Via email, reader Denis wonders "Where did the Money go?"
Hello Mish
I read many times on your blog how bubbles created by the Fed led to the overpricing of assets such as real estate and stocks. Someone paid those overpriced valuations. So, where is the money? At some point will that money be used to mitigate the economic doom?
Denis
Illusion of Wealth
Let's take a look at a real estate example, then the stock market. Please consider home ownership rates.
In 2002 there were 71,278,000 owner occupied homes. In 2006 there were 75,380,000 owner occupied homes. The difference is 4,102,000 homes.
Thus, the overwhelming percent of the population did not buy a house in the biggest bubble years 2003-2006. Most had a house for many years and millions of others rented throughout.
Therefore it's safe to say that most homeowners rode home valuations up, then down, feeling rather wealthy in 2005-2006, and decidedly less wealthy now.
Anywhere, USA
Consider a typical subdivision of 200 houses, Anywhere USA where the homes are all relatively similar in size and value. Assume those homes were worth $250,000 in 2002 and $450,000 in 2006, with a few of sales at varying prices, but no sales since 2006.
Now let's assume one person has to sell now and all he can get is $220,000. Poof. Conceptually, the entire subdivision was just repriced on one sale.
Disregarding that sale, no money went anywhere (except of course via rising property taxes over the years to pay overly generous wages and pension benefits to police, fire department and other government workers).
On a percentage basis, few bought or sold during the years in question.
In general terms, the winners were those who sold at or near the top (and those benefiting from rising property taxes). The losers were those who bought near the top (along with taxpayers under the burden of rising property taxes).
Of course, many millions took out home equity lines and bought boats or made home improvements. However, those loans (except for loans in foreclosure or default) are still on the books of banks, most likely not marked-to-market.
Repricing Events
In the example above, 1 house out of 200 sold, yet that lone sale set the price for the entire neighborhood. Given that current buyers will not pay 2006 prices, repricing occurs whether any transactions take place or not.
Such repricing events happen all the time in the stock market as well.
For example, in premarket trading of as little as 100 shares, stocks can rise or fall 5% or more easily. Money does not go anywhere per se. Rather valuations change, just as happened in my housing example above.
To understand how valuations change over long periods of time, please consider Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think
Cycles of PE Compression and Expansion
Over long periods of time PE ratios tend to compress and expand. Unless "it's different this time", history says that we are in a secular downtrend in PEs. From 1983 until 2000, investors had the tailwinds PE expansion at their back. Since 2000, PEs fluctuated but the stock market never returned to valuations that typically mark a bear market bottom.
Of course, there are hedge fund managers who made $5 billion or more in the crash, but that pales in comparison to the valuation of the stock market which changed by $trillions on the way up and the same amount on the way down.
On an ongoing basis, broker-dealers and CEOs take their cut (and huge bonuses as well). Here is a case-in-point: Anthony Mozilo, CEO of Countrywide Financial, single-handedly cashed out over $1 billion in shares and options (but that was over the course of a decade).
Will Mozilo use his $billion to help mitigate the economic doom?
How far would it go, even if he did? $1 billion is extremely tiny compared to the total stock market valuation and housing bubble bust.
So Where Did the Money Go?Clearly, Wall Street took a tiny percentage (and continues to do so). Those CEOs and broker-dealers take their cut whether the market goes up or down. They don't care what happens to anyone in the process.
A few big hedge funds betting the stock market would drop made out very well. However, the stock market would have plunged whether anyone bet against it or not.
At the housing and stock market peaks, presumed wealth was nothing but an illusion caused by the Fed's serial bubble blowing policies. It would have been impossible for everyone to cash out then, or cash out now.
Thus, most of the money went to "money heaven" which is to say nowhere at all. It was not really "money" in the first place, but rather unrealistic valuations (and in regards to real estate, a mountain of debt that cannot be paid back).
Valuations went up, then down, repriced over time (with Wall Street siphoning off a bit in both directions). This helps explain why the rich get richer and the middle-class continually shrinks.
Millions of lives, late to each bubble-blowing party, take on too much debt and are destroyed in the process. Bernanke's policies ensure it's going to happen again.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post ListJohn Paulson, of the eponymous uber-hedge fund did an hour-long
interview with the Financial Crisis Inquiry Commission. I listened to
it (thanks to NYT Dealbook,
although not sure where they got it from), and really, I got a kick out
of it even though I think my carpal-tunnel is really flaring up now.
Anyway, without further ado, here's what the man behind the Greatest Trade Ever has to say about the Financial Crisis…
When
asked what he saw, when, and why he decided to get short, he said
“First thing we noticed was that real estate market appeared very
frothy, values rose very rapidly, which led me to believe real estate
markets were over valued.” That’s pretty simple/straightforward, no?
I think it’s pretty interesting that he said the 3 homes he’s bought
were all out of foreclosure, and they’d increased in value 4-5x over a
2-3 year period through ~'2005. Apparently the impetus for the
research that led to The Trade was literally staring him in the face
every time he got home from work!
He explained his approach, and the way he put it makes me really
think the guys who didn’t leave their trading desks & “never saw
the bubble/crash coming” really had their heads buried in the sand
deeper than I previously thought. As Paulson said, “Credit markets
were very frothy, very little attention paid to risk, spreads were very
low, we thought when those securities correct, it could present
opportunities on short side.”
Their research approach was pretty straight-forward: Focus on
subprime, where they were amazed at how low quality the underwriting
was, and how low the credit characteristics were on the loans. They
found the average FICO was around 630, and over half of the loans were
for cash-out refi’s, which were based on appraised, not sales prices
(so “value” could be manipulated). For many of these loans, LTV was
very, very high, 80, 90, 100% with many of them concentrated in
California (no surprise there). Close to have of the mortgages they
looked at were of the stated-income, no-doc variety.
Those who did report incomes had D/I ratios of > 40% before taxes and insurance. 80% of them were ARMs, so-called 2/28’s
with teaser rates around 6-7% for those first 2 years, but after they
reset, the rates were L+ 600bps which at the point would have doubled
the interest rate on these loans, and Paulson & Co thought there
was very little - if any - chance borrowers would be able to afford the
higher payments.
Once the rates reset, the only thing these borrowers could do would
be to sell, refinance, or default. These were people spending > 40%
of their gross income on their mortgages already, once the rate jumped
up after the teaser period, they expected that many borrowers would
simply default, and the price of the RMBS into which these loans were
securitized would fall drastically, while the price of the protection
(CDS, etc) Paulson bought on them would skyrocket.
Paulson & co also went much further in their analysis,
well-beyond what many of those on Wall Street were doing. In May,
2006, they researched growth of 100 MSA’s
and found that there was a correlation between growth and the
performance of subprime loans originated within them. As growth rates
slowed, defaults rose. From 2000-2005, they found that with 0% growth,
there’d be losses of around 7% in the mortgage pools.
When they looked at the structure of the RMBS they found the average
securitization had 18 separate tranches and that the BBB level only had
5.6% subordination, essentially, once losses surpassed that point, the
tranches would become impaired, and if they reached 7% losses (what
Paulson thought would happen once home price appreciation only slowed
to 0%), the entire tranch would get wiped-out entirely.
By mid-2006, home prices not only had slowed to 0% but were actually
decreasing, albeit slowly, only about 1%. Even still, demand from
institutional investors was so great, spreads tightened to 100bps.
Why? Because as Paulson went on to explain, institutional investors
were buying up the BBB tranches (the lowest investment grade ones) in
hoards.
While he didn’t say it, I will (for the umpteenth time!): This
is what happens when institutions effectively outsource credit research
to the Ratings Agencies, even though many had/have internal credit
analysis groups (ahem IKB ahem). They buy the highest-yielding
security you can find that meets your investment guidelines, which
meant that for many, they could only buy securities deemed by the brain
trusts at the Ratings Agencies as “Investment Grade.”
Paulson started their credit fund in June, 2006, and as he
explained, it wasn’t really as simple as it may seem. Historically -
going back to about WWII - the average loss on subprime securities was
60bps, nowhere near what Paulson & Co expected was about to
happen. As he said “according to the mortgage people, there’d never
been a default on an investment grade (IG) mortgage security.” These
same people were also of the mindset that they’ll NEVER get to the
levels where the BBB tranches are impaired let alone wiped out
completely. These were also the same people who said that not since
the Great Depression there hadn’t been a single period where home
prices declined nation-wide. These same people thought, worst case,
home price growth would drop to 0% temporarily and then return to
growth, just like before.
Why would “the mortgage people” expect anything else? From their
desks on the trading floors in Manhattan, Stamford, London, and
everywhere else, things looked just peachy! Spreads were tightening,
demand for product was up, and more importantly, so were bonuses! As
far as they knew, the mammoth mortgage finance machine they’d created,
based on their complex models and securities was working perfectly…
Paulson also made a distinction missed by many if not most: Everyone
was looking at nominal home price appreciation, but real appreciation
numbers were much different. Going back 25+ years using real growth
rates, they found that prices had never appreciated nearly as quickly
as they had from 2000-2005, and that this trend was unlikely to
continue for much longer, i.e. there would be a correction and then
mean reversion. Their thought was that once this correction came
about, because of the poor mortgage quality and questionable
assumptions/structures in mortgage securities, losses would be much
worse than estimated.
Paulson was intent to make one distinction, one that must have been
the cause of at least some frustration (followed by fantastic
jubilation), that they did their own analysis, they weren’t really
trying to attack “the mortgage people’s” views specifically. Instead,
they were trying to understand the conventional wisdom and understand
why they had contrary viewpoints. As myself and countless others have
pointed out over the years since, the mortgage industry (I guess we’ll
stick with calling them “the mortgage people?”) brushed Paulson off as
“inexperienced, as novices in the mortgage market, they were very, very
much in the minority...Even our friends thought we were so wrong they
felt sorry for us…”
The mortgage people didn’t see any problems because there’d never
been a default, except for one manufactured housing (mobile home) deal
in the early 1990’s in California.
"The Ratings agencies - Moody's - wouldn’t let you buy protection on
securities from a particular state, because they ensured that the pools
were geographically diversified, so they were essentially national
pools, although California loans had the highest concentrations therein
the pools correspond to the level of home sales in each state."
What I found surprising from the interview is that Paulson actually
praised the mortgage underwriting/originating practices of the big
established banks like Wells Fargo and JP Morgan, which he said
generally had the best underwriting standards and controls. The worst
were from the New Centuries and Ameriquests, eclipsed in their lax
standards only by the mom & pop type shops who were really just
sales businesses who made money on the volume of product they
originated and sold to Investment Banks like Lehman and Morgan Stanley
that didn’t have their own origination network.
These smaller “rogue” mortgage originators were mostly private
entities who weren’t under the same scrutiny of their larger,
publically-traded “competition.” Their sales teams were compensated
purely on quantity of loans originated with little-to-no care for
quality. These were the guys who routinely falsified documents,
appraisals, incomes, assets and/or encouraged borrowers to do the
same. These were the kind of places that made Countrywide’s standards
and controls look almost honorable by comparison.
The FCIC then asked Paulson about the infamous ABACUS debacle.
Paulson’s tone when responding to questions from the FCIC here was so,
so, awesome; you could hear it in his voice, like he wanted to just say
“are you guys freaking kidding me? Seriously?!?! REALLY?!??!” every
time they asked him about how CDO’s got made. He basically said
(paraphrasing) “If ACA and IKB or Moody’s didn’t like the ~100 subprime
reference securities we helped pick for the deal, they could have…not
bought the deal or - get this - replaced them with ones they liked
better…I couldn’t have gone short if they hadn’t gone long, they agreed
on the reference portfolio, it got rated, boom, done” It sounded like
he just wanted to say something like “Hello morons?! This is how
Finance works, HELLOOO!!!”
The ABACUS conversation ended pretty awkwardly (as you might
imagine), and then the FCIC moved onto asking Paulson about his Prime
Brokerage relationships and what he thought about the Banks.
Interestingly (to me, at least), Paulson had much of it’s assets with
Bear Stearn’s Prime Brokerage primarily because the way Bear was
structured , the PB assets were ring-fenced from the rest of Bear’s
assets in a separate subsidiary, so even if Bear went down, the PB
assets would theoretically be safe. The rest of Paulson’s assets were
with Goldman’s PB. When Bear’s Cioffi/Tanin-run internal hedge funds
failed, Paulson saw that as the proverbial canary in a coal mine; they
knew the crap that Bear, Lehman, and everyone else had on their books.
They didn’t pulled all of their cash balances from their prime brokers
and set up a contra-account at Bank of New York, where, by the time
Lehman went Bankrupt, they were holding most of their assets in
Treasuries there.
Next, the FCIC asked him about regulators and banks and what people
could (or, better, SHOULD) have done that might have prevented the
crisis. Paulson called out the Fed for not enforcing the mortgage
standards that were already in effect. He mentioned that pre-2000,
no-doc loans were only given to people who could put 50% down and only
represented about 1% of the mortgage market, but only a few years
later, originators were “underwriting” NINJA loans with 100% LTV!
Paulson went on to explain how simple fixes, so-to-speak, just
enforcing existing regulations like requiring income/asset
verification, that homes were owner-occupied, and a downpayment, as low
as 5% would have made a huge difference. Most of the mortgages that
failed didn’t have those characteristics. Excessive leverage and poor
understanding of the credit, problems Paulson also say brought down
Bear and lehman. They were leveraged (total assets: tangible common
equity) on average, 35:1. At that sort of massive leverage, a 3% drop
in assets would wipe out every $ of equity!
Even if that ratio was brought down to 12:1 and you increase their
capital ratio to 8%, the banks still couldn’t hold some of the riskier,
more illiquid assets like Private Equity interests, equity tranches of
CDO’s, lower-rated buyout debt from many real estate deals, and other
assets that themselves were already highly-leveraged. Adding further
leverage to assets themselves already levered an additional 12:1 is
just lunacy. No financial firm should be able to do that, at max those
assets should only be allowed to be levered 2:1 (similar to the max
leverage for stocks due to Fed Regulation T).
He went on (this is pretty much verbatim, emphasis mine): “Under
those scenarios, I don’t think either bank would default. AIG FP was
absurd and exemplified the derivative market where you can sell
protection with zero collateral. AIG FP Sold $500bn in protection with
$5bn collateral, 100:1 collateral. ACA was collateral agent, they were
like 120:1 leveraged. $50bn protection on $60mm collateral. You have
to hold collateral, we need margin requirements for both buying &
selling protection. It’s not the derivative itself that’s the problem, it was the margin requirements (or lack thereof).
We need something like Reg T (max 2:1 leverage at trade inception).
What these guys did would be like like buying $100 of stocks with $1 of
equity, a tiny downward move is a huge loss of equity. In all, these
four things would have likely prevented the crisis:
- Mortgage underwriting standards, simple & logical
- Higher bank capital ratios
- Higher capital against risk assets
- Margin requirements against derivatives
Paulson was then asked about the Ratings Agencies and what role they
played in the bubble/crisis. Regular readers know where I stand on
them & NRSRO regs, and no surprise, Paulson is similarly critical,
particularly of the issuer-pays compensation structure, calling it the
perverse incentive that it really is, despite whatever nonsense
rhetoric RA executives say.
That, combined with being public (or part of public companies) and
they were in this race to keep pace with their competitors, to keep up
earnings growth with their derivatives business, which he called a
“perverse economic incentive that may have led to their laxness in
rating securities”
He went-on to explain this same - in the immortal words of Citi CEO
Chuck Prince - “keep dancing while the music’s still playing” -
incentive structure led the Banks to take similarly short-sighted
actions as they struggled to keep up earnings, growth, and of course,
bonuses. At that point, the only way to do that was to grow their
balance sheets, add more leverage to earn spread. In Paulson’s words
“Once things go up like that, you don’t see any downside, so at top of
market they just weren’t looking at the downside, just upside, became
more and more aggressive until they blew up.”
Paulson said the Fed certaintly could have cracked-down on
lax-underwriting standards, eliminated negative-amortization loans,
stated-income, 100% LTV, IO’s, etc where most of the problems
developed. On the banks and more broad financial services industry, he
said “…people became delusional, ‘we can leverage AAA 100:1…’ if you had margin requirements against derivatives, AIG could have NEVER happened. If they held higher equity against risky investments, they would have never defaulted. Constructively,
that’s what Basel 3 says, 8% equity/capital and higher risk weightings
for illiquid risky type assets. I think adoption of those rules will
lead to a safer financial system.”
When asked about the role of Fannie May & Freddie Mac, he
pointed out the problem was largely similar to what brought down the
banks and AIG: excessive leverage and poor oversight/underwriting.
“They deviated from their underwriting standards as a way to gain share
in alternate mortgage securities, of poor quality & higher losses.
Second, they were also massively leveraged 80-120:1 if you include
on-balance sheet assets & guarantees which is way more than any
financial institution should have.”
Yea, I think 120:1 leverage is just a wee bit more than prudent, just a bit though…
From this interview it seems painfully clear that those with whom
the safety of the Financial System rested were in a deep coma at the
helm, Bank executives, regulators, Congress, institutional money
managers, all of them. It’s clear that the nonsensical argument
put-forward by Tom Arnold & Yves Smith
that those who were shorting housing, subprime, etc were NOT IN ANY
WAY, SHAPE, OR FORM remotely responsible for causing the crisis.
Institutional managers were not gobbling-up BBB-rated RMBS CDO tranches
because shops like Paulson & Co were shorting them. Like I said
before: they wanted the highest yield they could get away with holding!
As Paulson said, anyone who looked at the data he did should have
noticed the impending doom, but apparently, either very, very few
people did that type or analysis or they did and just, like Chuck
Prince said, kept on dancing until the music stopped.
These traders thought tight spreads indicated safety, which is just
wrong in so many ways. These are the same morons who - thought they
should know better - constantly confuse correlation with causation.
Low spreads may have been historically correlated with low default and
loss rates, but low spreads do not cause low losses/defaults. Spreads,
like stocks, trade as a function of supply and demand, and all low
spreads indicate(d) is that, as Paulson noted, institutional managers
were swallowing up as much of these MBS and derivatives (for reasons I
explained above), and, like a bunch of lemmings, all thought history
would continue despite significant evidence suggesting this time, it
was actually different.
One other thing that critics and the public at large probably
doesn’t know is that Paulson & Co had a MASSIVE internal,
independent research effort wherein they did crazy things like *gasp*
look at loan-level data. Imagine that! This enabled them to hunt for
CDO and other product that contained an inordinate amount of crap for
them to short. This same work also helped them to buy RMBS/CMBS etc
when the market turned in 2008 and 2009. They had done the work, and knew what they were willing to pay once it was time to go long.
I’m not saying there’s anything necessarily wrong technical,
momentum, and quantitative trading strategies. There is, however,
something very wrong, and very dangerous about relying on these
strategies alone while ignoring fundamentals, as evidenced by the
housing crisis. Those who did the hard work like Paulson & Co.
made the greatest trade ever, while those who ignored or were otherwise
blind to the fundamentals got absolutely crushed.
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If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
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bench craft company
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
bench craft companyNeighborhood news aggregator Outside.in has been acquired by AOL, according to multiple reports this morning. Apparently it's being bought for less than the big pile of money that high-profile investors put into it, back when hopes were ...
If he had been a known "conservative" or "tea party" member, and if it were a Democrat governor's news conference, this would be the #1 lead item, ahead of Sheen etc, and President you-know-who would have already flown into town (or the ...
March 5, 2011. The Big News Isn't Jobs, It's Wages. Robert Reich, Huffington Post. Tweet. AP Photo. Are we making progress on the jobs front? The Bureau of Labor Statistics reports 192000 new jobs in February (220000 new jobs in the ...
