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This is not the Great Depression

http://caps.fool.com/Blogs/ViewPost.aspx?bpid=101316&t=0...

The current credit crisis, recession, or whatever you want to call the mess that the world finds itself in right now has many moving parts and subplots, however when one thinks about it at the highest level it all boils down to one thing…risk. The problem with the United States’ economy is not one of liquidity like it was during the Great Depression when there was a run on banks and the government responded too slowly. Everyone’s favorite student of the Depression, Ben Bernanke, will make sure that there is plenty of money floating around out there. You can be sure of that.

Unfortunately the government's flooding of the market with money will not in itself necessarily cure what currently ails our economy. The problem that we currently face is actually a rapid, dramatic swing in sentiment from a complete ignorance of risk to extreme risk aversion.

During the bull market of the last several years, both banks and consumers levered up, consumers did so by taking on additional debt that banks made readily available and the Federal Reserve made too cheap, hedge funds levered up seeking to juice their returns, and worst of all investment banks levered up to 20, 30, and possibly even 40-1 because the SEC, Phil Grahm, and others idiotically decided to allow them to.

Leverage is great on the way up, but boy oh boy does it ever hurt on the way down. Just ask all of those CEOs like Aubrey McClendon, Chesapeke Energy’s CEO who was recently forced to sell nearly his entire stake in the company that he helped build because of a margin call. As companies delever, they are being forced to sell assets, some which are garbage and others which actually have value, into a risk averse market that has very few buyers.

Making matters worse, banks are afraid to lend money to companies, and even each other right now. They would rather use the liquidity that the Treasury and the Fed are pumping into the system to wind down their leverage to a more reasonable level than lend it to other parties.

This rapid reduction in the velocity of money means that regardless of how much cash the government prints it won’t do much good until banks begin to lend again. When banks don’t lend, many companies have problems. Credit has been the lifeblood of our recent economic expansion. When companies do not have adequate access to capital, things often grind to a screeching halt.

The painful deleveraging process is happening at the consumer level as well. As consumer confidence falls to levels never before seen and the unemployment rate rises, consumers are pulling back on spending, some are even, gasp, saving money for a rainy day. Unfortunately, those who are still willing to spend money like a drunken sailor often find themselves unable to do so as banks are unwilling to lend money, shutting down the home ATM by pulling HELOCs and actually having reasonable mortgage standards, lowering limits on credit cards, etc…

So this is where we find ourselves today. The question is, what will fix this and how bad will things get. I have been wracking my brain trying to come up with an answer to these questions and here’s what I think. The only thing that will fix the risk aversion that we are currently seeing and restore confidence to both consumers and banks is…time.


In time housing values will eventually find a bottom. When housing does bottom, banks will no longer have to worried about the mortgage backed securities, and all of the other exotic products that were developed over the past decade because the bad ones will have blown up and good ones will remain.

In time banks will be so overcapitalized that they will eventually, gradually begin to lend again.

In time, the leverage that banks took on will be wound down.

During the period which all of these things are occurring, the United States, and probably much of the rest of the world will experience a recession, the length and depth of which will depend upon how long the deleveraging, recapitalization, and restoration of confidence take.

People who claim that we are headed for another Great Depression have no idea what they are talking about. The unemployment rate hit 25% during the peak of that period. It currently sits at only 6.1%. I know that the BLS and government employment numbers probably underestimate the level of joblessness, but still even in a worst case scenario few envision the unemployment rate hitting double digits. If it does, that brings us the sort of pain that we had in the terrible, yet far from depression like 1982-1983 recession.

The Federal Reserve and the Treasury are hell bent on preventing a depression, they will print, print, print money until banks are choking on it and have to eventually lend it out. Furthermore, the next President (which I strongly suspect will be a Democrat) will work with Congress and the Senate to spend, spend, spend money to prop up the economy. The last thing that a new administration wants is a depression. They will completely forget about fiscal restraint and the budget deficit and do whatever it takes to prop up the economy giving rebates to millions of people, earmarking tons of money for new infrastructure projects, on, and on, and on…

Is this the right thing to do? I’m not sure that it is. The likely outcome of this is that the current recession will be followed by yet another bubble of some sort as well as massive inflation, followed by another possibly more painful bursting. But that will be someone else’s problem a few years down the road, not theirs. Just ask Alan Greenspan.

I'm not saying that everything is all peachy, just that it isn't as bad as the doomsday, get your canned food and guns ready, end-of-the-world crowd say it will be. Keep averaging into the market a little at a time, buying stock in quality companies at exceptional prices. Eventually things will turn around, even the Great Depression ended and this is no depression.

Deej

P.S. I am not taking anything for granted and I am doing as much research as I can on this subject. I am about to start another book on the Great Depression called The Forgotten Man.
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Absolutely fantastic write-up Deej. While I mostly agree with that great write-up, allow me to play devil's advocate.

I don't know about the rest of investors currently in the market, but my biggest fears in this investing environment in not future negative growth, unemployment, overvaluation relative to future earnings, or even the clogged credit system, or corporate bond yields peaking (signaling future bond defaults).

My biggest fears are the effects of all this on the Credit Default Swap market (the Trillion dollar elephant in the room), which could have a domino effect the likes of which we have never seen before. This type of derivative wasn't around during the Great Depression, over even the 1982-83 recession. I'm sure many realize by now how severe these instruments can be.

If one firm fails (and hence defaults on its bonds), it could take down 5 other firms that sold insurance on that company's bonds (too cheaply, with a large notional exposure). And those 5 firms can cause the defaults of 10 more firms who were selling insurance on some of those 5 companies' bonds.

The big risk is the obvious domino effect this could have as more corporate bonds default, causing more corporate bonds to default. (Which according to current corporate yields, and well respected investors, will be a very large number).

The good news is the gov. is now guaranteeing bank debt.

However, banks weren't the only ones involved in CDSs. I predict many insurance companies (which the gov. is currently not guaranteeing the debt of) will fall, as most have sold thier bond default insurance way too cheaply.

CDSs are sold not only on financial institutions' debt, but company stalwarts like GE as well. All these financial institutions have so much exposure to corporate America's (and the rest of the world's) corporate and mortgage bond defaults, that it could cause a large portion of corporate americal to dissapear in a short time frame.

And then once the CDSs explode, this leaves all of the other counterparty risks on the table that those institutions were exposed to failing to meet their obligations. (Like currency and commodity hedging that other companies depend on).

Its all pretty scary stuff. I don't mean to scare people, but the panic is not without merit. What gives me great relief is that the U.S. government IS NOW aware of the significance of the problem (and plans to somehow quickly regulate it) and how it can effect nearly every financial institution in corporate america. It doesn't hurt that the smartest, and perhaps most ethical and respected, investor on the planet is bullish on America and equities.

Don't get me wrong...I am invested in U.S. equities as well as corporate bonds and cash, but I'm fully aware of the VERY significant risks ahead, even at historically VERY cheap fundamentals.

I wonder if the average investor is aware yet of just how significant the CDS market is? This is my fear. That they haven't priced this in yet, b/c they aren't aware of THIS somewhat complex problem and how big and intertwined it is, and are only focusing on much lower earnings and very high unemployment.

Regards,

Frank
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Some have long been aware of this problem, including Farifax Finacial's Prem Watsa (called the Buffett of the North" by) Businessweek.

I'd encourage of you to take a look at his letters to shareholders (going back to early 2000) how how he predicted this exact scenario.

Link to shareholder letters:
http://fairfax.ca/financial.htm

Disclosure: I am a shareholder in Fairfax Financial.
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Frank,

Interesting concerns. Seems we don't know what is around the next bend or where the speculators have been.

Check out this article and then guess as Abbot and Costello use to say "who's on first?"

http://www.atimes.com/atimes/Global_Economy/JJ22Dj03.html


Bears
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It seems scary to me that you even had to start a post titled "This is not the Great Depression." This sounds very similar to Bear Stearns saying they are not having any liquidity problems two days before they went bust, or Bernanke saying the economy is sound one week before he lowered rates emergently by 50 basis points. The only difference I can see is that there is a lot of money being printed, so instead of a deflationary depression we might have an inflationary one. I'm not sure which is worse, it may be that an inflationary one is worse. Remember, Greenspan testified today that his whole understanding of how the economy and markets function and respond to events was wrong. It maybe that Bernanke's understanding is not reality either.

I'll believe your prediction when we start to turn the corner.

Larry
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Thanks Frank. You're absolutely right, derivatives could end up being a major problem. That's part of what is adding to the uncertainty right now and causing banks to tighten their purse strings.

Funny that you should mention derivatives, I wrote a little on the subject just this morning:

"I anyone else as disgusted with Alan Greenspan as I am?

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” - Alan Greenspan circa 2004

I have been thinking about Alan Greenspan's role in the current financial crisis this morning, probably because he is scheduled to testify today before the House Committee of Government Oversight and Reform. I'm sure that I wasn't the first person to hammer on "The Maestro," but I have been bashing him in my blog since February. He absolutely disgusts me. What I wrote about him back then still applies today, but the more we find out about this financial crisis, the more I feel that he was as responsible as anyone for the mess that we currently find ourselves in.

Here's what I wrote on the subject back in February:

"Because a huge chunk of this mess that we’ve gotten ourselves into now is Alan Greenspan’s fault. Did Bernanke lower the Federal Funds rate to almost nothing and leave it there for years creating the mother of all housing bubbles...no, it was Greenspan. He borrowed from Peter to pay Paul as the saying goes, or in this case I suppose that he was borrowing from Ben to pay Alan, pushing off a little economic pain years ago [the bursting of the tech bubble] for a much worse situation today. Then just when things are about to get really bad, Greenspan just rides off into the sunset and makes more money than the average U.S. citizen could ever imagine in the private sector by writing books, consulting, and giving speeches while poor Bernanke is left to clean up his mess. I realize that Bernanke is not blameless in this whole situation, but he certainly didn’t start it."

I understand that everyone makes mistakes, even me if you can believe that, but what infuriates me more than the mistakes that Greenspan made is his complete lack of accountability. If you screw up, own up to it. I will have a lot more respect for you. Greenspan has repeatedly refused to accept any responsibility for his role in the financial crisis

This morning I came across a great article on Mr. Greenspan and how he is as responsible as anyone for the current financial crisis: Taking Hard New Look at a Greenspan Legacy (http://www.nytimes.com/2008/10/09/business/economy/09greensp...)

I already mentioned how I feel about Greenspan's role in inflating the housing bubble, but this article talks about the role he played in the world of derivatives. For those of you who aren't familiar with them, and I suspect that most who visit this site are by now, derivatives are completely unregulated...at least until now...financial instruments that were developed to hedge against investment losses.

The creation of and trading of derivatives, along with securitization, encouraged companies to take much more risk than they normally would have if they didn't have this form of insurance and if they actually had to keep some of the paper that they were issuing on their books. Since 2002, the derivatives market has increased nearly fivefold, from $106 trillion to its current $531 trillion.

Instead of protecting companies from risk, derivatives are now actually making banks more risk averse and less willing to lend money to each other. No one really knows who has exposure to what and everyone is skeptical of how derivatives contracts are being valued.

For over a decade Mr. Greenspan was one of the leading proponents against government regulation of the derivatives market and at the time his opinion carried a lot of weight. Here's what he said on the subject at a Senate hearing in 2003 “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so...“We think it would be a mistake” to more deeply regulate the contracts.

Anyhow, Greenspan and his smug refusal to acknowledge that he played any part in the mess that we find ourselves in today makes me sick. Perhaps he will change his tune in today's testimony, but I doubt it. I hope that they hold his feet to the fire.

Deej"
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Here are a couple of interesting articles related to the CDS topic that i mentioned earlier.

Ben Stein recently explains some of the risk in plain (and scary) english:

His first article:
http://finance.yahoo.com/expert/article/yourlife/109609

His more recent article:
http://finance.yahoo.com/expert/article/yourlife/115733

-----------------

Although there is a major systemic risk problem in this type of derivative, the media may have gone too far in spreading the fear, in my opinion (given the recent government interventions to limit the insolvency/counterparty portion of the risk). However, their is still potential for a more systemic meltdown b/c the gov. may accidentally let more "Lehmans" slip through the safety net.

Many intelligent people, including Ben Stein, and the folks on CNBC seem unaware that the $60 TRILLION dollars in outstanding notional value of CDSs that are reported in the press are grossly overstating the severity of the problem, because of the "netting out" effects. Though I agree with Dilian Rattigan, that "They had less regulation than a slot machine in Reno."


This brief, obscure article explains why: (I'm sure you can find better articles that may carry more merit, but this one is short and sweet)
http://infoproc.blogspot.com/2008/09/notional-vs-net-complex...


The previous settlement auctions generated some concern in the market, with investors fearful about the size of the payments the final settlement price would mean for sellers of the credit default swaps. It appears some of these fears may have been overblown.

For example, on Wednesday the DTCC said the settlement of the outstanding trades on Lehman's credit default swaps resulted in payments of $5.2 billion from net sellers of that protection to the net buyers of the protection. Prior to this, much larger numbers were thrown around because some forecasts were based off an estimated notional value of Lehman's CDS of $400 billion.

With the final value of a Lehman CDS put at just over eight cents on the dollar, there had been some estimates the final payments on the Lehman CDS would be over $360 billion. Turns out, those estimates were very wrong.
----------------------

While this confusion still seems unclear to the media and other highly followed bloggers/pundits (by them scaring the crap out of people) it has been a bit overstated -(causing more of decline than may otherwise have been the case).

I wrote this to clear up my previous message under this thread. While a domino of defaults can occur b/c of CDSs, this is now likely to be limited by the governments around the world, through minimization of the counterparty/insolvency risks that may trigger auctions that result in settlements that are closer to notional values.


That is why I am still buying!

(Though my hand shakes a little when i click the mouse).


--Hope I clarified my view a bit more with this post.

Cheers,

Frank


P.S.~ I'm not picking on Ben Stein, I think he is a very sharp guy. I just think the situation is not being well explained.
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"This is not the Great Depression"

I agree. It's more like a crater of biblical proportions or a black hole sucking $$$ by the trillions.

Where do the lost trillions go anyway? Is there a bank that keeps them?
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People who claim that we are headed for another Great Depression have no idea what they are talking about. The unemployment rate hit 25% during the peak of that period. It currently sits at only 6.1%. I know that the BLS and government employment numbers probably underestimate the level of joblessness, but still even in a worst case scenario few envision the unemployment rate hitting double digits. If it does, that brings us the sort of pain that we had in the terrible, yet far from depression like 1982-1983 recession.

I think the problem is analyzing this downturn from the perspectives of last several downturns. This is a mistake, IMO. It has a global dimension and is a result of simultaneous bursting of many bubbles at a global scale: commodities, property and equities. It is easy to say that this is only a deleveraging taking place at all levels. What is not easy is to realize the implication of this deleveraging. The implication, IMO, is a sea change in the way people in the developed world lead their lives. Credit has been a part of this world's lives for more than a quarter century. This is coming to an end. This will impact the growth rate of companies as people start spending within their means and growth resumes at a far smaller scale over the next few decades (yup! decades not years).

This may not be a great depression but this is a life changing event at a global scale unlike the downturns in the last 50 years. This downturn is likely to see the rise of China as an economic superpower with its massive reserves and wherewithals for continued spending. Very much the similar phenomenon that led to rise of US as a superpower in the 20th century. The power center is shifting in a decisive manner.

We are likely to see double digit unemployments. They could go upto 25%. The collapse is on a gigantic scale with no potential of recovery in the same fashion as earlier downturns due to permanent destruction of spending habits and easy credit. It is true that due to a much better global management of this downturn, we will not see some of the excesses of the great depression era but that is not reason to assume that we will miss that severity. 25 years of non stop spending. This is the paying time, finally. The payment process has begun with several trillions of dollars worth of bailout on a global scale. The effect is yet to trickle to the grassroot level, but it surely will.

So it is only in this repsect that we do not compare it to the great depression of the 20th century. But it is likely to be the one for the 21st century. The pain may be less severe than the last one simply because mankind has advanced a lot during the last 100 years. It is very much similar to the impact that epidemics from modern viruses wich do not wipe out large swathes of population as they use to a century ago. But to say that the viruses of today are not as demonic as of the past won't be correct.

I'm not saying that everything is all peachy, just that it isn't as bad as the doomsday, get your canned food and guns ready, end-of-the-world crowd say it will be.

I think it is time to get the canned food ready if not the guns, yet.

Keep averaging into the market a little at a time, buying stock in quality companies at exceptional prices.

Averaging is good but calling the current prices exceptional is something that I would not agree to. They may be a low but exceptional only in comparison to the past levels and may not be so to the future levels for the reasons I have already discussed.

Eventually things will turn around, even the Great Depression ended and this is no depression.

Everything will turn around indeed. Great depression ended but to a huge cost. 3 years to bottom out at 11% of the highs and 23 more years to rise back. This is no depression, so far. Only 50% (close to) ride down to the bottom as of now and only one year into this mess. I remember people saying several months ago that there is no way this will be close to the tech crash which was once in a century event. Not anymore. I remember people calling oil at $80 its bottom and justifying OPEC cuts as an effective mechanism to keep its prices in check. I guess not anymore at below $65.

If not anything, this downturn teaches us that valuations alone are not the right metric to determine the crash potential at a massive scale. Without P/E of 100+ and without terrorist attacks we can have a bigger heart attack is now well proven. I guess this is one of the reasons why no one anticipated this.

Anurag
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"I guess this is one of the reasons why no one anticipated this."

No one in this service, that's for sure. However there's many outside of this service that have. Unfortunately for most, we chose to take the optimistic outlook.

For those that remain optimistic, they may and can be eventually rewarded. In the meantime I for one has gone into trading overdrive and have taken advantage of the carnage going on.
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In the meantime I for one has gone into trading overdrive and have taken advantage of the carnage going on.

I bought aggressively, even at a bit of margin, till the point DOW hit near 8000 a week or so ago. Since then I have stopped as I have run out of cash and feel that building cash reserves has to be done and trading must be stopped as global economies finally dive into recession. Much cheaper prices are possible. It is not visible if that will happen but the potential is high.

I am not selling and hope that I don't have to as the job market worsens. I am in a hi-tech job and the potential of a job loss is significantly higher now. I am already turning into a depression mode by starting to aggessively restrain spending at all levels. Still keeping the regular 401 and IRA contributions intact. That is the only risk I am taking as of now.
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I'm surprised i haven't seen much talk about currencies yet on these boards, given the very dramatic declines of other currencies against the dollar recently (putting the yen aside).

Hopefully, not many global gains companies thought their currencies would continue to appreciate against the dollar and took unwise currency derivate bets. Or hopefully, none of them made the usual mistake of borrowing money in dollars (thinking it will continue to depreciate) and earning in their local currencies. Might be worth digging into the financials of some of our foreign holdings to see if there were any speculative bets going on in those companies.
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"Much cheaper prices are possible"


Precisely the reason for my trading going into overdrive. Sold out most of my GG positions at double digits and got them back at ridiculous single digits and actually ended up with a meaningful cash position I'm holding for better prices on some great US stocks.

I thought earlier today when US futures were limit down on all fronts would be day to go all in. It does not look like I will get that chance. Oh well, maybe next week?
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"Credit has been a part of this world's lives for more than a quarter century. This is coming to an end. This will impact the growth rate of companies as people start spending within their means and growth resumes at a far smaller scale over the next few decades (yup! decades not years).
"

This is a key point where I disagree Anurag -

Credit has become an essential part of the system and will not be disposed of. We've gone through de-leveraging cycles before, although never on such a massive global scale ... this will cause a much greater downturn, but it won't cause such a fundamental change in the overall system.

Consider the solutions of the Fed and other central banks ... they are trying to increase liquidity, give cash infusions to banks, secure bank-to-bank loans or anything that will support the ability of the banks to lend. You can argue about the effectiveness of their methods to date, but you have to keep their the intentions in mind. Bernanke is clear about his stance thinking outside the box on this one and coming up with more radical approaches if necessary to getting bank lending back in place.

Will the banks be more conservative for the next few or several years? Sure. Will the government step in with additional regulation? Yes. However, the market will stabilize at some point and bull market thinking will resume (in other words - greed will set in). Once this happens, regulating banks will be every bit as difficult as herding cats. Many will remain conservative, but newcomers will start crazy expansion plans through arbitrage - borrow cheap and lend at a premium. This will create competition among banks that means even the conservative ones will have to take more risks to stay competitive. Bubbles will form again and burst again - its the way markets fundamentally work and it won't change. Note that this isn't new - consider the Italian banks lending in the middle ages with their booms and busts and the economic havoc created periodically - the difference is mainly in scale, global reach, increased speed of development, etc but the fundamental process remains.

Watch the bubble form and burst, learn from it, position accordingly and remember - everyone will live the bubble and burst, but most will not even try to understand it. Information arbitrage, time arbitrage, straight-up gambling, call it what you will- I will never get a margin account, but will always be saving for the stock market, focusing on the trends and discussing the theories.

-John T
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On the home owner/buyer side of credit, I don't believe there will be any magic bullet. There will still be lending but it will be based on credit score and existing debt, as it should.

Corporate credit. Same again, daily receipts make to the operational credit pool (borrowing against billing invoices) Credit rating will determine interest rates and ability to get good terms.

Consumer credit. This one will be hard and many will get hurt. If a class of bankruptcy could be set that simply allows extended years on credit balances at fixed rates, that could help. That still leaves people locked into leases and car loans. Spoke with a car dealer once and asked how people could support some of these lease prices. His answer, they cant. He went on to explain about a couple who came in and got two new vehicles for a combined lease of $1200.00. He said they were not good credit risks. That was just before the roof began to fall in.

When speaking of the great depression, I feel you must remember the run on banks. It closed down 5000 of them by the time it was over (yes, they were small banks, but that was the us financial system. That called in loans and the spiral continued. The government does seem to be stepping up ... or stepping in, but I don't believe they have a clear Idea of what they are stepping into.

Bears
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All interesting theories but I doubt anyone knows for sure how any of this will play out. It could take turns beyond people's expectations.

"Anyone who considers arithmetical methods of producing random numbers is, of course, in a state of sin." (Quoted in Knuth, 1968, Vol. 2, also in Goldstine, 1972, p. 297.)
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This is a key point where I disagree Anurag -

Credit has become an essential part of the system and will not be disposed of. We've gone through de-leveraging cycles before, although never on such a massive global scale ... this will cause a much greater downturn, but it won't cause such a fundamental change in the overall system.


I should have made it clear. By credit, I mean the enormous personal debt that ppl carry and not the credit at a business level. Consumer spending is 2/3 of the US economy and I get British economy too. As people learn to live within their means, the spending will temper.

I think the global credit crunch will come to an end much earlier. A large improvement would have been made by the summers next year. What we are now seeing is the regular crash but at a gigantic scale and intensity.

My post clearly differentiated between the 1932 depression and the potential upcoming one. During that period ppl lost their savings with massive and widespread bank failures. The steps taken today have prevented those events. But then there are new ones at play here.

This recession will devastate those who have loose jobs and can't find new ones, even if they have 6 months emergency cash and have lived well within their means. The mortgages will act like millstones tied on the necks. Families with children will be hardest hit. These things have happened in the past also but the likelihood of a severe and prolonged slump is much higher especially when coupled with the real estate crash. Today we can't even get out of these mortgages. My total debt payment (credit cards, car, mortgage) is less than 30% of my income. Have 6 months of emergency cash. But a prolonged downturn with job loss (if it happens) and no replacement and stuck with a -20% equity in the house is likely to be anything but pretty. Equity liquidation will be the only choice left. Far too many ppl are in in a far worse position than I am.
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In the meantime the crater is beginning to heal.

From the heartland of the mortgage crisis, the Miami Herald is reporting today that sales of existing homes have picked up for the second consecutive month. By more than 50% in some areas due mainly to prices going back to 2004 levels. Not good for my own home value which I bought in 1990.

Now it looks like I won't have a problem related to the max on capital gains exempted from taxation. Ouch! but the problem with the mortgages are beginning to heal. Home values apparently are not heading to zero and Banks holding foreclosed properties will actually recover significant monies from their holdings.

I thought I'd cheer you guys up :D

http://www.miamiherald.com/business/story/740881.html
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