October 21, 2007
Given that house prices are now falling across the board, it means that every valuation made last year was wrong.
In May 1720,William King, the Protestant Archbishop of Dublin, writing about the speculative mania for shares in a company called the South Sea Scheme that had overtaken the city, warned: ‘‘Most who go into this matter are well aware that it will not succeed but hope to sell before the price fall.”
Meanwhile, Richard Cantillon, the great Irish economist, warned about the South Sea speculation frenzy, pointing out that while prices can be kept up ‘‘for months, maybe years . . . a melancholy prospect awaits those who stay in the market last’’.
These warnings were triggered by the announcement in April 1720 that the South Sea Company, the entity issuing shares, would lend against it own stock. This would only mean that before the collapse, prices would rocket higher as people got into debt to the company to buy shares that the company had issued in the first place.
The so-called ‘South Sea Bubble’, which left thousands of Irish investors broke was simply an example of the speculation that has characterised financial markets over the years. (After losing a fortune speculating in the South Sea Company, Isaac Newton mused that he could ‘‘calculate the motions of heavenly bodies but not the madness of the people’’.)
The Irish have been involved in plenty of great frenzies down the years. Amazing as it sounds, in the winter of 1847, when half the country was starving, many Dubliners were up to their necks in debts speculating on Irish shares in the railway companies that were vying to roll out a rail network to a famished country.
In the preceding years, a railway boom across the water had led to mass migration from Ireland to England. An estimated 200,000 Irishmen worked on the British railways. Those ‘navvies’ (which stems from the nickname the ‘navigators’, which was what Irish workers who built the British canals in the 18th century were called) served exactly the same purpose as the Polish labourers on the sites in Ireland now.
Ironically, in 1847 the British parliament suggested that more and more workers would be needed, as there seemed to be no end in sight to railway building. Apparently, the ‘fundamentals’ at the time guaranteed this optimism. But, like all booms, the railway boom came to an abrupt halt when it was least expected. By 1848, railway shares were in freefall, exposing all sorts of malfeasance and skulduggery.
Again, the Irish were so prominent in this carry-on that Charles Dickens based his swindling banker, Mr Merdle, in Little Dorriton an Irish MP, John Sadleir. Little Dorrit was a serialised book published in the late 1850s.
Sadleir, the MP for Carlow, founded the Catholic Defence Association and was a leading figure in the Irish Independence Party. He was found poisoned on Hampstead Heath in 1856, having committed suicide.
Behind the respectability of his political career, Sadleir was a monumental fraudster. He had speculated wildly on railway stocks, defrauding hundreds of small investors as he forged shares in a railway company of which he was chairman.
He also misappropriated â‚¬400,000 from a consortium of Irish banks to cover his losses on railway shares. According to Dickens, Sadleir epitomised the greed of the boom, where no deal was too big to be financed and where other people’s money was there to be used and abused at will.
This is the lesson of all financial frenzies: when things are going well, no one asks any questions, but when the market turns, people get hurt, dodgy practices are exposed and reputations are tarnished.
What the boom hides, the slump exposes and former pin-up boys are often revealed as tricksters. This ebb and flow process was evocatively summed up by Warren Buffett when he said: ‘‘It is only when the tide goes out do you really see who is swimming in the nude.”
A similar development is occurring here as our property frenzy succumbs to the logic of financial gravity. This week we saw a solicitor being hauled into court over claims of questionable mortgage practices and claims that he misused client funds. This will not be the last of these types of stories.
The reason is fairly simple. During the great Irish housing boom, like the South Sea Bubble, the railway mania of the Famine years or the likes of Enron more recently, investors became carried away on the effervescence of easy money. As JP Morgan, the legendary American banker, observed: ‘‘Nothing undermines your financial judgment as much as the sight of your neighbour getting rich.”
This procedure – half virus, half envy – certainly applied here in the past few years as thousands of us joined the great property frenzy. Last year, 59 per cent of all houses bought were purchased either as investments or holiday homes.
More astonishingly, â‚¬8 billion was invested by Irish people in overseas property. At times, it seems as if most of the country is involved.
With so much cash sloshing around, there are bound to be some casualties and bad eggs. But what if, like all previous financial frenzies, there is a systemic failure which almost guarantees fraud?
Think about how money is raised from Irish banks to buy property. The most crucial number is the valuation that the potential investor gets on the relevant property. Given that house prices are now falling across the board, it means that every valuation made last year was wrong.
By definition, every valuation, therefore, overvalued the asset. When the market is rising, everyone has an incentive to overvalue the price of the asset: the valuer because he is often the same estate agent who is selling; the broker because he gets a commission; and the bank because it makes money lending cash. Systemically, the entire edifice is geared to making the upswing more dramatic and downturn more precipitous.
Anyone trying to sell a property bought last year will realise the valuation was wrong. Can they sue the valuer now? No: they were fully aware of the game and, in so many cases, the buyer was aware that the valuer was trying to get the value ‘up’, so that the buyer could get as much leverage as possible. Expect more questionable dealing to be revealed in the next few months.
The Archbishop of Dublin was right: the people who will get really burned are those who hang on longest. Very often, they are the ones who were last in and can least afford it.