Learn about Wealth Destruction 1 Video

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Learn about Wealth Destruction 1

Let’s do an example of how a housing bubble can lead to wealth destruction and I really just want to hit the point home that once wealth is destroyed. All legislation can do is kind of redistribute who takes the loses that you can’t create wealth all of a sudden out of legislation. You can maybe create incentives for investments etc, etc but well talk about that in the future video. So let say in year one, I have a neighborhood and you know your brothers goes out and builds a new development and they built five houses. Let me draw those five houses. House one, house two, house three, house four and house five and let say that this was a normal home buying environment. So this could have been I don’t know 1995. Actually let just say, let just for the sake of argument. Let say that this 1995, 1995 although I want this to be an abstract example, so we call that year one. But in 1995 these people, they find you know find if I have new families that go buy the house. They pay 100,000 each for the house. They pay a 100,000 for the houses each family and these were conforming loans. There wasn’t this whole CDO and morgues back security markets, so essentially these people have to put 20% down and they had good credits course, and all the rest. So immediately they have 20,000 dollars of equity and an 80,000 dollar loan right, 20K equity that’s my code, E for equity and then 80,000 loans. I don’t have to write that down or 80,000 more in peach, right. And that good credit etc, etc. Now we have this whole securitization of lending becomes a lot easier. It becomes easier and easier every year because the housing the price has go up. So people stop taking risk into consideration and let say that where we get to the year 2005 but this could be an abstract example or it could be year two whatever. In 2005 all of a sudden every one has, everyone is getting access to funding. The people who have houses actually don’t want to sell the houses because their convinced that their housing prices are going up so fast that its only a matter of time before there are millionaires just with their housing loan and then they could maybe retire off of it. But there’s so much funding, anyone get a loan and let say that this first homeowners maybe they have to move or maybe they just want to move to a cheaper location or maybe their kids have gone to college. So they just want to downsize. They decide to sell their house and because there so much demand out there. Anyone can get a loan. Frankly, the person who’s going to be able to give the highest bid on the house is a person to some degree who’s most reckless or most prudent and anyway I won’t go into that. But let’s say they pay a million dollars for the house. Okay, they have no money down, million dollar loan, sub-prime, negative amortizations. They have no credit rating etc, etc. well they pay a million dollars that was a purchase price of the house and we could just say, you know they have zero equity, and they have a million loan. And of course this guy is great now. Let just this, you know he probably did build equity over that 10 years from 1995-2005 but even if you didn’t, even if he all did is he paid the interest on this 80,000 dollars loan. This guy he had 20,000. Now he gets a million pays off the 80, so he essentially gets 920,000+20,000 he had before. So here, he you know her moves to Costa Rico whatever with 940,000 dollars and lives like a king although I’ve heard Costa Rico has also becomes expensive. But anyway, what happens now in the neighborhood? These people didn’t sell their houses; they didn’t find some cub-prime individual that was willing to bid up the house. They didn’t, nothing happened no money changes hands but all of a sudden these people say, well you know what our houses are just as nice as this first house at sold, maybe its even better. So our houses are also worth a million dollars. So we all have this kind of, you could paper wealth here for million dollars just from one transaction and actually this is a five house neighborhood. This could happen in a 500 house neighborhood. You just have to find one person to overpay for house and then everyone in the neighborhood all of a sudden feels that their house is worth that much, and just said of thin air just by one person getting cheap credit and overpaying for something. Everyone in the neighborhood thinks that they just got 900,000 dollars of wealth. There are least in this example. You never see a nine fold increase; sorry a nine fold increase in property price but you has it. It wasn’t crazy to see two fold increases in a year over the last. Well we have seen nine fold increases over 10 years which is the example here. It’s actually not that crazy. I mean that’s all of their notional wealth but all these people, you know they don’t want to sell. One they liked there house. Their kids are still there and they say, wow you know in 10 years my house went from a 100K to one million and another 10 years my house is going to from I don’t know, a million to 10 million. Why will I sell it? I can then retire off the house. They don’t think who could buy 10 million dollar house in 10 years. The only people who could, well anyway I'll a do on a video on that. I just don’t want to run out of time. But they can still monetize this. They can say, well you know when I go to my fashionable plan is they say oh it’s so insufficient for you to have all of that equity sitting in your house, right. How much equity do they have? They have 20,000 before and even if they didn’t build in the equity. Well they paid morgues. They now have another 900,000 dollars of equity, right. So these people, they financial planners say, oh and their siblings and whatever says and their friends at work say, oh your balance sheet is so insufficient. Why don’t you take some of that equity and invest it or put it to work? So they’ll say, oh that’s a good idea. I'll go get a home equity loan, so let say this person. They go to a bank and bank says, okay sure I'll give you a 500,000 dollar home equity loan and in exchange get, I don’t know 8% interest on that loan. So this is the bank and the bank thinks it got a great deal because this 500,000 dollar loan. It’s not just; it’s an unsecured loan. It’s not like if this person can’t pay, they’ll just file bankruptcy and there’s nothing that the bank can get hold off. This home equity loan is secured by the house. So the bank says well if this person doesn’t pay that 500,000 dollar loan, if they default for whatever reason. I get their house and their house is worth a million dollars, right. Well why do I think its a million dollars, because a house in the neighborhood sold for a million dollars and frankly that’s how unfortunately housing was assess. People will just say, oh another house in this neighborhood sold for a million. This one must be worth a million because it’s a very similar or maybe it’s even a better house. So this banker thinks they have a great deal. This is better than lending to buying treasuries. I'm getting 8% maybe treasuries are giving me 3 of 4% and if they default on it. I actually get an asset. This probably worth more than the loan amount and I auction that often and easily get my 500,000 dollars bank. So the risk managers within the bank think they have great deal and they’re probably slice and dice these things and sold it to other people, and kind of got it rated and planned and all of that. But what happens next? Well let say 2005 in our imaginary universe was the peak of the credit cycle that was the year that credit was the looses and as soon as some of these people who have no jobs, and got this, some of million dollars loans. They probably couldn’t even pay the morgues on their loan not to speak of, you know continuing it or they probably they couldn’t even pay the lower rate, the original teaser loan. So maybe they start to default, credits starts getting tighter and let say this guy actually gets for clothes. And so he gives the house back to the bank. The bank auctions it off and let say when the bank auctions it off. It only gets I don’t know, it only gets 300,000 dollars for the house. It only gets 300,000 dollars for the house and in the meantime where did all of these people do with their 500,000 dollars they had? Well their intention was to take this home equity loans and put that money to work, invest it in some way and they say, oh, what’s a better investment than doing home improvements because we all know a house is the best investment. So unfortunately, a lot of that 500,000 dollars, it gets “invested” in granted counter tops, two more bathrooms per house more bathrooms, hard wood floors or let say wood floors. And you could imagine you know thy wont treat themselves too. So they did a little vacation. So what’s “invested” their house because they say, oh well this increase the value of my house and oh a side benefit. I would really look good relative to the neighbors and live it up, and I can live beyond essentially what my income would predict. And I’ve done some videos on investments versus consumption but I argued that this wasn’t real investment that 500,000 dollars that this was consumption because it’s not making the world more productive in anyway. It’s not increasing the total economic pie for the world, so it’s not an investment. It maybe it is investment if it somehow makes you our asset more emotionally appealing to some greater fool to pay more for it but its not and so you didn’t build a factory or you didn’t invent some new technology that would make all of us richer. You just poured some money into something that’s going to make your lifestyle a little bit better and maybe the next person who buys your house. But anyway, this house got for enclose on, it’s not worth. Its get auction off, its gets auction off for 300,000 dollars maybe this is the year 2006. Now all of a sudden, all of these people probably all of them who took this home equity home. Let’s say all of them did it, right. They all say G; I'm paying a 500,000 dollar loan. Actually I'm paying 500,000 dollars plus my original 80,000 loan. So I have 580,000 dollars of depth on an asset that just sold for 300,000 dollars. So what do you think they’re going to do? And I just realized I'm out of time, so I continue this in the next video.

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Let’s do an example of how a housing bubble can lead to wealth destruction and I really just want to hit the point home that once wealth is destroyed. All legislation can do is kind of redistribute who takes the loses that you can’t create wealth all of a sudden out of legislation. You can maybe create incentives for investments etc, etc but well talk about that in the future video. So let say in year one, I have a neighborhood and you know your brothers goes out and builds a new development and they built five houses. Let me draw those five houses. House one, house two, house three, house four and house five and let say that this was a normal home buying environment. So this could have been I don’t know 1995. Actually let just say, let just for the sake of argument. Let say that this 1995, 1995 although I want this to be an abstract example, so we call that year one.

But in 1995 these people, they find you know find if I have new families that go buy the house. They pay 100,000 each for the house. They pay a 100,000 for the houses each family and these were conforming loans. There wasn’t this whole CDO and morgues back security markets, so essentially these people have to put 20% down and they had good credits course, and all the rest. So immediately they have 20,000 dollars of equity and an 80,000 dollar loan right, 20K equity that’s my code, E for equity and then 80,000 loans. I don’t have to write that down or 80,000 more in peach, right. And that good credit etc, etc.

Now we have this whole securitization of lending becomes a lot easier. It becomes easier and easier every year because the housing the price has go up. So people stop taking risk into consideration and let say that where we get to the year 2005 but this could be an abstract example or it could be year two whatever. In 2005 all of a sudden every one has, everyone is getting access to funding. The people who have houses actually don’t want to sell the houses because their convinced that their housing prices are going up so fast that its only a matter of time before there are millionaires just with their housing loan and then they could maybe retire off of it. But there’s so much funding, anyone get a loan and let say that this first homeowners maybe they have to move or maybe they just want to move to a cheaper location or maybe their kids have gone to college. So they just want to downsize.

They decide to sell their house and because there so much demand out there. Anyone can get a loan. Frankly, the person who’s going to be able to give the highest bid on the house is a person to some degree who’s most reckless or most prudent and anyway I won’t go into that. But let’s say they pay a million dollars for the house. Okay, they have no money down, million dollar loan, sub-prime, negative amortizations. They have no credit rating etc, etc. well they pay a million dollars that was a purchase price of the house and we could just say, you know they have zero equity, and they have a million loan. And of course this guy is great now. Let just this, you know he probably did build equity over that 10 years from 1995-2005 but even if you didn’t, even if he all did is he paid the interest on this 80,000 dollars loan. This guy he had 20,000. Now he gets a million pays off the 80, so he essentially gets 920,000+20,000 he had before.

So here, he you know her moves to Costa Rico whatever with 940,000 dollars and lives like a king although I’ve heard Costa Rico has also becomes expensive. But anyway, what happens now in the neighborhood? These people didn’t sell their houses; they didn’t find some cub-prime individual that was willing to bid up the house. They didn’t, nothing happened no money changes hands but all of a sudden these people say, well you know what our houses are just as nice as this first house at sold, maybe its even better. So our houses are also worth a million dollars. So we all have this kind of, you could paper wealth here for million dollars just from one transaction and actually this is a five house neighborhood.

This could happen in a 500 house neighborhood. You just have to find one person to overpay for house and then everyone in the neighborhood all of a sudden feels that their house is worth that much, and just said of thin air just by one person getting cheap credit and overpaying for something. Everyone in the neighborhood thinks that they just got 900,000 dollars of wealth. There are least in this example. You never see a nine fold increase; sorry a nine fold increase in property price but you has it. It wasn’t crazy to see two fold increases in a year over the last. Well we have seen nine fold increases over 10 years which is the example here. It’s actually not that crazy. I mean that’s all of their notional wealth but all these people, you know they don’t want to sell.

One they liked there house. Their kids are still there and they say, wow you know in 10 years my house went from a 100K to one million and another 10 years my house is going to from I don’t know, a million to 10 million. Why will I sell it? I can then retire off the house. They don’t think who could buy 10 million dollar house in 10 years. The only people who could, well anyway I'll a do on a video on that. I just don’t want to run out of time. But they can still monetize this. They can say, well you know when I go to my fashionable plan is they say oh it’s so insufficient for you to have all of that equity sitting in your house, right. How much equity do they have?

They have 20,000 before and even if they didn’t build in the equity. Well they paid morgues. They now have another 900,000 dollars of equity, right. So these people, they financial planners say, oh and their siblings and whatever says and their friends at work say, oh your balance sheet is so insufficient. Why don’t you take some of that equity and invest it or put it to work? So they’ll say, oh that’s a good idea. I'll go get a home equity loan, so let say this person. They go to a bank and bank says, okay sure I'll give you a 500,000 dollar home equity loan and in exchange get, I don’t know 8% interest on that loan. So this is the bank and the bank thinks it got a great deal because this 500,000 dollar loan. It’s not just; it’s an unsecured loan. It’s not like if this person can’t pay, they’ll just file bankruptcy and there’s nothing that the bank can get hold off.

This home equity loan is secured by the house. So the bank says well if this person doesn’t pay that 500,000 dollar loan, if they default for whatever reason. I get their house and their house is worth a million dollars, right. Well why do I think its a million dollars, because a house in the neighborhood sold for a million dollars and frankly that’s how unfortunately housing was assess. People will just say, oh another house in this neighborhood sold for a million. This one must be worth a million because it’s a very similar or maybe it’s even a better house.

So this banker thinks they have a great deal. This is better than lending to buying treasuries. I'm getting 8% maybe treasuries are giving me 3 of 4% and if they default on it. I actually get an asset. This probably worth more than the loan amount and I auction that often and easily get my 500,000 dollars bank. So the risk managers within the bank think they have great deal and they’re probably slice and dice these things and sold it to other people, and kind of got it rated and planned and all of that. But what happens next? Well let say 2005 in our imaginary universe was the peak of the credit cycle that was the year that credit was the looses and as soon as some of these people who have no jobs, and got this, some of million dollars loans.

They probably couldn’t even pay the morgues on their loan not to speak of, you know continuing it or they probably they couldn’t even pay the lower rate, the original teaser loan. So maybe they start to default, credits starts getting tighter and let say this guy actually gets for clothes. And so he gives the house back to the bank. The bank auctions it off and let say when the bank auctions it off. It only gets I don’t know, it only gets 300,000 dollars for the house. It only gets 300,000 dollars for the house and in the meantime where did all of these people do with their 500,000 dollars they had? Well their intention was to take this home equity loans and put that money to work, invest it in some way and they say, oh, what’s a better investment than doing home improvements because we all know a house is the best investment.

So unfortunately, a lot of that 500,000 dollars, it gets “invested” in granted counter tops, two more bathrooms per house more bathrooms, hard wood floors or let say wood floors. And you could imagine you know thy wont treat themselves too. So they did a little vacation. So what’s “invested” their house because they say, oh well this increase the value of my house and oh a side benefit. I would really look good relative to the neighbors and live it up, and I can live beyond essentially what my income would predict. And I’ve done some videos on investments versus consumption but I argued that this wasn’t real investment that 500,000 dollars that this was consumption because it’s not making the world more productive in anyway.

It’s not increasing the total economic pie for the world, so it’s not an investment. It maybe it is investment if it somehow makes you our asset more emotionally appealing to some greater fool to pay more for it but its not and so you didn’t build a factory or you didn’t invent some new technology that would make all of us richer. You just poured some money into something that’s going to make your lifestyle a little bit better and maybe the next person who buys your house. But anyway, this house got for enclose on, it’s not worth. Its get auction off, its gets auction off for 300,000 dollars maybe this is the year 2006. Now all of a sudden, all of these people probably all of them who took this home equity home. Let’s say all of them did it, right.

They all say G; I'm paying a 500,000 dollar loan. Actually I'm paying 500,000 dollars plus my original 80,000 loan. So I have 580,000 dollars of depth on an asset that just sold for 300,000 dollars. So what do you think they’re going to do? And I just realized I'm out of time, so I continue this in the next video.

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