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Building a House of Cards


Someone effectively pulled 10's out of the deck, thereby creating a greater edge for the casino and a greater disadvantage for the home buyer.

Minyanville welcomes it's newest professor, Mark Bloudek. Mark began working with his current business partner in early 2002. He has specialized in Arbitrage trading in the FX market, private venture funding , gaming, and alternative investments for five years. He is also Managing Director at Armada Capital Partners in Seattle, WA heading up all alternative and strategic investments.

First of all, I am very excited to be a part of the Minyanville experience. My background comes from traditional investments (stocks, bonds, foreign exchange) and alternative investments. My basic approach to investing is to access all the possible outcomes to any given situation and establish probabilities for each outcome. I do this with various types of investments including, but not limited to, Foreign Exchange and games such as blackjack.

When looking at the current landscape in the investing arena, I can't help but see many parallels between investing/purchasing real estate and playing the card game blackjack. For those that are not familiar with blackjack, it is a card game where the goal is to get as close to the total 21 as you can by adding up the point values of your cards, without going over. When you start the first hand, the deck is uniform and the house (casino) has a slight edge (approximately 0.5 %) if you play your hand correctly. But after the first hand is dealt the odds change because the deck is no longer a uniform deck.

The key to the player gaining an advantage against the casino in the game of blackjack is for there to be extra 10's (10's, Jacks, Queens, and Kings) and Aces than there would normally be in the deck. So after the first hand, if a player were to see many more small cards than large cards played, there would be a higher than normal amount of 10's and aces available in the deck. Therefore, the game of blackjack is one of dynamic (or ever-changing) probabilities, depending on the composition of the deck.

In my opinion, the investing landscape exhibits these same types of characteristics. Let's take the price performance of the residential housing market as an example and look at the possible outcomes of future price gains/losses. I use this example because of the recent intense debate over the future price of residential real estate, especially as it relates to the MBS market.

Over the past few years, real estate prices have shot up much faster than the pace of inflation in many major metropolitan areas. This created what we now know as the housing bubble. But what are the probabilities of an outright decline in real estate prices over, say, the next 18-24 months?

Was the price performance of the past few years a random event that will have little to no bearing on future performance? Or have the probabilities changed in regards to price performance in the future? I would suggest that the probabilities of future price appreciation/depreciation have indeed changed due to the price action of the past few years. The main reason for this is that affordability of residential real estate has been significantly eroded.

Therefore fewer people can afford the average home and the ratio of house price to median income is up significantly. This puts many people and families at additional risk when they purchase a home because more of their income must go towards paying the mortgage.
This leaves people with a much smaller margin for error. Additionally, mortgage ARM resets is another variable supporting a different probability outcome for future prices. Therefore, the probability of home prices actually falling is much greater than in years past due to the stretched home price/median income ratio and the ARM resets.

Someone effectively pulled 10's out of the deck, thereby creating a greater edge for the casino and a greater disadvantage for the home buyer. I wonder if S&P, Moody's, and Fitch changed their assumptions about the probabilities of home price appreciation/depreciation as the prices for homes climbed ever higher? Wouldn't this have made for more efficient pricing of MBS and CDO's? Would they still have been able to rate approximately 80% of a CDO AAA if they had changed their probabilities about home price behavior?
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