By Sally Duros
A long, long time ago it seems, I worked in a large gray stone
government building with long, marble echoing hallways, and frosted
glass doors that opened into lots of nooks and crannies and bureaus
that constituted many balkanized fiefdoms.
It was said that getting things done there was like pushing a
feather through honey, and it was. Even more frustrating than the
push back of the honey was the fact that even when you were doing
one thing with the best of intentions, you were unwittingly doing
something different. And as it would often turn out, what you were
actually doing was not what was actually required, although nobody
would actually say that.
It was your job to somehow sniff out the correct direction to go
in, and woe be it to you if you messed up.
I’m sensing a similar dynamic in the real estate market these days
as regulators, the press and industry players try to figure out
what the fallout will be from the subprime mortgage market.
There are many crannies in this nook, and it is difficult, perhaps
even foolish to talk about one without talking about all of them.
But unless you are an economist and given to dismal utterances, how
do you talk about them?
Nationally, we saw March sales of existing homes dropping a
dramatic 8 percent. Here in the Chicago area, sales of existing
homes fell 22 percent from the year earlier period, a sales level
that looks a lot like 2002. But what does it mean? How far will it
What’s been missing for me is a unifying theory that brings these
pieces together so we can see from the balcony how important the
Luckily, a wise friend forwarded to me a copy of a newsletter by
John F. Mauldin (JohnMauldin@Investorsinsight.com) that offers a
theory for better understanding the subprime mortgage market.
The article, “The Plankton Theory meets Minsky,” by Paul McCulley,
explains why many investment professionals think the problems
arising from subprime mortgages and the housing market slowdown
will affect our economy in a significant way.
The article begins this way:
“The Plankton Theory, like life itself, begins and ends in the
ocean. Plankton, of course, are almost microscopic organisms that
serve as food for higher life forms. . . . Logic would suggest,
therefore, that in attempting to forecast the well-being of the
Great White Whale, Jaws, or even Jaws II, that one of the factors
to consider would be the status and future outlook of the plankton.
These words were written by PIMCO bond expert Bill Gross in 1980.
He then goes on to describe the dramatic escalation of housing
prices at that time. And he states, “In the case of real estate,
the plankton would be the first-time buyer with a desire to own
their own home but with very little capital to carry it off.”
And we come to understand that the great white whale would be the
That’s where Minsky comes in.
Hyman Minsky was a Harvard University economist. “A fundamental
characteristic of our economy,” Minsky wrote in 1974, “is that the
financial system swings between robustness and fragility, and these
swings are an integral part of the process that generates business
cycles,” according to the Wikipedia. Economist Henry Kaufman said
that Minsky showed that financial markets could move to excess, ie.
move to a bubble.
Now here’s how Minsky meets the plankton.
In extremely oversimplified terms — and I apologize to McCulley
and for nuances that I butcher here — Minsky says that there are
three types of players in a market. First, those who have
sufficient cash to meet their contractual obligations. Second,
those who are speculative, who can only make payments based on
“income account,” and must issue new debt to meet maturing debt.
And third, Ponzi agents with insufficient cash who can only sell
assets or borrow.
McCulley says exotic mortgages — subprime, interest only,
pay-option — and their lenders are examples of Minsky’s
speculative and Ponzi units. But Minsky’s theories say that by the
market’s nature, this game must end and Ponzi borrowers will cash
out. That is what we are seeing now.
So we are back to where we began: These mortgages are the food of
the Plankton — the first-time homebuyer — and as Gross says:
“when the time comes that the plankton can’t pull homeownership
off, then the “plankton” would disappear, and the rapid escalation
in real estate prices would ease as well.”
Says McCulley: “The ongoing meltdown in the subprime mortgage
market would not matter, except for those directly involved, except
that it marks the the unraveling of Ponzi finance units that on the
margin were the plankton of the bubbling property sea of recent
years.” You can read the entire article at
Credit: The Chicago Sun-Times -COPYRIGHT- Â© 2007 Chicago Sun-Times.