Now you see it now you dont

Folks, this morning there's a very interesting article in the Sunday Midday which talks about the greed of people and the bursting of the asset bubble. (http://www.mid-day.com/news/2009/jan/040109-Bharat-Nagar-slum-dwellers-lucrative-offers-turned-down-builders-recession-Mumbai-news.htm)

So what went wrong except for the fact that they were asking for 2 Crores for land that they had usurped from  the common taxpayer ?

Simple the property price rise as explained earlier by me was an "asset bubble"

Here's a very interesting anecdote sent to me by a reader that describes how an "asset bubble" builds up and what are its consequences.

Once upon a time far far away, there was a little island country. The land of this country was the tiny island itself.

The total money in circulation was 2 dollar 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 which had no inherent value. B and C each owned 1 dollar. 

 

Citizen A	Citizen B	Citizen C	Total Capital of country
Land	$ 1	$ 1	$ 2

2. B decided to purchase the land from A for 1 dollar. So, A and C now each own 1 dollar while B owned a piece of land that is worth 1 dollar. The net asset of the country = 3 dollar.

Citizen A	Citizen B	Citizen C	Nett Assets of country
$ 1	Land ( worth 1 Dollar)	$ 1	$ 3

3. 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 dollar.

• A has a loan to C of 1 dollar, so his net asset is 1 dollar.
• B sold his land and got 2 dollar, so his net asset is 2 dollar.
• C owned the piece of land worth 2 dollar but with his 1 dollar debt to A; his net asset is 1 dollar.
• The net asset of the country = 4 dollar.

 

Citizen A	Citizen B	Citizen C	Nett Assets of country
Loan to Citizen C of $ 1	$ 2	Land (worth 2 dollars) less Debt of $1 to A = Nett of $1	$ 4

4. A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar from B and acquired the land back from C for 3 dollar. The payment is by 2 dollar 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 dollar.
• But since he owed B 2 dollar, his net asset is 1 dollar.
• B loaned 2 dollar to A. So his net asset is 2 dollar.
• C now has the 2 coins. His net asset is also 2 dollar.
• The net asset of the country = 5 dollar. A bubble is building up.

Citizen A	Citizen B	Citizen C	Nett Assets of country
Land (worth 3 dollars) less Debt of $2 to B = Nett of $1	Loan to Citizen A of $ 2	$ 2	$ 5

 

 5. 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 dollar. The payment is by borrowing 2 dollar from C and cancellation of his 2 dollar loan to A.

• As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollar.
• B owned a piece of land that is worth 4 dollar but since he has a debt of 2 dollar with C, his net Asset is 2 dollar.
• C loaned 2 dollar to B, so his net asset is 2 dollar.
• The net asset of the country = 6 dollar. Even though, the country has only one piece of land and 2 Dollar in circulation.

 

Citizen A	Citizen B	Citizen C	Nett Assets of country
$ 2	Land (worth 4 dollars) less Debt of $2 to C = Nett of $2	Loan to Citizen B of $ 2	$ 6

6. Everybody has made money and everybody felt happy and prosperous.

7. One day an evil wind blew. 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 dollar in circulation, I think after all the land that B owns is worth at most 1 dollar only."

A also thought the same.

8. Nobody wanted to buy land anymore. In the end, A owns the 2 dollar coins; his net asset is 2 dollar. B owed C 2 dollar and the land he owned which he thought worth 4 dollar is now 1 dollar. His net asset becomes -1 dollar.

C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset is still 2 dollar, his Heart is palpitating.

The net asset of the country = 3 dollar again.

 

Citizen A	Citizen B	Citizen C	Nett Assets of country
$ 2	Land (worth 1 dollars) less Debt of $2 to C = Nett of -$1	Loan to Citizen B of $ 2	$ 3

 Who has stolen the 3 dollar from the country?

Of course, before the bubble burst Everyone thought B's land was worth 4 dollar. Actually, right before the collapse, the net asset of the country was 6 dollar in paper.  

What must be kept in mind is though C's net asset is still 2 dollar, his heart is palpitating about the inherent value of the land owned by B used as collateral for the loan so he calls in his loan to B. 

The net asset of the country = 3 dollar again.

9. B had no choice but to declare bankruptcy. C as to relinquish his 2 dollar 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 dollar.
• B is bankrupt; his net asset is 0 dollar. (B lost everything)
• C got no choice but end up with a land worth only 1 dollar (C lost one dollar)
• The net asset of the country = 3 dollar.

 

Citizen A	Citizen B	Citizen C	Nett Assets of country
$ 2	$ 0 (bankrupt)	Land (worth 1 dollars) (loss of $ 1 on bad debt of Citizen B) = Nett of $1	$ 3

 

****************Moral of the Story***************************

In every cycle, 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 -

· When a bubble is building up, the debt of individual in a country to one another is also building up.

· This story of the island is a close 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. This can happen in a multi currency system

· An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar. In a realistic scenario the value could actually drop to a fraction of the original value.

· When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. The asset could shrink or in worst case, they go bankrupt.

· If there is another citizen D either holding a dollar or another piece of land but refrain to take part in the game. At the end of the day, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw on a notional basis.

· When the bubble was in the growing phase, everybody made money.

· 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.

· The actual worth of land or stocks depends largely on psychology of demand and supply so we would be wise to keep in mind that the value of the assets you hold is virtual.

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When we put that in context of the article from Property Times Mumbai this week (http://www.narains.com/Text-Residential-Expect-the-Unexpected.html) and we get a very interesting situation as regards the property prices in Mumbai.

I had written about Mumbai prices in my article in 2007 ( http://theindipatriot.blogspot.com/2007/07/property-prices-in-mumbai.html ) and I had mentioned there would be a new 3 year or so low post 2008 when the asset bubble went bust and people like Citizen B came to their senses. ( it started mid 2007 so close enough but the way the velocity of money has compressed the 2008 date may make the 3 year period shorter)

The article also says that according to me that this low will be followed by a new high as per the chart shown in the article.

At that time in 2007 I had advised my readers who looked to me for advice not to jump in on the rising market but to wait for the dip to get in, my call now is Q2 2009 end onwards may just be the time to start reaping the benefits of the patience you have shown.