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David's Macro Blog

Analysis and commentary on business, economics, real estate, financial markets, and other fun topics

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Tag: real estate bubble

When did Wall Street become the dumb money?

Why did traders who lost on their bets still earn millions (sometimes tens of millions) in income?

Author Micheal Lewis (Liars Poker, Moneyball, The Blind Side) explains the answers to both of these questions in his best-selling book, The Big Short. He writes so that even his mother could understand the intricacies of the financial system that the wrecked the global economy for the next decade.

The most remarkable thing to me is that individual traders on BOTH sides of the bet (for or against subprime mortgages) got rich while their firms collapsed and taxpayers got the bill.

Watch the C-SPAN interview with Michael Lewis below:

My Favorite Quotes

That the Wall Street firms had become the dumb money at the poker table. Somehow these firms, which used to be the smart money… When I left Soloman Brothers, the last thing you wanted to do if you were an investor, was be on the other side of one of Soloman Brothers trades. There was some zero-sum bet to be made with Soloman Brothers, you did not make it because you were sure to lose money. And what had happened was somehow the firms had become, had turned stupid as institutions, they’d become the dumb money. That made me curious. Something big had changed. The natural question was, who was the smart money? That led me to my characters because they were the smart money.

They didn’t know their own balance sheets. He doesn’t persuasively know his own business.

The whole financial system is organized around a bet.

The minute that the Wall Street firms were in the business of harvesting middle class and lower middle class Americans for their home equity value (via sub-prime loans) and making loans to them against it, there was a natural risk of abuse because just generally in financial transactions people are bewildered.

There were lots of cases where the nature of the loan was sort of disguised from the person who was borrowing the money. Teaser rates should be criminal. You essentially talk someone into taking a loan out that has an artificially low rate for the first couple of years so it looks very tempting. Then it skyrockets after two years.

There were 3 trillion dollars of loans there were dubious [referring to sub prime and alt-A]

But then seeing this explosion of lending again in this beast he (Steven Eisman) thought he slayed back in the 90’s, the sub-prime mortgage lending business and he says this is all going to blow up again, this is going to end badly because I know how this business is done. It’s a sinister business.

Interviewer: “So the $180 billion taxpayers dollars that went to AIG then went to Goldman Sachs (and other Wall Street firms) to pay off bets?”

ML: “Yes, yes, yes – for bets”

Interviewer: “Why did Hank Paulson and Ben Bernanke want to pay off the gambling debts of AIG?”

ML: “Because all the other Wall Street firms were on the other side of (AIG’s) bets and if AIG didn’t pay off then those firms would have experienced losses. For example Goldman Sachs lost on its bet to Michael Burry, but they thought they were just brokering the bet between Michael Burry and AIG so they paid off Michael Burry and they are out of pocket. They want to get paid by AIG, or they have a $13 billion loss. Paulson and Bernanke are thinking, if we don’t make the Wall Street firms whole, they will collapse, the market is not going to believe they’ll survive. And they would have all collapsed.”

Interviewer: “Who got hurt?”

ML: “Not the Wall Street firms. The rest of the country got hurt by what the Wall Street firms had been doing the last five years, generating this frenzy of finance where finance shouldn’t have happened.”

This was to me, my revelation. First, that the financial system had organized itself around this bet. And second, no matter which side of this bet you were on, you STILL got rich personally. Your institution might have lost huge sums of money, but you yourself got rich.

The only social purpose I had in writing the book was, I thought if I could explain this to people, they’d be outraged. And they need to know.

Derivatives are meant to redistribute the risk in an intelligent way.

None of those people in Davos made a lot of money betting against the subprime mortgage market. If they really understood it, that’s what they would have done.

Michael Lewis on his personal profession of book writing:

The interesting thing that I do is learn about something and communicating it in words.

Notes

Credit Default Swaps is the mechanism created in 2005 to bet against the subprime mortgage market. CDS is like an insurance policy and costs a couple percent per year.

CDS quickly became a way to bet against mortgages, instead of just an insurance policy against your own bonds defaulting.

Subprime mortgage bonds are pools of loans. Most were betting the bonds would pay off, just a few were betting against it – they were the smart money who ran the numbers, not just looking for commissions and transaction fees.

The unit selling most of the CDS was AIG FP (AIG financial products group). They used AIG’s AAA rating to sell insurance but reserved no capital against losses.

Real estate and mortgage fraud ran rampant during the 2000’s great housing bubble. We’ve all heard the stories but there have been few prosecutions, so it’s good to see some in progress.

David Crisp and Carl Cole were arrested by federal agents on mortgage fraud charges. They ran a prominent real estate brokerage in Bakersfield and apparently created straw buyers and manufactured false loan documents in order to sell homes and inflate housing prices.

Ten people, including Realtors, loan officers, and a notary, were arrested on 56 different indictments. It looks like these people will move from their private gated neighborhoods to a public gated high-density community of inmates.

Low interest rates and easy lending standards created an environment primed for mortgage fraud. It is good to see arrests that will likely result in jail time for the most prolific perpetrators. Unfortunately, this investigation took five years.

Rapidly rising home prices are not usually a good thing because they cause new buyers to pay high prices that are not supported by market fundamentals or their ability to pay back the debt.

Also check out the local news coverage of Crisp and Cole’s arrest at KGET.

Classical economics teaches that an economy, if properly managed, will remain in a state of equilibrium. This is because economists assume a perfect market place with rational actors who maximize their returns through their uniform access to all information.

As we know, the REAL world is much different from economic equations.

Instead, the real world economy moves through market cycles. These market cycles fluctuate between boom and bust as the market participants move through cycles of fear and greed and all sentiments in between.

The past 10 years have seen some amazing bubbles which were not sustainable because the asset prices got out of line with the underlying fundamentals supporting the market.

Let’s review the bubbles in our recent memory.

2000 Nasdaq index over 5000 – 9 years later the index is still off 60% from its peak.

2007 Real Estate Bubble – In just 2 years some markets are off 60% and the average is off 30%.

2008 Oil Price – The price per barrel peaked around $150 but then fell to under $40 in less than 2 years.

2009 US Treasuries??? If the future holds inflation then this may be just as large as the 2007 real estate bubble. However, if we continue with deflation, then maybe current yields are the new normal.

So, what bubble are we in now?

Please comment below and let me know what you think.

You might also like these posts on similar topics:

Is it possible that the great equity bubble of 2007 could fool the person best positioned to detect it?

Calculated Risk states in his post “A Comment on Fed Chairman Ben Bernanke” that Ben Bernanke misread the real estate bubble as Fed Governor, then as Chairman of the Presidential Council of Economic Advisers, and later as Federal Reserve Chairman.

How can Fed Chairman Ben Bernanke miss the biggest bubble in history?  Not only did he have the best education at Harvard, MIT, and Yale, but he also had access to all the data, experience, and team members that came with his powerful positions and titles.

In July 2005 Bernanke said:

“We’ve never had a decline in housing prices on a nationwide basis.  What I think is more likely is that house prices will slow, maybe stabilize … I don’t think it’s going to drive the economy too far from its full-employment path, though.”

From this one quote, made at the peak of the boom, we can see two things.  First, Ben did not believe that housing prices would fall much if any and that it was not conceivable that prices would fall across the country in all markets.  Secondly, any decline in housing prices would not slow the economy much to cause a significant increase in unemployment.

Now, just 4 years later we can see that we had the biggest housing boom (and bust) in history AND that the crash caused us to experience the unemployment unparalleled since the Great Depression.

In this case, a big trend (in asset prices and leverage) caused even the most well trained and experienced economic thinker, who has access to the best data, to get swept up and lose track of the fundamentals.

Why did this happen?  Share your opinion by commenting below.

Was the great real estate bubble of 2000 – 2007 preventable?

Who won and who lost?

Why weren’t the inevitable crash and current historic recession preventable or predictable by the best the brightest among us?

The following video from CNBC’s “House of Cards” (ht – Alan Sun) contains interviews with people in all parts of the real estate food chain: from borrowers to loan officers to lenders to wall street bankers to hedge fund operators to bond ratings analysts.

Wall Street will create what they can sell until there are no more buyers. This generates seemingly safe fee income which boosts quarterly profits and of course also produces undeserved multi-million dollar bonuses.

It is hard to believe now, but the banker’s financial models predicted 6% to 8% annual housing price increases forever into the future. How was this sustainable when household income wasn’t rising and probably wouldn’t rise much with global wage arbitrage? Many of the people on the front lines of this historic boom were young home buyers, recent MBA grads at Wall Street firms, etc. They had never known a down real estate market. It couldn’t even occur to them from experience that real estate goes anywhere but up in price.

The boom couldn’t start without Wall Street securitizing loans and selling them off to investors (many of them overseas). What type of WS culture creates an environment where there is strong incentive to sell what the market will buy and book a trading profit or fee income? No one had any incentive to stop the lucrative money train.
– Home buyers bought more house than they could afford.
– Loan officers originated more loans and earned significant income for basically just helping borrowers fill out a form (loan app).
– Wall Street bankers generated massive bonuses for themselves and quarterly profits for their firms.
– Rating agencies earned more fees rating mortgage backed securities (MBS) as AAA.

Isn’t it startling that nowhere was a fundamental issue like a borrower’s ability to service a loan and pay on time for 30 years ever discussed or considered?
The economic boom was NOT about fundamental value creation but solely a product of easy credit. Housing prices historically rise about 1% a year in line with increases in household income. They will revert to the mean over time. Essentially, there is no new economy or new economics. When we hear that in the MSM (mainstream media), look for the unsustainable bubble and prepare for it to end.

Why couldn’t Alan Greenspan, our economic “maestro”, our foremost authority on finance, interest rates and a stable economy, have warned us about the unsustainable boom and subsequent global economic collapse? He didn’t see the bubble. To make matters worse, he says:
“there is no doubt that somewhere in the future, we’ll have this conversation again. It will not be for quite a period of time, but it will occur because the flaws in human nature are such that we cannot change that, it does not work.”

Will you remember that all booms go bust?

Will you remember that what cannot go on forever must end?

Will you remember what your parents taught you? Just because everyone is doing it, doesn’t mean you have to do it too.

If history is any guide, almost all of us will forget what we learned by the time the next boom starts. Scary thought, isn’t it?