The Housing Crisis: What is the Smart Money Doing?

November 18, 2008

One of the terms that veterans of the stock market often use to describe buying patterns is ‘smart money.’ Smart money refers to buyers who are informed, intuitive, and quick enough to anticipate market trends before they actually occur. Conversely, the term ‘dumb’ money is the money from buyers who rush in after the boom occurs, and get stuck holding assets that are worth less than they paid for them in the first place. The relationship between smart money and dumb money is a natural part of any speculative market, and is as old as time. Ironically, a smart investor can easily become dumb money when the market turns against him.

Nowhere was this more evident than in the housing market. The problem with the housing market is that while it was a speculative market for many, a large amount of buyers simply regarded it in the same way that they would regard a car. The mindset of these buyers was that housing, like food and clothing, was a fundamental need. As a result, many of these people assumed that whatever price they were able to negotiate and afford for their house must have been a reasonable one. They planned on living in their houses for an extended period of time, perhaps even the life of the loan. Sure, they might occasionally withdraw equity from the house, but only in cases of need and importance: things like college tuition, home improvement, or paying down other debt. All of these seemed reasonable, since home values would always go up in the long run, right?

But even though the paradigm of rising home values is still intact over the long-term, no one had considered the possibility of a severe short-term decline in home values. Unfortunately, that is precisely what has happened over the last year and a half. Suddenly, a huge swath of people suddenly seemed like dumb money. What separates dumb money from smart money, of course, is the ability to react constructively and profitably to a negative situation.

So I spoke with a veteran real estate agent (of 30 years, no less!) last week, to get her opinion on what be smart money might be doing in these market conditions. In no uncertain terms, she said both herself and her colleagues believe that the market is not anywhere near its trough. A true rebound, she said, would only occur when prices dropped far enough that credit-worthy first-time buyers would feel comfortable making purchases. These would be the buyers who fit into the profile I mentioned above, who regard housing first as a necessity, and second as a long-term investment.

These people weren’t quite the same as the smart money I had in mind, so I clarified my line of questioning.

“The people with money to spend, who know how to spend it…what are they doing right now? Are they just waiting on the sidelines, or have they started to brave the waters again?”

With that definition, she immediately knew who I was referring to. She pointed me to a few recent statistics, conveniently located on a website she frequents.

“You’ll see that it shows a [5.5%] rise in existing-home sales, but an 11.5% drop in new-home sales,” she commented. “Now think about it…does that seem rational?”

Of course, those numbers, indicating a huge spread, do not seem reasonable in the least. I told her so.

She explained the discrepancy by saying that “What it means is you have banks who are just beyond desperate to get rid of these, and are willing to do so in any way they can.”

As she said this, I realized that I had my answer. “So smart money could be hedging the values on their own properties by swooping in on foreclosures and short sales.” Yes, I said it more as a statement than as a question.

She responded with a characteristically Midwestern aphorism (she is originally from Nebraska, I discovered). “I can’t say for sure, but I’m pretty sure. So take that and two dollars, and buy yourself a cup of coffee.” I took her advice, and took a walk to my neighborhood Starbucks that evening.

The next day I discovered during a meeting at my office that my manager was considering making a hedge play on her own real estate property. She lives in a three-bedroom condo about twenty minutes from Los Angeles (by my estimation, probably worth around $600,000), but shared with us that she was strongly considering buying either a house or a condo in San Diego.

Sometimes the difference between smart money and dumb money can simply be the ability to sense opportunity. As I said above, the long-term paradigm for home-ownership has not changed. Unlike tulips and tech-stocks, people will always need homes, and it logically follows that home values will always appreciate over the life of a mortgage. So when banks start accepting short-sales (as in low-ball) offers on homes, smart money sees a potential profit at a very low risk. It’s worth noting that these are not the flippers, who so famously created artificial levels of demand in the housing market that contributed to the bust we are all suffering through. These are shrewd individuals with high credit scores, who see a significant opportunity to improve their net worth over a long period of time.

It doesn’t mean that we’re in for a quick recovery. But that is logic you can’t argue with.