:1 is called the leverage ratio of your investment. And it is 10:1, since the thing you’re investing in is worth 10 times as much as the cash you put in.

Leverage is great if the thing you invested in grows a lot in value over a short period of time, because it allows you to make a lot of money by investing only a small portion of your own cash!

Unfortunately, the reverse is also true.

If the thing you invested in loses value, then it is very easy for you to lose a lot of money – even more than the initial amount you put in!

While Warren Buffet’s ethics may be a stinker, I do agree with his views on employing leverage:

If you’re smart, you don’t need leverage. If you’re dumb, you have no business using it.
Warren Buffet

Even though, over the long-term, returns made on equities outperformed returns made on property, by far, almost no sane person will leverage themselves 10:1 to invest in equities (i.e. shares).

For most people, this is way too nerve wrecking to even consider. If you suggest such a thing, you might be labelled a gambler, or worse, a madman.

And yet, everyday, average middle-class-30-year-old Joes all around me are buying properties in which they are leveraged 10:1 (and even more), without a second thought.

After spending many months thinking about this phenomenon I can only put it down to the fact that the truth doesn’t matter.

It’s just another asset class

In case you think I have a deluded and deep seated mistrust of property that most likely stems from a childhood nightmare of being swallowed by a house, let me just make my position official:

I have zero issues with investing in residential property.

Residential property is just another asset class.

I don’t currently, but I have in the past allocated a portion of my investment portfolio to residential property (both locally and abroad), by buying shares in publicly listed companies whose business it is to buy and rent out houses and flats.

I just don’t view residential property as a magic-unicorn-galloping-over-a-rainbow-of-profits type of investment with which “you can never go wrong”.

I’ve spent a significant portion of my adult life looking for investments like those, but unfortunately I haven’t found one yet.

Liability and Liquidity

If you are still adamant that you want to invest in residential property, then I have a great suggestion for you:

Why don’t you just buy some shares in publicly listed companies whose business it is to buy and rent out residential properties?

If you do some research and choose a good one, chances are that they are better than you at spotting and buying well-priced properties and collecting rent, because that is what the people who work for those companies do for a living.

There are also some other advantages about investing in residential property by buying shares in publicly listed companies.

  • You can have a more diversified investment portfolio: By only buying a few shares you are able to limit your exposure to residential property to a reasonable percentage of your net worth.
  • You have limited liability: If the company goes bust, you will not be liable for any losses. Comparatively, if you buy a property using debt and, for whatever reason, become bankrupt and can’t afford to make the bond payments, then you most likely have quite a few years of hell to look forward to.
  • Shares in publicly listed companies are liquid: If you ever need to do so in a hurry, it will only take you about 5 minutes and a few key-strokes to sell all the shares you hold in almost any publicly listed company. Selling a house, on the other hand, is a ludicrously expensive multi-month administrative nightmare.

Interest rates and timing your property purchase

Residential property is an asset class that is very directly influenced by the cost of borrowing money.

In our society, it is considered a perfectly normal and responsible thing for a person to finance the purchase of a house by getting a 20-year loan from a bank.

In fact, it is considered such a normal thing for the average middle-class-30-year-old Joe to be a debt slave for most of his life, that if you had to suggest to him that he should save up for a house and only purchase it once he had saved up enough money to buy it outright, using cash, he will probably think that you are crazy to even suggest such a thing.

But, I digress.

My point is, the vast majority of residential properties are paid for using borrowed money.

Because of this, when interest rates go up, so do monthly bond payments. When bond payments go up, some people can’t afford to make their bond payments and they are forced to sell their homes, or default on their bond. A few actually do default, resulting in a seizure and forced sale of their properties by the bank.

To summarize: When interest rates go up, property prices fall (or increase very slowly, usually at a rate lower than inflation), because the available supply of residential properties increases, while at the same time the demand for residential properties decreases. Conversely, when interest rates go down, residential property prices usually go up quickly, because more people can afford to take out bigger loans!

The first rule of business is: buy low, sell high.

This is such an obvious concept and yet, in practice, it is very difficult to do, because it usually means doing the exact opposite to what everyone around you is doing.

If you are going to buy a property, for whatever reason, then at least buy it at the best possible time.

And when would that be?

Well, of course, a few months after interest rates hit their peak after having risen quickly for two or three years in a row.

Take a look at the graph below, which shows the prime interest rate in South Africa over the last few decades.

2014 started with interest rates at record lows and just entering an upward cycle.

In my opinion, the present is just about the worst possible time for anyone to be invested in residential property.

You will know it is the right time to buy your dream home by looking for a few of these signs:

  • Interest rates are starting to stabilize at a high rate, after rising steadily for two or three years in a row.
  • Many people are trying to sell their properties, some in a real panic, because they are struggling to make their monthly bond payments.
  • You hear many tales of properties being foreclosed on, also in neighbourhoods where people are considered to be wealthy.
  • People around you are generally feeling quite negative about owning property.

When the blood is in the streets, my friends, that is the ideal time to buy your dream home.

Paying rent is simply throwing away money every month

I often hear people making this argument. I’m sorry, but that is just a silly thing to say.

Upon purchasing the average middle-class-suburbia home, you’re not only paying a massive amount of TAX to the government, you’re also forking over a significant amount in fees for bond registration, deeds and a bunch of other stupid banalities. Never mind the commission that goes to the estate agent.

Property tax, commission and other fees can easily add up to over 15% of the purchase price of a house. This makes residential property one of the most expensive asset classes to invest in, at least as far as up-front costs are concerned.

Then, once your bond is registered and you are the proud owner of your new home, you’ll be paying interest to a bank, every month, until your bond is paid off.

And don’t forget about maintenance! You know… paint starts peeling, roof start leaking, toilet stops flushing, that type of thing.

Lastly, you’ll also be forking out on a monthly basis for rates & taxes. Which,as property owners in Greece found out just recently, can easily go up by sevenfold in two years, if your government is anything like most governments are.

Safe-haven investment my ass.

Except for squatting on someone else’s land, there’s no such thing as living for free.

So are you saying no one should ever own a house?

No, of course not.

I’m saying people should save up for their family homes and buy them cash.

The saving part should be done by building a well diversified investment porfolio and the home buying part should be treated as an expense, rather than the purchase of an asset.

I know… in the world we live in I’m very much on my own in suggesting such a boring and outdated thing.

But I’ve looked at the facts, and even though I’m well aware that the truth doesn’t matter, I also know that nothing matters to anybody until it matters to everybody – and by then it’s too late.

If you disagree or find a flaw in my logic, please leave a comment below. I’d love to be proven wrong, and I’m willing and eager to consider any counter arguments.

oftwominds-Charles Hugh Smith: Why Banks Are Doomed: Technology and Risk

oftwominds-Charles Hugh Smith: Why Banks Are Doomed: Technology and Risk.

It’s not just that banks are no longer needed–they pose a needless and potentially catastrophic risk to the nation. To understand why, we need to understand the key characteristics of risk.

The entire banking sector is based on two illusions:

1. Thanks to modern portfolio management, bank debt is now riskless.

2. Technology only enhances banks’ tools to skim profits; it does not undermine the fundamental role of banks.

The global financial meltdown of 2008-09 definitively proved riskless bank debt is an illusion. If you want to understand why risk cannot eliminated, please read Benoit Mandelbrot’s book The (Mis)Behavior of Markets.

Technology does not just enable high-frequency trading; it enables capital and borrowers to bypass banks entirely. I addressed this yesterday in Banks Are Obsolete: The Entire Parasitic Sector Can Be Eliminated.

Unfortunately for banks, higher education, buggy whip manufacturers, etc., monopoly and propaganda are no match for technology. Just because a system worked in the past in a specific set of technological constraints does not mean it continues to be a practical solution when those technological constraints dissolve.

The current banking system is essentially based on two 19th century legacies. In that bygone era, banks were a repository of accounting expertise (keeping track of multitudes of accounts, interest, etc.) and risk assessment/management expertise (choosing the lowest-risk borrowers).

Both of these functions are now automated. The funny thing about technology is that those threatened by fundamental improvements in technology attempt to harness it to save their industry from extinction. For example, overpriced colleges now charge thousands of dollars for nearly costless massively open online courses (MOOCs) because they retain a monopoly on accreditation (diplomas). Once students are accredited directly–an advancement enabled by technology–colleges’ monopoly disappears and so does their raison d’etre.

The same is true of banks. Now that accounting and risk assessment are automated, and borrowers and owners of capital can exchange funds in transparent digital marketplaces, there is no need for banks. But according to banks, only they have the expertise to create riskless debt.

It’s not just that banks are no longer needed–they pose a needless and potentially catastrophic risk to the nation. To understand why, we need to understand the key characteristics of risk.

Moral hazard is what happens when people who make bad decisions suffer no consequences. Once decision-makers offload consequence onto others, they are free to make increasingly risky bets, knowing that they will personally suffer no losses if the bets go bad.

The current banking system is defined by moral hazard. “Too big to fail” also means “too big to jail:” no matter how criminal or risky the bank managements’ decisions, the decision-makers not only suffered no consequences, they walked away from the smouldering ruins with tens of millions of dollars in personal wealth.
Absent any consequence, the system created perverse incentives to pyramid risky bets and derivatives to increase profits–a substantial share of which flowed directly into the personal accounts of the managers.

The perfection of moral hazard in the current banking system can be illustrated by what happened to the last CEO of Lehman Brother, Richard Fuld: he walked away from the wreckage with $222 million. This is not an outlier; it is the direct result of a system based on moral hazard, too-big-to-jail and perverse incentives to increase systemic risk for personal gain.

And who picked up all the losses? The American taxpayer. Privatize profits, socialize losses: that’s the heart of moral hazard.

Concentrating the ability to leverage stupendous systemic bets in a few hands leads to a concentration of risk. Just before America’s financial sector imploded, banks had pyramided $2.5 trillion in dodgy mortgages into derivatives and exotic financial instruments with a face value of $35 trillion–14 times the underlying collateral and more than double the size of the U.S. economy.

In a web-enabled transparent exchange of borrowers bidding for capital, the risk is intrinsically dispersed over millions of participants. Not only is risk dispersed, but the consequences of bad decisions and bad bets fall solely to those who made the decision and the bet. This is the foundation of a sound, stable, fair financial system.

In a transparent marketplace of millions of participants, a handful of participants will be unable to acquire enough profit to capture the political process. The present banking system is not just a financial threat to the nation, it is a political threat because its outsized profits enable bankers to capture the regulatory and governance machinery.

chart courtesy of Market Daily Briefing

The problem with concentrating leverage and moral hazard is that risk is also concentrated. And when risk is concentrated rather than dispersed, it inevitably breaks out of the “riskless” corral. This is the foundation of my aphorism: Central planning perfects the power of threats to bypass the system’s defenses.

We can understand this dynamic with an analogy to bacteria and antibiotics. By attempting to eliminate the risk of infection by flooding the system with antibiotics, central planning actually perfects the search for bacteria that are immune to the antibiotics. These few bacteria will bypass the system’s defenses and destroy the system from within.

The banking/financial sector claims to be eliminating risk, but what it’s actually doing is perfecting the threats that will destroy the system from within. Another way to understand this is to look at what happened to home mortgages in the runup to the meltdown of 2008: the “safest” part of the financial sector ended up triggering the collapse of the entire pyramid of risk.

Once we concentrate risk and impose perverse incentives and moral hazard as the foundations of our financial/banking system, then we guarantee the risk will explode out of whatever sector is considered “safe.”

Once you eliminate the “risk” of weak bacteria, you perfect the threat that will kill the host.

The banking sector cannot be reformed, for its very nature is to concentrate systemic risk and moral hazard into breeding grounds of systemic collapse. The only way to eliminate the threat posed by banks is to eliminate the banks and replace them with transparent exchanges where borrowers and owners of capital openly bid for yield (interest rates) and capital.

Bankers (and their fellow financial parasites) will claim they are essential and the nation will collapse without them. But this is precisely opposite of reality: the very existence of banks threatens the nation and democracy.

One last happy thought: technology cannot be put back in the bottle. The financial/banking sector wants to use technology to increase its middleman skim, but the technology that is already out of the bottle will dismantle the sector as a function of what technology enables: faster, better, cheaper, with greater transparency, fairness and the proper distribution of risk.

There may well be a place for credit unions and community banks in the spectrum of exchanges, but these localized, decentralized enterprises would be unable to amass dangerous concentrations of risk and political influence in a truly transparent and decentralized system of exchanges.

Of related interest:

Certainty, Complex Systems, and Unintended Consequences (February 14, 2014)

Our Middleman-Skimming Economy (February 11, 2014)

Physical Gold Shortage Goes Mainstream | Zero Hedge

Physical Gold Shortage Goes Mainstream | Zero Hedge.

While the topic of rehypothecation and the shortage of physical gold is well covered here at Zero Hedge (and the ever-changing COMEX gold vaults’ inventories), it appears the concept of the exploding “leverage” or default risk of the COMEX has now hit the mainstream media. As BNN reports, veteran trader Tres Knippa, pointing to recent futures data, says “there may not be enough gold to go around if everyone with a futures contract insists on taking delivery of physical bullion.” As he goes on to explain to a disquieted anchor, “the underlying story here is that the people acquiring physical gold continue to do that. And that’s what is important,” noting large investors like hedge fund manager Kyle Bass are taking delivery of the gold they’re buying. Knippa’s parting advice, buy physical gold; avoid paper.

 

One of the problems…

That won’t end well…

And the excellent summary from a veteran trader:

 

Knippa warns that if 1 entity asks for delivery of a position-limit-size long in gold, it will absorb 81% of COMEX’s inventory… and if 2 entities were to do so… COMEX has a problem…

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