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Stuck Between a Rock and a Soft Place
By Bill Bonner | Published  12/21/2006 | Stocks | Unrated
Stuck Between a Rock and a Soft Place

Today, we lead with a question from a dear reader:

"I am a happily married man...I love my wife; she's beautiful, smart and she loves me. But here's the problem - she is an actress. I've always heard that actresses make bad wives, so I'm thinking about divorcing her. Am I being an idiot?"

Answer: Yes, you are an idiot. We don't see what your wife sees in you. You'll be lucky if she doesn't leave YOU.

OK...the actual question is a bit harder...but not much. Our reader is wondering whether he should stick with a good investment, or speculate on the housing market.

"I know you do not give advice but I was just curious what you think about my financial position and/or what you would do in it.

"I own a 14-unit apartment building in Huntington Beach, California. I bought it a couple of years ago. There has been about $1 million in appreciation. My wife wants to sell, but I bought it before we were married and had our first child. I always considered it as my retirement after paying for 30 years.

"The problem with selling would be:
1- capital gains taxes,
2- what to do with the money, and
3- the fact that we live in the front owners' home of the same property.

"We would have to move and my wife would want to buy a big, expensive house.

"I feel stuck because my property taxes are relatively low as I purchased the building from my father and I was able to benefit from a California tax law that basically lets me keep his tax rate.

"I have a feeling that the bottom is going to fall out of our real estate market. Would you rather be the owner of an apartment building that has historically always been at 100%, cash out the building and buy a home, or sell and just rent?

"I don't think my wife would want to rent for long, however. We are looking to find a home for long term so we can grow our family.

"Sorry for the rambling, but what is your position?"

We are glad you asked...because it gives us a chance to make a point.

In both the cases, the man is caught between a rock and a soft place...between the private world he can understand and master, and the vast public spectacle, with its frauds, conceits, and wild guesses. In both cases, what he knows from his own personal experience is at odds with what he thinks he knows from reading the paper.

The husband in our first example believes actresses make bad wives. Perhaps he is right, in general. Statistically, it could be true. But statistics do not make a man happy or rich. Instead, it is his individual circumstances that count. Actresses may be a vain and fickle lot; but he seems to have found a good one. The fact that other actresses may be more trouble than they are worth should be irrelevant to him.

Our dear reader, meanwhile, believes property prices will fall. Though we've said so many times ourselves, we claim no credit for giving him that idea. We're hardly the only ones to think so. But at least we don't take the idea seriously enough to ditch a good situation just to take advantage of it.

If we were thinking more clearly this morning, we'd have more to say about this. For now, we will let it go with the following advice: statistically, the average man may die at 73; but if we were you, we wouldn't drop dead until we were good and ready.

*** The hottest new thing in capitalism is the rise of "private equity." Groups of rich investors pool their money, borrow still more money, and buy companies. Ten years ago, these groups gathered together only about $10 billion; today, the figure is higher than $300 billion.

Michael Lewis comments:

"Even those gargantuan numbers fail to do justice to this peculiar financial event. Private equity is not served up without piles of debt - the typical debt-to-equity ratio of a company after it has been bought by a private-equity firm is two-to-one - and so the actual purchasing power in the hands of private equity fund managers is something like three times as much as they have in their bank accounts. It's as if a giant and especially successful new stock market has been created alongside the old one."

Our Australia-based correspondent, Dan Denning, adds this:

"The tech bubble may turn out to be a dress rehearsal for an even bigger bubble and threat now. Why do I say that?
 
"Here's the difference between today and 2000. Seven trillion dollars was wiped out when the tech bubble burst, proving that it was largely fictitious wealth. The real economy didn't really miss a beat...because the money people lost was not money people really had.

"It was paper gains, never realized, and ultimately lost...So all in all, for the most part, it was easy come, easy go.
 
"Today is much different. People have more at stake (the roof over their head), and less margin for error (fewer real assets on the balance sheet, more liabilities) and there is a connection between private equity/money shuffling capitalism and the housing markets...the connection is debt. And the debt is what makes this bubble different and worse than the last bubble.
 
"All that is at the household level. If the private equity boom continues (as I believe it will), it will also leave a mountain of debt rubble after the bubble bursts at the corporate level. It's odd, of course, that something as ephemeral as a bubble can leave real debt. Yet because the private equity guys are paying 40 cents for a $1.20 worth of future earnings (making up the difference with borrowed money), the newly-private companies are saddled up with debt they wouldn't have otherwise taken on before. This is, as the article notes, not real investment in new productive assets. It's debt that merely facilitates the transfer of ownership of the company's assets.

"And if all these smart, well-paid, even better-tailored, and perfectly coiffed money shufflers get it wrong - synergies not realized, profits not optimized, value not extracted - then you get a company performing worse than before, with considerable liabilities, and no recourse to additional sources of capital.
 
"This is probably when the private equity guys will try to re-float the company on the gullible public (if they are not fired or jailed first). But who is going to buy a freshly disorganized, debt-ridden company as a new public offering? It's like expecting to see a brad new baby boy come out of the womb...and seeing Frankenstein instead...a not-quite stillborn abomination of corporate parts, crudely reassembled (after) being disassembled, and presented as a new life.
 
"Some schmuck or lump will ante up. There's always an idiot. But there is something different about this bubble that's sinister and dangerous. And it does remind me that Mary Shelley was making a good point with Frankenstein...science in its hubris sometimes forgets that there's a lot it doesn't know. It messes with the laws of nature and the results are invariably bad. Financial innovation may have reached that point too...where we've disfigured the institutions of capitalism so badly that we are bound to get a monster in short order.
 
"We've gotten used to thinking financial crises can happen and be ameliorated with more liquidity. Peso Crisis, Russian default, Amaranth...none of them brought down the house. We have become desensitized...or blasé about real risk. For most of us, the riskiest thing we do in any given week is cross the street or drive a car. We're not going to starve, or be killed by a neighboring tribe (unless you are in Iraq), or fall victim to cholera.
 
"Of course we are not immune to the effects of a genuine financial pandemic. And this latest strain of affluenza saddles up private and public balance sheets with huge liabilities to go along with declining asset values.

"It's the kind of trade only a very stupid or very immoral man could make. Unfortunately, there are a lot of both in the world right now. And most of them are living in the best apartments in Mayfair, Manhattan, and Manley Beach...for now.

"It wasn't really until today that I ever thought I'd actually live through something as audacious and destructive as John Law's Banque Royale and the Mississippi or South Sea Bubbles. But I think we're watching it happen right before our eyes.

"Biggest...Bubble...Ever."

Bill Bonner is the President of Agora Publishing.  For more on Bill Bonner, visit The Daily Reckoning.