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Saturday, September 20, 2008

ECONOMICS 101 AND THE HOUSING MARKET DEBACLE

ECONOMICS 101 AND THE HOUSING MARKET DEBACLE

I have entitled this Blog: Economics 101 and the Housing Debacle. In order to get an understanding of what happened and how we got to where we are, let us start at the beginning.

First, you want to buy a home, you go to a realtor who finds you one. S/he finds a closing agent who represents numerous institutions who will lend you the money to purchase the house.

Second, the lending representative asks for your financial statement which is never checked for accuracy so you may fudge your assets upwards and perhaps your liabilities downwards a bit so that on paper, at least, you look like you can afford the house.

Third, simultaneously the realtor and/or closing agent will require an appraiser to state how much the house is worth. Usually, the appraiser who is working in tandem with all the others is told that it might be nice if the appraisal were to reach a level where it would be easy to secure a loan of a certain amount so it will be in line with what you can afford as evidenced by your financial statement. Through the manipulation of comparing so-called comparable homes in the area, this is easily accomplished.

Fourth, depending upon the lending institution and your finances it is determined that you may need to come up with a down payment of between 20-25 % because the lending institution will give a loan of only 75-80 % of the total evaluation of the house.

Fifth, so you have the documents to close the deal: the house and its quasi-accurate appraisal, the quasi-accurate financial statement, the realtor who is waiting for his commission, and the closing agent representing a lending institution. Perhaps there is a lawyer or two representing either you, the seller or both.

Sixth, The initial bank giving the loan collects a batch and sells them to another bank or financial institution but what they sell is more than just the mortgage. They sell the original loan plus the potential income from the loan which is anticipated over the term of the loan, perhaps 15, 20, 0r 30 years. The new financial institution now owns a mortgage and a piece of paper representing future earnings which they bought with real money. On their book the institution place a debit of what was paid and an asset represented by a piece of paper promising money sometime in the future.

Seventh, this institution now sells packages of these instruments to other institutions who wish to make money buying and selling this worthless paper – worthless because the paper does not really represent anything real and tangible but rather a promise of something which might occur in the future. This is all done using a creative device only a graduate from a fancy business school could devise. The creative device is called “ARBITRAGE” which is a fancy word meaning “MARGIN.” Sometimes this arbitrage may be at a ratio of 100:1 or even 1,000:1.

Eighth, one can easily see that when the value of the real property decreases by even a small amount which can occur when someone defaults on the original house and the value of other houses in the same area decreases, the domino effect upon the arbitraged investments will spiral downwards very rapidly when the reverse of the arbitrage is impacted – that is, the reverse of the 100:1 or 1,000:1. Remember what was posted on the balance sheet for the debits and the assets. The debits remained the same from the initial payout for the instrument, but the assets are now brought up to date with the new and current evaluations. Although it is a simple adjustment on paper, the value of a company is determined by the bottom line figure on the balance sheet. Because of the reverse effect of the arbitrage, it will be no time before the company is bankrupt.

It is said that only 5% of the housing market is defaulting, and that 95% is sound. Has anyone wondered how and why 5% of something can negatively affect the market when 95% is sound? It is because of arbitrage – remember the 1,000:1. If we were to give a mathematical weight of 1,000 to the 5% (1,000 X .05 =50) and 1 to the 95% (1 X .95 = .95), we can understand why the ratio between 50 an .95 (50/.95 = 52.63) is 52.63. Isn’t mathematics great? The 5% of the market is affecting the overall situation by 52.63 times.

The main problem is that the new age hot shots educated in the great business schools constantly devise ways and instruments which create value where there is no value. (Remember Enron and the valueless instruments they created?) And these hot shots go one step further. They buy and sell these worthless paper entities using arbitrage at 1,000:1 giving a false impression and raising 1,000 times more money on paper which is worthless. This is great, if you can get away with it. But they do as in the cases of Enron and the financial institutions now falling apart because of the sub-prime debacle until, of course, when the house of cards begin to fall. And the house of cards ALWAYS falls eventually with many innocent people suffering as a result.

I am currently writing a book on: The Trading of Worthless Paper Entities wherein I go into more detail on this subject. I welcome your comments on the subject.

nicola michael (c. Tauraso, M.D.)
Director, Tauraso Medical Clinic
Web site: www.drtauraso.com
Blog site: http://www.drtauraso.com/blog/index.htm
Email: drtauraso@drtauraso.com

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