All markets are connected. A major move in one area of the market has an effect on other areas of the market.
When commodity prices fall, the Aussie dollar usually drops in value.
Airline stocks benefit when fuel costs are lower. So it pays for investors in this sector to watch the price of crude oil.
But most investors make a common mistake.
They assume that global financial markets are based on the stock market.
Global financial markets are based on the real estate market
Think about it. The world’s financial and banking system is based on lending money backed by the security of real estate.
When you apply for a loan, here’s one of the first questions they ask: ‘Do you own your own home?’
If you do, or at least own your home with a mortgage, the bank will take it further.
If you don’t, chances are your loan application will not be approved.
It’s the same around the world. Banks are far more willing to lend money to people and companies who can put up real estate as security.
Sure, there’s a connection between economic growth and company earnings. And companies who grow their earnings usually see rising stock prices.
But there’s a disconnect in perception about global financial markets. It’s the reason why most investors don’t see the difference between a temporary correction versus a major crisis.
It was a land crisis first and foremost that brought on the GFC.
The problem hit the financial system later. That’s why we watch the US real estate market for signs of trouble.
Phil Anderson detailed the history of US real estate crises in his book, The Secret Life of Real Estate and Banking. You can get it on Amazon.
The book details the US real estate market all the way back to 1800 when the US government first began to sell land to the public.
There’s a recurring theme. Land prices rise and then collapse in regular cycles. The peak of each cycle is accompanied by excessive lending, usually via some new form of finance.
In 2004, Phil unveiled the history of US real estate cycles to a group of like-minded individuals. He told us to watch for excessive lending into 2006 and 2007. And that a collapse would follow into 2010.
Importantly, he also said that markets would boom thereafter.
It’s important to understand history. Looking back at history will increase your awareness about themes when they repeat in the future.
The history of Aussie real estate
Let’s look back to the 1970s.
This is when the Real Estate Investment Trusts (REITs) became the vehicle for excessive speculation.
The REITs raised huge amounts of capital and put it into speculative real estate projects. When the bubble burst, here’s what happened to the stock market:
The Dow Jones Index went from 1067 to 570 in just under two years — a drop of 46.5%.
There were major bank failures. The authorities then isolated the problem with the REITs and bailed out other banks.
The markets recovered and a new real estate cycle was under way.
The next peak was in the late 1980s.
This time, excessive lending in the US came from the Savings and Loans Associations (S&Ls).
In 1982, US President Ronald Reagan changed the rules for S&Ls when he signed the Garn-St Germain Depository Institutions Act.
Interest rate restrictions were removed. S&Ls were newly permitted to make commercial loans. And limits on loan-to-value ratios were swiped, allowing risky loans to be advanced with federally-insured deposits.
It was a free-for-all. Within three years, S&L assets increased by 56%. Some of the smaller banks tripled in size.
The crisis came in 1989 when land prices started to fall. This led to the biggest banking crisis since 1929. By 1995, half of the nation’s S&Ls had failed.
President Bush unveiled a bailout plan to close failed banks and stop further losses. Markets quickly recovered and yet another cycle was under way.
We move on to 2004 when Phil describes the history. He tells us to watch out for a new form of excessive lending into 2006 and 2007. This is the time frame for the next peak in real estate values.
Sure enough, along came stories about mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs).
It might have started like this…
A couple of investment bankers chat about starting a new investment product.
They reckon fat fees can be earned if they bundle up some mortgages into a bond that can be sold to institutions and the public.
Investors earn higher interest rates backed by the solid security of a mortgage.
Once the ball is rolling, other bankers were meanwhile worried about the risk of lending money for real estate. Property prices were rocketing higher and higher.
They look at the new mortgage bond products. The risk of lending can be removed. They can bundle risky mortgages into a bond and offload the risk onto someone else.
The race was on for these bankers to make more and more risky loans to people who would never be able to repay.
Hey, it’s a mortgage! We’ll get the agencies to rate it AAA and sell the risk to someone else!
All of a sudden, it was possible to lend $1 million to a maid who would never be able to keep up with her repayments.
This continued until it was time for the cycle to kick in. Phil Anderson had given us the timing and we watched as it unravelled.
The cause of the GFC was a downward turn in property prices. As real estate prices fell, the security behind the mortgages put bank loans under water.
The value of property was no longer enough to cover risky loans and a full-blown banking crisis was on.
As usual, the government stepped in with a rescue plan. This time it was bigger than anything done before.
And again, as usual, Phil was right. The market recovered in line with the expected cycle and prices began to rise.
Australian property prices fell over the last year. It’s part of the mid-cycle pause. There’s usually some form of economic slowdown ahead.
We wouldn’t expect anything dramatic. None of the usual signs are about. There’s no sign of excessive lending and no distressed selling.
Editor, Money Morning Trader
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