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Ignorance is Bliss

House of Cards

There’s been a lot of panic recently associated to the collapse of Bear Stearn, one of the largest financial institutions in the world. Yes this is dramatic and will have far reaching consequences, but there’s something far scarier than that which pretty much everyone is overlooking. And in this case, this ignorance is what’s preventing the economy from collapsing. Ignorance is bliss!

Yes a major financial institution collapsed. Yes it happened in just a few days. Yes it’s a catastrophe. But there’s something far larger and more ominous looming just beneath the covers. The really really really scary part is that no one wanted to acquire them for pennies on the dollar without the Fed’s adding $30 billion to sweeten the deal!!!

Why is that? I can only come up with two reasons, both of which are incredibly scary.

  1. Everybody else is on the edge of insolvency and can’t afford a fire sale deal, even for pennies on the dollar.
  2. The number on the balance sheet are much worse than they appear and hence the revenues are collapsing (mortgages defaults are much much much higher than expected).

All I can say is WOW! Both of these options are incredibly scary and lead me to conclude that the worse hasn’t even yet begun.

[Disclaimer: Please note my numbers in the following analogy aren’t to scale as I haven’t yet had the time to fully absorb the details. ]

To take an analogy on a smaller scale, imagine that you own a house worth $600,000. Everything seems to be going fine, then within two days you somehow can’t meet your obligations. In other words you’ve become insolvent because of a cashflow issue almost instantaneously. Now imagine further that you can’t find any buyers for your house, even at $20,000. Yes the house does come with a mortgage that you have to assume, but it’s also being rented and is earning revenues. Up until a few days ago, you were supposedly maintaining profitability on it.

Which is scarier? The fact that you went insolvent or that there are no buyers when the house is going for a steal? By far the scariest thing is that there are no buyers. But now imagine further that to eventually get a buyer you need to have a third party (the Fed’s) add a large sum of money to make the deal happen. Getting pennies on the dollar wasn’t enough.

Which means either the revenues on the property weren’t exactly as good as you you stated or there is no one else with enough capital to buy a house at a fire sale price. I sincerely hope it’s because the deal wasn’t lucrative enough (the revenues weren’t as good as stated), otherwise the alternative is much worse and you can expect many more insolvency in the near future!

If it’s the later, than ignorance truly is bliss and might even save the economy!

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  •     Justin
    · March 19th, 2008  · 1:41 am  · Permalink

    There’s something I don’t get.

    “Now imagine further that you can’t find any buyers for your house, even at $20,000. Yes the house does come with a mortgage that you have to assume, but it’s also being rented and is earning revenues.”

    Say that that $600k house has a $500k mortgage on it. If I have to assume the $500k mortgage (i.e. I am taking on a $500k debt), how can it be said that I am buying the house for $20k?

    If I was actually paying only $20k for the house, then yes it would be a steal.

    If I put “no money down” and simply assume the mortgage, haven’t I just bought the house for $500k fully financed? I still bought it for $500k didn’t I?

    Can you clear that up for me? Thanks!

  •     Steph
    · March 20th, 2008  · 5:03 pm  · Permalink

    Hi Justin,

    Yes you are correct. Which is pretty much option 2, the numbers on the balance sheet aren’t really correct. More or less. That’s why I included the disclaimer, I haven’t yet had a chance to fully look at the numbers 😉

    But let’s assume it’s a 500k mortgage. Up until a few days ago the revenues (rent) where enough to cover the 500k mortgage and give some profit. So what’s happened since? In this case the rent’s no longer being paid in full and that number is totally wrong (which means that a lot of mortgages on their balance sheet are foreclosing, a lot more than they had us believe the week before).

    But from my understanding, the mortgage left over on was much less than 500k (in relation). How much, I don’t know, that’s where I haven’t yet had the time to investigate. But my guess is that if $30 billion is enough for the buyout to go through it must be in that range or lower…

    You’re analysis is completely correct.

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