What exactly will happen for the next 20 years in the housing market.

In trying to figure out what will happen in the future, I try to figure out if there is some sort of "model" that applies to the situation.

The housing bubble bursting is sort of hard to nail down, since it is pretty unprecedented. Housing prices as a whole have never really come down in this country. It's also hard to remember, but houses also used to not have such a "speculative" element to their pricing. House flipping was pretty marginal business, pretty much under the purview of sleazy infomercials until the late 90's.

But I think I have the housing market modeled pretty well, in a way that I think reflects the respective payoffs to the parties involved (and maybe I've talked about this before... I'm getting old).

It's our old friend, options.

See, when "we" build a house, we are "long" one house. Now, how it is financed is a secondary concern, but the asset, the house, exists, and we are "long" that house.

How it is financed does cleave the payoffs from this asset in a fairly interesting way.

When you buy a house, if you pay all cash, the payoff is simple: you gain and/or lose dollar for dollar whatever the house gains or loses. Pretty simple, the all-cash example is linear.

But when you buy a house, using one or more non-recourse mortgages (ie they can only take the house on default), you can't really lose monetarily anything once the house goes below the collective principle of the mortgage(s).

The "strike price" of the home is the sum of the mortgage principle. If you "cash out" (ie sell), you get the amount over and above the mortgage sum owed. If the sell price is below that, you simply get nothing.

Of course, it's more complicated than that, since there is also a cost borne of the hit to your credit record, and any sort of "psychic" or other costs, such as mental anguish, and such.

But this does model the purchase of a home using non-recourse debt.

So what is the payoff to the other side?

Well, if you study your options trading strategies, and I have, you know that to simulate a "long" payoff, you need to buy 1 call option (that's us, the home buyer), and sell 1 put option.

As an aside, a call option gives you the right (not the obligation) to buy a share of stock at a given price in a given period of time. A put option gives you the right (not obligation) to "put" a share of stock to someone at a given price within a given period of time.

So the "payoff" diagram of a call option looks like this (strike price = $30):

Call option payoff, $30 strike price.

So, say instead of $30 strike prices on shares of stock, think $300,000 mortgage on your home. Anything above that, you win, anything below... well, you just walk away.

So, we know we are "long" a house, financing ignored. And the home buyer is really long a call option, with a strike price of the mortgage amount. And for illustration purposes we'll ignore the fact that actually the home buyers "expiration date" and strike price change a bit everyday, since the mortgage is being paid off bit by bit thus lowering the strike price. We'll sort of look at it as a call option with a shorter expiration (like 1 year), with a sort of "blended" strike price of the average owed during the year.

So the other side of this transaction is the bank, and if you know anything about options, you know that they are essentially short a put option.

If they were long a put option, they could "put" the asset (ie house) to someone at a fixed price, something that's nice when prices are falling. But they aren't long, they are short, or the exact opposite. They can have the asset put to them at a fixed price, aka the mortgage principle.

So if the buyer owes $300K, and walks from the house worth $200K, the bank is out $100K. Simple.

So this is our housing market model: Buyers are long call options, banks are short puts the summation of these 2 positions equating to being long 1 house.

You might wonder, "Why in the hell would the banks ever go into a business with severely limited upside, and one hell of a lot of downside?"

Well, that's a good question. And the reason is simple, and was intimated to earlier: Banks receive "premium" (ie your mortgage interest payments) for bearing risk.

Think of an interest-only mortgage: The bank can receive (and invest) this amount every month for 30 years, and at the end they will either receive nothing (ie the house is worth more than the mortgage), or they will have to pay some amount that the house has fallen below the mortgage.

And before now, the idea that a house would be worth less in any decent period in the future was pretty absurd. In fact, this "bet" for banks was, and always has been, a pretty safe one.

But let's get back to our little housing model. To figure out the value of our home buyers "call option" we'd use Black-Scholes. I don't want to go into the mechanics of the formula, primarily because I don't fully understand them, but I do know a few things about option pricing.

When you are buying a call option, the price goes UP when:

1. The volatility of returns goes up.
2. The strike price goes down.
3. The time to expiration is increased.

These are all pretty straightforward assumptions.

When the price of a stock is all over the place, the options for that stock, both puts and calls, go up in price.

When the "strike price" goes down, the value of a call goes up, since it's intrinsic value goes up.

When the time to expiration increases, you have more time for the stock to go above your strinke price, and so the value of a call goes up.

So, let's think about the historical aspects of this state of affairs, a bunch of Americo's long call options, and a bunch of banks short puts on the largest store of wealth on Earth, the US housing market.

Well, with respect to Black-Scholes, we can say that the call option buyer probably wants lower volatility, since that lowers the price of their option. The put seller actually can charge more at times of high volatility.

But US housing was never really volatile before 1997. Up a few percent here & there. Maybe once in awhile there would be a regional spike higher or lower, but on the whole home prices moved very steadily, if not slowly, higher. Home volatility has been historically low.

Lowering the "strike price" on a home, basically means increasing the down payment. This pushes up the value of a home owners "call option". It means they have more to lose if the price goes down.

The fundamental thing a large down payment does is it moves the strike price to the left, while the home value remains the same. The home buyer already has built-in "intrinsic value", and a pretty good cushion on which to make money. Similarly, the banks "loss point" moves way down (to the left, to the left), and given fairly stable returns over time, can pretty much count on a long, stable stream of interest payments from a call buyer who has got their financial ass on the line.

OK, so we've had this regime of stable returns, steadily incraesing prices, and fairly hefty down payments until about the past decade.

Then, what happens in any speculative bubble happened to buyers of home call options: They started buying more and more, and banks having lost their senses, also started participating, despite the fact that the increased volatility had actually imperiled the "value" of their vast holding of short puts (home mortgages).

The volatility pushed UP what people were willing to pay for call options, and increased the "premium" received for short puts. And slowly but surely, down payments shrunk, literally to nothing; ie the strike prices on homes equaled their value, and call buyers had almost nothing at risk except the transaction costs, which had actually grown considerably... but were still dwarfed by the potential gains.

And while prices were going up wildly, no really cared. Call prices, bought at little or nothing due to shriveling credit standards, leveraged returns to the sky. Instead of putting 20% down on a home & living in it, people put 3% down on 10 homes (that's 7, plus 3 more on credit cards, so I can retire in the Bahamas!).

And if your house went up 10% when you put 20% down, that was a nice 50% payoff.

But hell, if you put 3% down on 10 homes, and prices went up 10%, that was over 300% on the same money! Even with thick 1%+ transaction costs, it was still worth it.

And so our bubble was created. As usual, with high volatility and increasing strike prices (leverage), and the inherent risk associated with both.

So where are we now? Yes, yes.

Strangely, we have too many homes. That would be that pesky pursuit of 300% returns on 10 homes, not 1, kicking in.

Yeah, should have seen that coming.

Second, the banks hold short put options on assets (those 10 homes no one wants) that have plummeted in value. Yeah, this would be that pesky mortgage crisis I've been hearing about.

Yes, banks ALWAYS have a fairly limited upside on speculative bubbles, but typically (and theoretically) unlimited downside... well, at least to zero, or 100% losses on the assets.

Given that the cumulative sum of US homes was in the low to mid $20 trillion dollar range when this party got started, and prices have fallen off 40%, AND banks had the good sense to spike the party punchbowl with down payments of near 0%, well you've got yourself a recipe for a financial conflagration the likes of which cannot be imagined.

That tells us where we are. And might I add that this blog was around before this monster catastrophe even got started, way back in Dec 2006. And I'll try not to pull a muscle patting myself on the back here, but put all these option analogies together -- the increasing volatility, the shrinking "strike prices" (down payments), and you can see that while the individual call option owners (that's us) had quite a bit to lose (the collective "net worth" of homes in 2006 was many trillions), it was ALWAYS the banks that had the most to lose in a truly colossal meltdown of home prices.

You and me? We can just walk away. The banks just keep losing. And losing.

Or do they?

Our True and Goodly leaders have seen their way clear to taking our money, yes all that medicade and social security cash, and give it back to the fine local put sellers who are losing their shirts (ie Patty Moss et al).

So actually, our model is somewhat off. Because way down in the depths of the left hand side of our option payoff graph, the banks own a long put: They are putting their losses to the American people.

Way, way off to the left... something strange is happening. The banks have received something of almost mond-boggling value: A "free" put option.

Or is it 2 free puts options?

Because, if you look at the payoff diagram of a short put, you see it is the "horizontal" mirroring of a long put. A short put option has a flat payoff as prices increase (simple interest payment collection), but bends lower as prices fall (foreclosure).

Let's say banks on the whole have $15 trillion in mortgages outstanding. That "bend" lower is at $15 trillion and lower. But somehow, banks losses are being capped at an amount equal to what is probably their total capitalization, or about $1-2 trillion, I'd guess.

So somewhere around the $13 trillion mark, the linear negative payoff flattens. More absurdly, it actually seems to turn UP, and head back towards ZERO.

So the banks REAL PAYOFF seems to be a flat line, with a "V" in the middle. It pays banks to be nowhere near the bottom of this V. Be far above, or far below... but not in it's deadly center.

This raises all sorts of issues of fiduciary peril, the likes of which I hope you can clearly see.

But what I find far more interesting is the "offset".

We're STILL only long that one house (or one hundred millions houses... same diff). And Obama Jeebus W Bush has issued the banks somewhere between 1 and 2 FREE put options, meaning their losses are CAPPED below certain loss levels.

So WHO is paying for that put option... or options?

Ah yes... the answer is, of course, us! The American Taxpayer is paying for it.

So, to balance the equation of issuing banks a put option, we are going SHORT a put.

So now the tables are turned. What we thought was our collective "long call"on our homes, with unlimited upside and limited downside, has transformed. Our government has FORCED us to issue a SHORT PUT on the American housing stock, subjecting US to the full brunt of losses below a certain strike price.

But we don't receive interest. And with volatility at it's maximum, the value being lost is worth TRILLIONS.

THIS is the legacy we are leaving to posterity: The payoff of buying a home in this country has been fundamentally altered. Your call option is still in place. You can still win when/if prices go up.

But lurking on the dark side of the mortgage collective is the implicit short put option that will bail out the banks, AND STICK YOU WITH THE FULL BRUNT OF THE LOSSES.

The FLAT left-hand side of the payoff matrix is A LIE. YOU own the losses down there, NOT banks.

Maybe we should have known. How can banks, with their relatively thin capitalization, sustain losses FOREVER? Answer, they can't and they never could. There was always an implicit saving put option owned down there for them in the form of a government bailout.

So you are, as a home buyer, buying a huge call option when you buy a house, and now you KNOW that you are also PAYING for a put option as well. Never really "knew" it before... circumstances had always let it expire worthless, cuz prices inexoribly & continually went up. Not anymore. Prices CAN go down. A lot.

That fucking put option can take EVERYTHING.

Hmmmm...

This whole housing "investment" scheme seems a LOT less attractive. My upside is "unlimited" yes... but my fucking downside is also UNLIMITED. There's a "flat spot" there in the middle... but damn, we sliced through that like butter, and went straight to massive bank bailouts like flies go to shit.

Yes, yes... I will think twice about ever buying into this payoff matrix. It's not as good as it once was. Before now, it was all caviar and Lamborghini's. Now there's real pain if things don't work out.

No... I don't think I'll be doing that again.

So now... You Will See It Coming. Because THAT is what is going to happen. No more difficult to figure out than simply modeling the situation, and analyzing the payoffs.

It was this easy in 2006. But strangely, Patty Moss and the vast pool of experts the Bully and the rest of Bend media relied on had a curious dearth of insight into the problem.

This is a problem No One Saw Coming.

I did. You probably did.

Know thyself, motherfucker.

So when, in 5 or 10 years, when housing demand has simply Gone Away, and the Bully is interviewing Experts Who Cannot Explain What Is Going On, you'll know:

The payoffs have changed. "We" CAN LOSE. We are losing. But the debt? It's our kids problem, so who gives a shit.

Well, you should, cuz it's not really our kids... unless you're damn near dead already. It's us. The debt bomb is ticking, and we owe. Civilizations always die impaled on the pike of debt. Always.

The problem isn't going broke, it's worse than that. We'll lose this country.

To see our "bankers", look East.

Both the borrower & lender have nukes.

And a lender with nukes will always recover the vig.

Cowboy hats & bikini's... cures anythingDamn...

Thumbs up to NUKES!