Reaping What You Sow: Hedge Fund and Housing Bubble Edition

Last week we got to watch as the markets went wild with the realization they were over leveraged on bad debt, until Bernanke rode in with a huge bailout, answering a question (and settling some bets) on whether he was an inflation fighter, or an inflationist (he's an inflationist, and he has now proved it.) This Monday, we'll get to see if the markets are reassured enough, and over the next few weeks we'll get to see whether or not more failures occur anyway (sure, you can give banks money, but do they really want to buy out fundamentally lousy debt instruments at anything near face? Not unless Bernanke and his counterparts have been really twisting arms. Maybe not even then.)

But I don't want to talk about last week, I want to talk about this last decade, which Stirling Newberry calls the Decade of Stupid. I'm hearing a lot of revisionism from people who should know better, that Greenspan wasn't to blame and if he was, well, he had no choice.

The only really appropriate answer to that is, alas, unprintable. So let's take a march down memory lane. We all remember the Internet bubble of the late 90s. It should have ended in 98, but Greenspan was caught between a bubble and hard place and he made the fateful decision to put his foot to the pedal and flood the world with money. In 2000 the bubble finally burst, and the rich took a huge loss.

That simply couldn't be allowed, so a few things happened. First Greenspan dropped interest rates to generational low rates. One can argue that this was the right thing to do, so I won't get on his case too hard. But he kept them there for a year, then raised them much too slowly. The result was a real-estate bubble, one a number of us were talking about as early as 2002. Those mortgages were taken, cut up and turned into securities (CDOs, or collateralized debt obligations) and those were sold as investment vehicles. In the meantime, as the bubble progressed, it started using loan types not seen in large numbers since the depression - nothing down, liar's loans (where you state your income), variable loans where the payments jumped after a few years but the first few years were very low, and so on. Underwriting standards were essentially abandoned and anyone was allowed to have a mortgage, whether they could afford it or not. Despite all the nattering about "sub-prime" the weakness in underwriting extended well into Alt-A (the sort of good class) and into Prime loans (supposedly solid loans). Because it was a bubble, and because in a bubble people have to pretend it's not a bubble and will never end the default rate was massively underestimated as well. (Aside: anyone remember Dow 36,000? The authors still get to go on TV and act as "experts - but all they were was shills cashing in on the 90's stock bubble by telling people it would never end.)

Even as Greenspan started raising rates slowly, money remained essentially free for the wealthy. For most of this period Japan kept its interest rate at 0% or close and if you were in a position to borrow at near prime in Japan, then take that money and use it elsewhere, you were able to massively benefit from arbitrage. Combined with leverage (a fancy word for taking the 10 million you borrowed from Japan and getting a 100 million dollar loan on it so you could gamble, er trade) and a rising market, even fools could and did make very good returns - 20% was the minimum I would have accepted, were I rich, during many of these years, and in many years returns were much higher for those in on the game. (Notice, by the way, how the world became divided into two groups - those with enough money to buy into the best funds; and peons like most people reading this, who were stuck with single digit returns).

But the bailout of the rich required more than this. It also included fiscal, that is to say - tax - policy. Bush's first major domestic priority, as we all remember, was to drop tax rates on the rich through the floor, so they could recover from the beating they took when the market collapsed.

Nor did Treasury fail to get in on all of this. When Bush dropped tax rates through the floor, combined with a recession, it caused huge government deficits to blossom almost overnight. At this point interest rates in the US were at generational lows. What would you do if you were Treasury Secretary in such a situation? Well, I don't know about you, but what I'd do is sell nothing but 30 year Treasuries so I could finance the deficit at the lowest possible rates for the longest time - lock in those generational lows. In fact I'd be rolling over as much debt as possible into long term bonds. That's not what Treasury did - what it did was eliminate the 30 year bond entirely, making 20 year bonds the longest duration - and sold as many short term duration bonds as possible - at a much higher cost to the government for borrowing.

Since the new long term Treasuries were the 20 and 10 year bonds what this meant was that people who had wanted 30 years were pretty much forced to buy the shorter "long" treasuries. Since those Treasuries compete with mortgage backed securities, that flooded the market with more securities. More supply, nothing else really changed = lower prices. Lower mortgage rates. The Treasury was juicing the mortgage market by eliminating 30 year Treasuries. And by selling lots of lower duration treasuries it was also juicing consumer loans and so forth.

Both the hedge fund and housing bubbles then were a creation of coordinated activity by the US government with the help of other nations (primarily the oilarchies and China, which is beyond the scope of this article). Other decisions (for example, allowing banks to ignore reserve requirements by buying "default insurance" thus expanding leverage massively) all did the same thing. Greenspan pushed the both the bubble - telling people that variable rate mortgages were a good buy at the exact best point to get a fixed rate mortgage and testifying before Congress about how tax cuts for the rich were great (and his prestige greatly helped get those cuts through.) So.. at the base of the economy - the housing bubble. At the peaks, free capital for trading and arbitrage games, and for slicing and dicing all the paper produced by the housing bubble and selling it to the world.

The beauty of the housing and securities bubbles, from the point of view of central bankers and rich people, is that they were designed not to cause widespread general inflation. Asset prices in the bond market should have limited impact on people's lives. Houses are the main asset most ordinary people have, but they are very illiquid, and while there was a fair bit of borrowing against value (the infamous home equity loans, in which home owners forgot that an asset you haven't sold doesn't have a real price you can count on).

Of course, it didn't quite work out - that nasty Iraq war and the price of oil, and all. That has crept into real world inflation (as opposed to the pablum that the BLS feeds us, with core inflation (the inflation you pay if you don't eat, heat your house, or drive) and which doesn't measure housing inflation (it uses rent equivalent, which hasn't kept up). Food inflation has recently spiked up for staples due in large part to the ethanol bill (a 19.5% increase in the price of eggs for example) but they have been rising at a steady clip for years now. Mechanized agriculture is very oil dependent and oil price increases do move down the chain very directly to food prices. More to the point, you have to eat. That's why food prices are rising while consumer electronic prices aren't - you can live without a surround sound system (some claims to the contrary), but stop eating, and the food withdrawal symptoms kick in pretty quick as I can attest from personal experience. Whenever you "have to" buy something, that means the supplier has pricing power - he won't eat his costs in most circumstances.

So the bubble went on, and started bursting about this time last year. Because CDOs and their cousins are listed at book values it took some time for the increasing defaults and bankruptcies to cascade through and start causing failures in heavily leveraged hedge funds and other investment vehicles. When they did, the panic hit, and you either were getting cents on the dollar, or you just couldn't sell the things at all.

And this is where Bernanke stepped in with loads of cash and a 50 basis point cut. Inflation had already been above target (even by the debased BLS stats) for some time. People actually paying mortgages had been in pain for about a year, and the housing bubble had clearly been deflating for some time. But, as Stirling points out it wasn't until rich people; until heavily leveraged investment vehicles with no regulation, who have fought against regulation, were in trouble, that Bernanke stepped in. You can't let rich people face the consequences of their actions, after all - but poor people are being allowed to go sink, despite plans from Edwards and Clinton for some sort of bailout (a billion won't cut it, but it's a start.)

The Housing Bubble and the highly leveraged hedge funds were both created by deliberate government policy - not just US policy, mind, but policy choices made in the golden triangle (Asia/America/The Middle Eastern Oilarchies). They were specifically created by deliberate actions by Treasury, the Fed, and Bush's tax cuts. The rich had to be rescued from their losses when the Internet bubble collapsed. Now the attempt is being made to rescue them from their losses in highly leveraged, unregulated hedge funds which bet heavily on another bubble.

And Bernanke has shown his colors. He won't cut rates to save normal people (if he was going to bail out ordinary mortgage holders he should have acted this time last year) - but he will bail out the rich. And if it's a choice between inflation and keeping the rich rich, well, he's made his choice. He's no Volcker.

So when people tell you this all couldn't have been foreseen; when they tell you rescuing the rich is the same as rescuing you; when they tell you Greenspan doesn't bear the blame for this or that the President has nothing to do with the economy, laugh at them, because unlike them you don't live in the eternal present and can remember what happened, oh, in the last ten years....

Note: Made a couple minor edits:

1) to clarify that if enough people had taken into account that it was a bubble in assigning risk then it wouldn't have been a bubble

2) a brief note that while this required concerted government action it also required the ok and assistance of both China/Japan and the Oilarchies (much of which I don't go into in the article, but one should be aware it's a gap. Japan gave the free capital; China fought inflation with cheap consumer goods and bought up tons of securities and kept the dollar from collapsing; the oilarchies kept recycling a lot of their profits into dollar denominated securities.)

Comments

[mrcontinental]

Keep telling yourselves that all is well sheep. Dump your money back into the market.

I just checked my gold stash. I swear it gets more beautiful every day.

[edstate]

Owning a home is NOT the "American Dream". This is just part of the product that was created by the real estate lobby, and backed up by the politicians and banks.

The "American Dream" is simple: opportunity via freedom.

[MissFortunate]

Well, when I can will "opportunity via freedom" to my daughter I will consider your point.

Everyone has a different American Dream, this is part of mine, regardless of what you think of it.

[nomoredead]

I saw an ad on TV earlier about refinancing out of the ARM into a fixed for a flat rate of $395.00 ...I think it was Ditech...I think there is going to be some major changes and help for the average person soon. Buffett and Ross are looking to buy distressed mortgage companies, and I'm sure they would like to keep "paying customers" so hang in there.

[edstate]

Lol. ...sorry. After reading the previous posts I cn understand why you thought I was referring to you. Of COURSE owning a home can be part of the "American Dream". It can even be someone's ONLY "American Dream"... my point is that it is not, by definition "it". Owning a home can be awesome. And make a ton of sense personally and financially. But I think this lofty, dreamy rhetoric has charmed a lot of people into thinking they *have* to own a home. Even when it's the LAST thing they should really be doing.

[TucsonEd]

MissFortunate there is no American Dream anymore. I've felt so many times like I was on EDTV with people watching how I would react to all the insanity going on around me while everyone else acted like nothing was wrong. I've wanted to scream so many times "Wake UP" because nothing in America is as we were told. The only reward for hard is work is more work. The relief for the poor is death.
Look down, look down,
You'll always be a slave
Look down, look down,
You're standing in your grave- chain gang from Les Miserables

[mgh234]

I'm going to touch on a point no one else probably would, but you state "(Notice, by the way, how the world became divided into two groups - those with enough money to buy into the best funds; and peons like most people reading this, who were stuck with single digit returns)."

There are MANY ETFs and mutual funds based on small-caps and high betas that have given 20-40%+ returns over the same time period

The finance world is very unfair, but don't make fake arguements...the problem is about ignorance and assymetry of information, not that fact we can't invest in hedge funds (which on average, barely even out perform)

If you want a high beta, you can get it...very few of these elitist funds for the rich you speak of have exceptional alphas (excess return in relation to risk)....the individual investor is just too risk adverse/doesn't understand beta.

[TXfemmom]

We have these cycles, over and over again, and the root of all of them is that the rich elite, the Tresury, and the government look after the rich, and screw the people upon which the country actually works.

[MissFortunate]

We purchased our new home late last year to many discouragements from friends, but we had to get in somehow (Southern california here). The home we bought would have gone for a good ten percent more than it did the previous year and the owners had already bought another house, they were stuck and very unwilling to move their price down although they had doubled their investment in the last ten years.

I was repeatedly told that it would be fine, we could refiance our arm before the deadline to do so. But what happens if our home is worth less than what we owe? And if interest rates don't go down, well, um, yes, we're screwed.

I took a risk, I knew it, but we also really wanted to buy a home. Many of our friends who work hard and make decent livings cannot afford to buys houses and to use this was something we also thought we'd never be able to do. So, where is the American dream? (Most of our friends are teachers and musicians, not stockbrokers and business people).

Why does my gamble mean less than the gamble of those who took a risk on investing in these kinds of mortgages? We'll manage, we will figure it out, but it still bothers me that my loss is not as big a deal as someone else's losss. What happens when all these people lose their homes and they can't spend their money?

[MissFortunate]

Excuse my typos, this is a very emotional issue for many :)

[azphil]

Your gamble means less because you are an average citizen and not a corporation or a plutocrat. You have just one vote in millions and they have millions to buy all the votes in Congress they need.

[rip]

Sorry, but it is hard to be sympathetic for you. You HAD to buy a home? Why was that? What is wrong with renting, especially when EVERYONE knows housing prices are/were absurd?

Why was that? Because you had to keep up with the Joneses? Because it's a dream of yours? I'd like to own a Bentley... doesn't mean I can get one.

I live in Southern California. I'd like to own a home. But I also refuse to buy just to buy, damn the cost. You could rent a comparable place to you home for a whole lot less than your mortgage. In fact, many people, who saw the bubble coming, sold their homes, locked in profits and started renting.

You bought into the pyramid scheme. And you very well might have to pay the price for getting in at the end.

Part of my is sympathetic for you. However the truth is, you, and you alone, allowed your current situation to happen.

[MissFortunate]

And that's why I said we will deal with the consequences. Ultimately that was my point, but corporations take risks as well and should have to face the same consequences as any individual. Huge difference!

I can make my payments, I didn't lie about my income, I have good credit, etc. This was a personal choice for me and my family. You've made your choice and I most certainly didn't ask you for your sympathy.

[MissFortunate]

And I never said I HAD to buy a home. But renting is like pouring money down the drain. We plan on staying in this house for many years to come and ultimately I know it's value with increase over time, I don't expect overnight increases, that was ridiculous (and part of the reason I bought the house was because I paid a lot less than what it was appraised for in the end.)

[newunderground]

Ok,
Maybe one of you educated finance types could educate me. When they (the news) says the fed "injected liquidity" into the market, what is the mechanism? What do they mean, and who gets the money, um I mean liquidity? I could use some over here, I'm parched.

[l.blissett]

newunderground,

i encourage you to watch this video -- money as debt:

http://video.google.com/videoplay?docid=-9050474362583451279

it is extremely well done, in that it makes extremely complicated concepts very easy to understand (well, easy enough, it still may take another viewing to really fully digest, if only just because the profundity of concepts makes the belly of the brain well beyond full depending on your current knowledge on the subject).

anyhow, if nothing else, it will perhaps answer your question (and then some) far better than any of us here (no matter how educated any of us are).

cheers

[keeplookin]

I think I'm gonna go to the nearest baby ward and just holler at all of 'em:

"Caveat Emptor! Welcome to Earth!!"

Little more dramatic than that thing about rose gardens...

[EdwardUlyssesCate]

Folks, you've got to know (or remember) that the first corporation tied into government was the British East India Company. Untold wealth was gained by lying, stealing and murder. It was formed in 1600. What is the address of the White House? 1600 Pennsylvania Avenue. Why does our flag closely resemble the BEIC's flag. Why is Hawaii's flag identical to BEIC's flag, except 7 stripes instead of 13? Just coincidences? The Money Kings NEVER gave up their individual wealth and power. Decendants and others that have joined them just morphed into today's environment. Now you see the results.

[GreedyOldPsychopaths]

Ian,

You make it all sound so...oh I don't know...conspiratorial? A scam to achieve worldwide plutocracy? Some interesting insights. Would appreciate further detail on China's role in propping up the dollar.

China appears to be in the catbird's seat, financially. What will they do with their foreign currency reserves, especially the dollar based assets? Will they be satisfied with a weaker and declining dollar value as the world's reserve currency or will they make a play on the EURO? If so, will OPEC and the EU follow suit? And what are the implications in the US?

It interesting to note the increasing frequency and magnitude of joint military exercises being conducted by China and Russia. This coupled with China's control of our debt has dangerous implications over Iran and potentially Taiwan should we not stop in Iraq.

[lbsaltzman]

When this economy busts which I think it will do within the year, Republicans are going to suffer their greatest losses since 1933. At that point the reputation of Greenspan, who should have know better, and Bernanke will be in the toilet. History will remember them as incompetents and shills for big business and the Republican party.

[olephart]

Privatize the profits and socialize the losses. American capitalism at its finest. In the 90's their slogan was "Vote Republican for a change". They didn't say that you'd like the change.

[GreedyOldPsychopaths]

Concise and accurate.

[Desiderata]

Don't underestimate the financial merchants. Anticipating the collapse of the economy due to the inevitable burst of the housing bubble, they bought from Congress the Bankruptcy Reform Act of 2005.

The Banks, Hedgefunds and BigCredit may have much wind taken out of their sails, but no one will escape paying every penny borrowed even into the grave. Think wage garnishments and inherited debt.

The United State of America is now one vast plantation of indentured servants by debt__from sea to shining sea.

[WIpatriot]

Helicopter Ben lives up to his billing.

[SensibleAmerican]

If you are a believer of the 80/20 theory, none of this comes as a surprise! 80% of any Country's wealth is in the hands of 20% of its population! They control power, pelf and purse strings. Is this something new?

Since time immemorial, Kings and Emperors have created bogus enemies and threats to amass wealth and conquer lands. Since time immemorial, religion has been used to advance the cause of the powers-that-be! Since time immemorial it is always the common Joe Schmoe left holding the bag!

Even during the dotcom/stocks' boom, most of the C-Level executives had sold off their holdings before it all hit the fan! At the end of the day (including 'Enrongates' of the world), it is Insurance Companies and FIs that make the money. That money is then given back to the common man to have him run up a debt which will last him through his career/ lifetime! The debt is held by the same FIs and Insurance Companies! That debt is called "assets"!

We often talk about Politicians taking monies from "special interests" and "lobbyists". It sounds so naive when all one has to do is look at the last General Election: over a BILLION was spent on primaries and general between the two parties. Where did all this money come from? Can any Presdential candidate ever win an election without tones sitting in her or his PAC coffers?!

A modern-day society/polity is "by the people, for the people and of the people". True, except just 'by', 'for' and 'of' 20% of the "people" ...