Saturday, October 11, 2008 Batuhan: In the eye of the storm (part 3) By Allan S.B. Batuhan Foreign Exchange
IT was supposed to be the next big thing—the New Economy.
The premise was that in this rapidly changing, globalized world of ours, people would be too busy to do the usual things; most of them would choose to do it from the convenience of their home computers.
On this premise, the whole dotcom boom was born.
Overnight, traditional businesses became “clicks and mortar” enterprises—combining traditional storefronts with web portals, allowing everyone to do almost everything without leaving their homes.
Believing in the dotcom gospel, Wall Street bought into the mantra and transformed any stock with a dotcom in its name to investment magnets.
Overnight funds moved into companies like Amazon, Yahoo and their kind, valuing their shares often at exponential multiples of their potential earnings.
The party was not to last.
In time, everyone begun to realize that although there was indeed promise in the dotcom future, the values that were attributed to that future could not possibly live up to their lofty expectations. So the asset bubble eventually burst, giving way to what the industry likes to call a “correction.”
There have been many such bubbles in Wall Street. Last week I touched briefly on the junk bond mania, which also collapsed in a heap. However, with many of our readers probably being only in their teens or younger during those earlier times, the dotcom phenomenon and its subsequent end probably is more instructive.
The latest problem in the financial markets is just one more example of how—as former Federal Reserve chairman Alan Greenspan called it—“irrational exuberance” often gives rise to undesirable consequences. This time though, the asset was something which is often literally considered “fire proof.”
And what could this asset be?
Well, houses, of course. More precisely, the mortgage that people use to purchase their homes.
The old adage that everyone needs a home to live in was the principle behind the belief that this new asset magnet could not possibly go wrong. And there is some truth behind it as well. After all, who does not need a roof over their heads? And when you add to this the fact that these were homes in the United States (for the most part) where new homeowners were entering the market at a very fast clip—everyone could really be seduced into believing that this was the failsafe way to make money – a lot of it in a very short amount of time.
In times past, real estate booms had a simple economic formula behind them.
Someone built properties, and others bought them. Some buy more than they need, in the hope that rising demand would eventually drive prices higher than what they originally paid for their purchases, and they could then sell them on to new buyers for a profit.
It was all easy to understand.
The builder knew how much the house cost, the buyers are aware how much money they paid for them, and both could quickly calculate how much profit they made for their efforts.
In the old world context of real property markets, the main player was the property. On this primary asset was attached a market value based on the supply and demand for it, and the value of this asset in this market was fairly easy to calculate, based on the interaction between the demand for the asset, and the available supply of it.
However, the market for real property was about to take an interesting turn, and it was this development that would eventually lead to the current meltdown in global financial markets.
