Financial Crisis - Will China be Next?

Holland, in 1637, saw a speculative frenzy that could have (should have?) warned the world about the dangers of financial bubbles. What happened in Holland is almost funny. People freaked out over buying and selling tulips, yes tulips, the flower. They weren't trading tulips because they were pretty; they traded them to make a financial killing. This became known as Tulipmania or Tulipomania. The prices of tulip bulbs started to climb, aided by seventeenth century version of a derivatives market. Investors would buy contracts on tulip bulbs not yet planted, trading in the contracts, not the tulips. At one point in the frenzy the price for a single tulip bulb exceeded the annual earnings of a skilled craftsman by a factor of 10. As with any speculative financial bubble, the prices of tulips eventually crashed. Tulipmania is now a metaphor for speculative excess.

The Dot Com Bubble

Before the real estate market began to launch toward the heavens, the late 1990s saw another tsunami of speculation. The Internet was the new economy, and new things mean that the old rules don't apply. People were buying common stock in companies that had no profits, no product to sell, but had one common trait: an idea. Just buy the stock; management would figure out a way to make money some day. Meanwhile we jumped into the game for fear of being left behind. And what happened? We got left behind. To be sure, solid technology companies weathered the storm, but stock prices dived.

We sure learned our lesson. Didn't we?

Remember that phrase from the constant barrage of mortgage loan ads? Yes, for a while real estate was red hot, very hot. In the United States in the early to mid 2000s we witnessed a real estate buying frenzy that made tulipmania look like a conservative investment strategy. In parts of the country a modest 2 bedroom ranch house could fetch $1 Million. We were all amazed at the skyrocketing prices. Aided by the federal government through the quasi governmental Freddie Mac and Fannie Mae, mortgage money became easy to get. A "no-doc mortgage" now seems like a quaint phrase from another time. No-doc simply meant "no documentation." A borrower wasn't required to show proof of income or assets. The rising value of the house was good enough for the bank. Another name for a no-doc mortgage was a "liar loan," an appropriate thing to call it because that is exactly what the borrower did: lie. Mortgage brokers were in on the game in a big way. Secure a mortgage for a client, collect the fee and move on to the next deal. Bankers were enjoying the game as well. After loaning the money, they would sell the mortgage to the next investor down the line. This is called "no skin in the game," meaning that the bank wasn't taking the risk, the next guy was, sort of like musical chairs. Whiz kids from the big investment banks bundled mortgages into lots known as tranches. They then created complex financial instruments called credit default swaps that were supposed to provide some form of insurance if large tranches of mortgages went south. It didn't work. Investment without risk sounds a lot like the mythical place of nirvana. But in a financial system it can bring chaos, which is exactly what happened.

I distinctly recall the diner and cocktail party conversations of the mid 2000s. Everybody seemed to agree that the price race couldn't continue. We knew it had to slow down. So what did we do? We kept on buying. We all seemed to think that the prices increases would start to slow down maybe but would never reverse. We refused to believe that the prices would stop, and then rocket in the opposite direction. We were all too busy enjoying the party that we didn’t notice that the house was on fire.

Europe, not wanting to feel left out, thought this bubble idea looked like fun. While visiting relatives in Ireland, I couldn't believe the prices that modest homes were selling for. The Celtic Tiger eventually turned out to be a confused kitten. Spain, Portugal, Italy and Greece tried to keep the party going - by borrowing money.

By 2012, real estate began to pick up, but the baseline prices of vast tracts of houses is a fraction of what they were a few years before. The credit crisis of 2008, combined with a recession and the already falling real estate values created a perfect storm of financial ruin.

Yes, people like bubbles. I say this because, despite warning signs, we get caught up in the thrill of speculation. During the Dot Com party I was in the process of selling my business. While riding in a cab to a meeting with my attorney and mergers consultant, the driver, hearing all the business talk in the back seat, asked us, in a very heavy accent, if he should invest in Yahoo. I suggested he talk to a stock broker about a conservative mutual fund. I doubt that he took my advice. I was reminded of the old story about an investor in 1929 who realized that the market was getting too hot when a shoe shine guy asked him for stock tips.

We like bubbles because they feel good. Imagine yourself standing inside a large bubble. you look up and see nothing but clear sky. Bubbles are like that - we can't see the edges. If bubbles have one thing in common, one phrase that sums up the craziness of a bubble it's this: "This time it will be different." No it won't.

The video to the right is from the CBS 60 Minutes segment that ran on March 2, 2013. Leslie Stahl is interviewing experts on the real estate market in China. If you want to understand just what a bubble is, watch this segment. It is amazing and scary. They show vast tracts of huge gleaming high-rise condo developments - that are EMPTY. As she says in the segment, you're not looking at acres, but "miles and miles and miles," of empty apartments. In a deserted shopping mall we see signs for Starbucks, Armani, KFC, and all of the usual trappings of stores to come. But they are just that, signs, nothing more. To make matters worse, the vast scene of empty apartments are actually owned by people, not just developers who couldn't find buyers. They're owned by people looking to make money by flipping them at a profit. But they're all empty. I couldn't help but think:"These people are as stupid as, well, us."

The Chinese government, seeking to develop a rising middle class, infused vast sums of money into building apartment towers. This employed an enormous number of laborers, further fueling the growth of the middle class. But governments act dumb. If you build it, they may not come. That's what's happening in China now. Market forces aren't at work, a planned economy is creating the market. As Milton Friedman once said:"The government solution to a problem is usually worse than the problem."

We should not indulge ourselves in schadenfreude, feeling smug about what China is going through. If (when?) the Chinese real estate bubble bursts, the pop will be felt around the world.

I'm done with my rant. I must tend to my tulips.

Copyright © 2013 by Russell F. Moran

Parts of this article has been excerpted from my book Justice in America – How it Works – How it Fails.