Dear Citi: I Love Free Markets

One of my favorite pastimes is watching greedy people get slapped in the face by the good old free market. This weekend’s greedy bastard is Charles Prince accompanied by Stan O’Neal and a plethora of hedge fund managers. If you don’t know today’s players they are the ex-CEOs of Citigroup and Merrill Lynch. Their greed started about five years with extremely low interest rates and a booming housing market. This was a perfect storm for banks. Loans were flying off the shelves and risk was almost nothing. If an owner couldn’t pay their loan they could just sell their home for a tidy profit, the bank was paid what they were owed and everyone was happy.

Fast forward to 2006 when investors had caught on to this housing craze. They could buy a condo in Miami, pre-construction for $15,000 down on a $300,000 unit. Sell it for $350,000 a year later and come out with a hefty $50,000 profit on a $15,000 investment. The champagne was flowing for everyone. But the sad truth is condos and houses only hold real value for one simple reason. Someone can live in them. If the people who intend to live in a house can’t afford said house they will not buy it. In late 2006 the boom days slowly ended as sellers found their potential buyers priced out of the market. “You mean I make $60,000 and can’t afford a starter home? I’ll rent thank you very much.” Now if an investor can’t rent a property for as much as their mortgage they’re screwed. The spiral begins.

More sellers + less buyers = Foreclosures

How does this affect our featured scum bags you ask? Let me explain. See when the market started to get over heated they created these great loan packages, ARMs, balloons, nothing down, interest only to get buyers into homes. And the buyers kept coming. But when the actual home owners were priced out the banks fueling the fire are left holding the bag. Now, if a buyer doesn’t have to put any money down on a loan, they have no risk. The bank holds everything. When the loan resets at a higher rate the bank loses all the value of the loss on sale.

Check out Fortune magazine from October for a detailed look into how banks packaged loans and sold the risky debt to hedge funds. It’s an extremely interesting story.

So now we have a declining market with no investors, no exotic loans, increased lending standards and desperate sellers. Prices are going to fall for the next few years. Sorry to be the one to break it to you. What this means for banks is writing down extreme losses on the loans that have essentially no collateral in a falling housing market. Citigroup already wrote down $6.5 billion in the third quarter and estimates are another $8 - 11 billion in losses are coming. You can also expect the announcement of some failed hedge funds in the next year as they have to actually account for their losses.

The free market always wins. Caveat Emptor - Buyer Beware.