A simple story

I come from a small town in rural eastern Montana. In fact there are VERY small towns in eastern Montana. On a business trip in 2003 I encountered a unique experience that I think provides a nice illustration of the current housing market.

Although my reach in business development literally stretched from southern Louisiana to Alaska and Michigan to Utah, this particular opportunity was close to home. My colleagues and I joined our counterparts from Canada, Texas, and beyond to tour an asset located in "our neighborhood." This meant dozens of people driving from one tiny farming community to another. Because our company operated in the neighborhood, some of us had family and relatives sprinkled throughout these towns. In one such instance, a colleague of mine knew a purveyor of baked goods in a town of a few hundred people in one of the most rural corners of a rural state.

Our team decided to stop, say hello to an acquaintance, and pick up a doughnut along the way: the long johns were rumored to be the best. In an interesting turn of events, each of the other competitors followed us into town to make the same stop.

The local market for doughnuts experienced a sudden rapid expansion. Fortunately, the week's baking had just come out of the oven, so the stock was large. Because distribution was faster than calculation, the doughnuts were laid out for each man to grab at will. Once each of us was satiated, the owner was glad to take our payment on the honor system.

Theoretically, the owner sold product before knowing our ability to pay. In the end she was paid, and it was a great day for business.

Imagine now that the next day the baker decided she would sell 5 dozen doughnuts everyday. Afterall, the day before she had nearly run out. Surely the market was ripe for the picking. If the next day she baked 5 dozen doughnuts expecting to sell them, she would likely be stuck with surplus inventory. Ultimately, she may have to throw some of the goods away.

This may be a silly example, but it is illustrative. Markets sometimes experience exceptional anomalies. There are occasional bubbles that cannot persist. Today's home market is largely suffering from too many doughnuts. They experienced a busy day and decided it was a lasting phenomenon. Now they are left with way too many tasty morsels and find themselves back in a one horse town.

Likewise, since they'd given away doughnuts (I mean houses) the day (I mean few years) before without worrying too much about each customer (I mean homebuyer's) ability to pay, they have disocvered their serving tray (I mean loan portfolio) is out of balance with their cash registers (I mean asset backed derivatives).

Obviously houses take a lot longer to build than doughnuts, and this is the point. The problem developed slowly based on bad credit standards, which encouraged the baking...errrr... building of way too many houses over time. It is only over time that the bakers....errrr.... builders can get rid of their over production. And it is only in time that those who passed out the doughnuts....errrr..... houses quickly without worrying about payment can recoup their losses.

This is a natural market reaction to incorrect market signals. One day's rush does not a doughnut market make. I am confident our small town baker knew this: shame our nation's lenders and homebuilders did not.