Explaining a Recession Simply and Clearly

Explaining a Recession Simply and Clearly
By Colin Murphy

Like many of our readers and clients, I'm the type of person who tunes in regularly to radio chat shows, current affairs programs and newspaper reports on how the global turbulence is affecting our house prices, our labour markets, our stock markets and our changing consumption habits.

There are lots of commentators out there who seem very qualified and sound like they know what they're talking about when discussing concepts like recapitalisation, nationalisation, liquidity ratios, deflationary pressures, credit ratings etc. and yet, when I've finished listening to them, I've usually forgotten what the question they were supposed to be answering was.

Sound familiar?

With that in mind, and throwing caution to the wind, I'm going to pose a few questions I think a lot of people would like answered, and I'll try and do as quickly and clearly as possible. Please bear in mind that all of these issues deserve much more comprehensive answers than the size of this newsletter or the limits of my ability permit.

How did the subprime mortgage crisis in the USA affect property prices in Ireland & Britain? Why are large international banking stocks trading at 30-60c per share when they were €20-€30 per share 18 months ago? Why have banks moved so rapidly from loose lending criteria to excessively strict lending criteria? Why is unemployment rising so quickly and why are our economies slowly so rapidly? How can a person safely invest in a property market without falling victim to another property crash in 2010 or 2011?

How did the subprime mortgage crisis in the USA affect property prices in Ireland & Britain?

The subprime market, i.e. the practise of offering high interest mortgages to people with a high risk of missing future payments, was just the most extreme example of a mind boggling variety of mortgage products. It was viewed to be of low risk overall because it was assumed the value of the properties they were secured against would always continue to rise and could be resold if the client defaulted on his loan.

While there was a time when mortgage lenders like AIB, Bank of Ireland, Barclays & RBS etc. could only source funds from their local markets and would simply offer a multiple of the deposits received from savers to borrowers who wished to take out a loan, this has not been the case for many years.

Nowadays, banks based in net borrowing economies (like the USA) receive vast sums of money from banks in net saving economies (like China). These banks then repackage this money in horrendously complicated ways and give other international banks operating in borrowing economies (like Ireland & the UK) access to it.

If the banks who lent to people with a high default risk operated in the old fashioned way and were not so interconnected with the global economy, their boardroom and their shareholders would be duly punished when these loans were not repaid and we would all move on.

However, this was not the case as institutions everywhere had products linked to these subprime mortgages. Gradually (from August-December 2007), it was realised that an unknown but potentially catastrophic proportion of the money lent to people and institutions all over the world would never be repaid.

During 2008, when Irish & British banks had much more limited access to global funds, mortgage lending duly slowed, reducing the amount of people who could afford to purchase a home, thus reducing the demand for housing. If a market suddenly realises that there is a large and impractical gap between supply and demand of any product, prices will fall dramatically, and they certainly have this time.

Why are large international banking stocks trading at 30-60c per share when they were €20-€30 per share 18 months ago?

At the moment, large and diverse Irish and British banks are being valued by stock markets at about one years profits, which is astounding. These low share prices have more to do with the markets perception of a banks ability to raise new capital than any major faults in their business models. If a bank cannot borrow cheaply from other banks or raise money from wealthy individuals and institutions, then it cannot function properly.

This is why governments are stepping in to provide funding to the banks so they in turn can pump it into the economy in ways only a bank can do (in the forms of mortgages, car loans, business loans, overdrafts etc.). Major problems will arise and people will start dumping shares when banks do not pass this money onto customers either because it has so much debt already and/or governments become very dangerously exposed to these enormous debts by providing continued support without the markets help.

Why have banks moved so rapidly from loose lending criteria to excessively strict lending criteria?

Banks need to abide by very strict laws which only allow them to lend money as a proportion of the cash they have access to. As a rule of thumb, if a bank has €10 million in liquid assets, it can lend €100 million to people in the form of car loans & mortgages etc. If a fictional banks' cash dipped to €7 million towards the end of the business day, and they had already lent €100 million to their customers, they would need to borrow €3 million from somewhere to remain solvent. They might borrow this €3 million for a night, a month or three months, but the interest rates for doing so were far lower than the interest rates they charged the customers they passed it onto.

When banks realised that many of the loans they were giving were worth less than they thought because of falling asset values, they needed to hold onto more cash to preserve this 10% ratio. This in turn meant they charged higher interest rates to other banks who wanted to borrow, which created a vicious circle dramatically reducing everybodies ability to lend money to their regular customers.

Why is unemployment rising so quickly and why are our economies slowly so rapidly?

If businesses (large and small) have less access to the loans they need to expand and the overdrafts they need to meet day to day expenses, either their business models will no longer be viable and they will shut down, or they will reduce their overheads dramatically and continue as a smaller entity.

If the average man or woman on the street is fearful of their job and/or realises they no longer have access to the overdrafts & credit card facilities they previously took for granted, they will spend less money and purchase less goods and services.

If companies are getting smaller and people are spending less, an economy will slow and GDP growth will contract.

How can a person safely invest in a property market without falling victim to another property crash in 2010 or 2011?

Firstly, thank you to those who have gotten this far though our newsletter. Secondly, and harsh as it may sound, there are several ways those who are still liquid can profitably take advantage of a global downturn which is causing much suffering to others.

One of these ways, which Someplace Else Ireland identified about eight months ago and launched as a comprehensive service about three months ago, is to purchase highly discounted and undervalued properties from distressed sellers. To maximise the return of these types of properties, they must be purchased in wealthy, democratic economies, with a history of renewal and recovery from recessions, and in fundamentally sound cities and neighborhoods where locals rent long term and have the ability to purchase and borrow against similar properties.

Regular readers will know of course, that I am referring to Florida. For the record, let me state that our focus is not on vacation homes. It is on long term lets to locals (only a small percentage of which work in the tourist industry). These properties are much more tax efficient, provide a much higher net rental return per square foot and are available at a higher discount than other property types.

Torcana Ltd is a property investment consultancy dealing with investments in foreclosed property, distressed property, and discounted property in USA, Spain, UK, and Panama. For more information please visit: - http://www.torcana.com

Article Source: http://EzineArticles.com/?expert=Colin_Murphy
http://EzineArticles.com/?Explaining-a-Recession-Simply-and-Clearly&id=2224382