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This is how bubble builds up !

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I got an interesting comment on one of my previous posts on Pune Real Estate. The commenter – Ranjeet – provides a story of how a bubble builds up especially in real estate space.

I found it quite interesting and thought it would be an interesting read for trak.in readers. I am producing the comment verbatim here..

STORY OF PUNE REAL ESTATE

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

  1. There were 3 citizens living on this island country.  A owned the land. B and C each owned 1 dollar.
  2. B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.

The net asset of the country now = 3 dollars.

  1. 3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.
    • A has a loan to C of 1 dollar, so his net asset is 1 dollar.
    • B sold his land and got 2 dollars, so his net asset is 2 dollars.
    • C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.

Thus, the net asset of the country = 4 dollars.

  1. A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.
    • B loaned 2 dollars to A. So his net asset is 2 dollars.
    • C now has the 2 coins. His net asset is also 2 dollars.

The net asset of the country = 5 dollars. A bubble is building up.

  1. B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.
    1. As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
    2. B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
    3. C loaned 2 dollars to B, so his net asset is 2 dollars.

The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.

  • Everybody has made money and everybody felt happy and prosperous.
  • One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.”
  • A also thought the same way.
  • Nobody wanted to buy land anymore.
  • So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
  • B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
  • C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
  • The net asset of the country = 3 dollars again.
  • So, who has stolen the 3 dollars from the country ? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.
  • B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.
  • A owns the 2 coins, his net asset is 2 dollars.
  • B is bankrupt, his net asset is 0 dollar. ( he lost everything )
  • C got no choice but end up with a land worth only 1 dollar
  • The net asset of the country = 3 dollars.

************ **End of the story; BUT ************ ********* ******

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting –

  1. When a bubble is building up, the debt of individuals to one another in a country is also building up.
  2. This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
  3. An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
  4. When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
  5. If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game,  he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
  6. When the bubble was in the growing phase, everybody made money.
  7. If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.
  8. As in the case of land, the above phenomenon applies to stocks as well.
  9. The actual worth of land or stocks depend largely on psychology

Phew…that was some explanation :)

Thanks Ranjeet for a wonderful comment !

  1. Yadu says

    Same is the case with Money and Debt. Watch this amazing yet simple video to understand the necessity of flow of money http://www.youtube.com/watch?v=vVkFb26u9g8 .

  2. Vikas says

    Nice story. It really helps to understand how asset value is increasing due to demand.

    As with any type of economic bubble, it is often claimed that a real estate bubble is difficult for many to identify except in hindsight, after the crash.

  3. David N says

    Builders are like middle aged women. It takes a woman courageous effort, to come to terms with the harsh reality of aging. You can continue to live in a make believe world for months or even couple of years?but natural aging just can’t be stopped.

    Those who read the signals and adjust their lifestyle, carry on with minimal impact, on their lives. Those who refuse to read signals and adjust lifestyle, end up in medical care.

    90% of women are smart enough to admirably adjust and are prepared well in advance. However, more than 90% of the builders react sluggishly to realities of the market which could affect, if not personal but definitely their financial health.

    In a booming market, builders were quick to react by resetting prices upward, every week. The possibility of making larger profits drove them to be extra alert! When market trend shows negativity, it is rightly expected that the same builders would be quick to act, to cut losses. After all, cutting losses is MORE IMPORTANT than making quicker profit. (In boom, whether one reacts quickly or not, there is profit, always. Its only the quantity of profit that varies. But in a sliding market, money gets burned. And that could be deadly)

    And this is exactly where builders have gone, dreadfully wrong. Even now, many are in a “make believe world”. Comforting themselves, with grandiose vision of early boom! Unfortunately, they are unaware that they are shooting themselves in the leg. And soon, the self inflicted injuries may aggravate.

    Cutting losses by aggressive pricing in anticipation of worsening market, should have been the mantra 9 to 12 months ago. But the opportunity was lost due to the blind belief that boom is perpetual and negative trend, a flash in the pan. Builders offered small cuts from August 08 onwards which had absolutely no impact.

    There were opportunities as late as September 08 to offer aggressive pricing and convert leads to Sales. But once the negative trend firmed into solid slide, NOTHING could work. Its only in December 08, after a whole year and a half of negativity, that few builders started to react with larger cuts. But the horses had bolted in September 08 itself. And builders who reacted late, know that the stable is empty.

    For the smarter builders, the market has indeed given an opportunity to prepare itself for the future. Those who have learned the lesson that procrastination will cause misery, may be quick to act during a slide, after the next boom!

    David at http://www.exclventures.com

  4. Deepak S says

    Everyone (expert) says Indian economy is different than others, means Indian normally pays loan.

    Think – If Indian stop to repay loans? Like American
    Then All banks will be shut down and all new real estate projects will be converted to JAIL

  5. xxx says

    Very simplistic and does not mirror the present situation at all for the simple fact that in our current system there can be inflation in both the coin (i.e. by RBI pumping money into the financial system) and land (by converting more protected/forest land for commercial utilization)

  6. Sukhminder Sukhi says

    Thanks for correcting me Shriniwas ji, you are absolutly right when saying ‘assume’ and ‘playing investment game’ while living in a ‘govt. house’. My perspective was damn basic that when one has a gold coin and other a peice of land then land is the winner value as coin itself needs land to stand on! A coin cannot be food or cloth until ‘exchanged’. So once these basic needs are met then we think of economics -‘the investment’. I qouted if this ‘exchange’ ends (or devalues) then basics emerge as winner and not the gold. In bubble scenario your and Arun’s examples hold good. Anyone can live without a gold as long as the basics are met. We buy or rent or whatever a peice of land because we need to live on land. A ‘demand’ or ‘need’ is actually a gold and that what makes gold a gold. So first comes a basic need then comes a ‘investment’ need – that’s why land wins gold :)

  7. Shriniwas Kulkarni says

    Kshitij – America is a monster economy. If you come here and see – there is no panic or mayhem in the crisis. Americans are ingenious and have immense amount of natural resources, land and the worlds best infrastructure. They can simply rebuild their economy based on the strength of the US$. The entire world treats the US $ as equivalent to gold – so please don’t underestimate the US economy. US has hard working smart people – who come in to work at 8 am everyday, work their full 40 hours a week and run their families. The quality of life the average American even in deep crisis is much much above even the richest folk in India.

    Sukhminder, your point that people without land are homeless in this example is wrong and so is the point of exchange value of the dollar. We can easily assume in this example that A, B, C are all self sufficient/have government housing or can live in rental homes and are playing this game for investment and likewise a dollar is nothing but a Gold coin – whose value is fixed – Gold is Gold is Gold. (As long as someone turns up with a platinum coin).

    Now to put it in terms of Indian real estate bubble – here is the scenario –
    1) IT professionals (or allied industries) started earning money in US$ (1500 US$ pm is a good pay in India). Note that this is Outsourced money [platinum coins in Gold Coin economy]
    2) Newly joined IT workers – start purchasing property (Bubble not built yet) by taking reasonably priced Bank loans in Gold coins.
    3) Builders build and sell houses and make some 10-15% standard profit
    4) IT worker pays off the loan to bank – converting the .

    – Enter the speculator/”investor” – whose purpose is to make profit in this demand supply system
    In an ideal greedless economy, the builder would have been happy with his/her profit of 15% and would continue the system. But looking at the high demand for buying (as IT companies are hiring year after year), and inflation the prices are cranked up and a hype is created saying that only X number of units remain (although more are available). Builder says his profit will increase, speculative buyers want to buy cheap and sell off at a profit.

    1) Fearing losing a good deal, many IT workers take loans (remember as long as they are are not fired they can pay back the loan) and buy houses at increasing prices.
    2) Speculative buyers buy homes to sell them off at a profit – they say worst case they can rent it out
    3) Banks report robust growth – and ease lending. Builder still needs to deliver the house, so they also borrow money from same bank/ from stock market – IPO and build for the consumer. – Builder is confident that sale of the homes will get him his profit even after he pays off the loan to bank.

    The bubble grows by such speed that the land that once cost 10 pieces of gold will be priced at 10 pieces of platinum.

    The net asset value of the land is in fact 10 coins + inflation – the price the buyer must pay must be 10 coins + inflation adjustment + builders profit + interest to the bank.

    All this “Growth” keeps on inflating the bubble – the Workers and builders lend money from the bank and pay each other. If the worker thinks – hold on a second, why am I paying 10 platinum coins for a house worth 10 gold coins then he should have avoided the deal after all. But he followed the crowd and took a loan of 5 platinum coins. (his payments/EMI now soar). Then alas the reality strikes. Demand stops as the companies halt hiring or shrink pay packages – as the platinum coins are drying up. If the worker has enough to bail himself/herself out – its fine. (They still think their house is worth 10 platinum coins). If not – Houston we have a problem.

    The land value will not appreciate beyond 10 platinum coins, as that would mean no one would buy it in hard times. Workers with loans who are laid off/ have lowered salaries are in deep trouble – their homes value is come to a standstill/reduced and their loans ares still the same.

    This bubble has a bad story for any non platinum worker who was earning in gold – and got a loan for 10 platinum coins. thinking that his investment will yield enough to repay it.

    Now what about the winners or losers in this game? Builders or buyers if they default on their loans will lose property to the bank/lender. If they do that – banks will collapse as they will have a worthless 10 gold coin house for which they lent 10 platinum coins. (As it happened in USA).

    But in India the story is different –
    For Workers/buyers there is a shame in not repaying your loan back so the workers will have to toil their way to repay a loan – cutting down on other expenses – slowing down other sectors. If they lose jobs and cant get another one – they are screwed and so are the banks who will repossess the houses.

    Builders cannot start new projects and will unwind slowly hoping for a revival – they will try to repay the loans if possible by cutting down their margins. Builders who aren’t in a position to do this are screwed and so are the banks who lent money to them.

    So there will be deflation of the bubble than a bursting (US it completely burst taking down the banks – who had invested this “asset value” in other countries – hence destroying those countries as well). In India I dont see a burst but a phussss. If jobs dry up n IT there is no real growth possible. This is a classic case of torturing the hen that lays golden eggs until it one day starts laying normal eggs. If the bubble was exposed earlier (learning from the 1997 bubble), smart people would not be in debt now. Those who are in debt are going to be the biggest losers in this game.

    Basically this is what happened in 1996-97 collapse – that time there was a speculative bubble led by the Gulf money – this time it was US money.

  8. Kshitij Agrawal says

    Its a really nice way to explain the basic cause of the US economic crisis which has shaken the global economy. I must congratulate the author for the lucid example which is actually the story of US sub prime mortgage crisis. The only difference I find is that since the island in the illustration has an isolated economy, the crisis may not affect other islands. But, since US is a major market of many services and goods, and almost every country trades with USA or is dependent on it, the current crisis has far reaching effects especially on the Third World countries like India. We have already witnessed the downsizing measures being taken by IT, ITeS and the airlines sector. The that question arises is why should we bear the brunt of what US did to live in the euphoria of economic growth. The placements at B schools and engineering colleges are also going to be affected. Phew…God save USA, God save us! Its a high time that we take measures to safeguard our economy from such turmoils.

  9. Sukhminder Sukhi says

    This is a nice story to understand the root cause of the effect. Now see what will be the value of 2 dollars of A if no one wants to exchange them either on island or out of island? Another fact is that A although with 2 dollars yet needs land to live means he is dependent on B. B although does not have any dollar but he is still not dependent on anyone to live. So the final winner can be B if dollar loses its value. This makes reality more gruesome than this story. Economics starts when first the basics are met.

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