The role of bankruptcy and foreclosure in setting up an economic rebound

One of the scariest things about becoming an adult is finding out how little the financial world has to do with math. But one particular aspect of our economic crisis that we all tend to view in human terms is being driven almost entirely by arithmetic. It has to do with foreclosure as an investment opportunity. Usually I harp on the first point: how psychology drives markets more than price, and thus is affected by subjective and sometimes even irrational factors like how many unemployed people you know or how much CNBC you watch. But the one part of the crisis where we do see the human factor, bankruptcies and foreclosures, has a vital mathematical component that bears watching. To understand this, you need only to understand one key fact about home foreclosures and one key fact about corporate bankruptcies. Foreclosures put homes into the hands of lenders who (1) aren't in the business of actually buying and selling homes, so they want to get them off their balance sheets as soon as possible, and (2) can afford to sell for less because they already made some money from the payments the borrower made before he began to fall behind. So a home sold at foreclosure typically sells for a third less than the regular market price. Bankruptcies put companies into the hands of bankruptcy judges, who try when possible to save the enterprise, and its jobs, and its products or services, by wiping out old debt and giving the enterprise a fresh start. The typical mechanism for this is to pay off the company's lenders with new stock, in place of money it hasn't got. The lenders, who (1) aren't in the business of owning companies and (2) can deduct their losses, either sell the stock, or, more often, move even faster, selling their IOUs to someone who actually does want that stock. We've seen investors buying homes are foreclosure, intending to flip them when the market improves. And just this month we've seen a good example of an investment firm buying debt in order to have future stock in a company that will emerge from bankruptcy. Cerberus Capital is moving to be a major shareholder in Hawaiian Telcom, paying millions for some of its debt. Investors shopping for deals like this - homes at one third off, cheap stock in a bankrupt company that may have future promise - are putting their money into this instead of something else. With bargains like this, why pay full price for a different investment? Investment capital we need for recovery won't be available until these bargains are exhausted. When Hospitality Advisors held its annual hotel industry briefing Friday at the Halekulani, the mainland speakers addressed this topic, suggesting that Hawaii loan defaults, like those on the mainland, are understated and will have to move through the pipeline before real economic growth can resume. We think of foreclosures and bankruptcies in human terms - we hope for a way to save the house, to save the company and the jobs it supports. And we should. But when it can't be prevented, it's better for this stuff to happen as a fast as possible, to get us to the point where these bargains are gone and investors stop thinking like vultures and begin looking for investments that grow the economy.