Probably the greatest disappointment to a modern man over the age of 50
comes when he looks in the mirror.
We say that not as a man who has just had his vacation in a bathing suit,
but as one who has spent the last couple of days reading the financial
press. The two are alike in that every time you look the picture seems to
get worse.
A brief summary of the sub-prime industry's business
model: There is a market, lenders noticed, of people who cannot afford
houses and do not qualify for the credit necessary to buy them. On the
surface of it, lending money to these people does not seem like a business
you would want to take up. But 'sub-prime'
borrowers could be decent fish, the sharks reasoned, as long as they could
make the mortgage payments. The quants did the math. The strategists looked
ahead. Even if the occasional client couldn't pay up, they had the rising
housing market to lift the value of their collateral. And so, a go-go new
financial industry got going...and pretty soon, its hustlers and
entrepreneurs - like the whiz kids of the dot.coms who preceded them
- were driving Ferraris and drinking Chateau Petrus.
The Orange County (California) Register:
"For Kal Elsayed, a former executive at New Century Financial, a large
lender based in Irvine, California, driving a red convertible Ferrari to
work at a company that provided home loans to people with low incomes and
weak credit might have appeared ostentatious, he now acknowledges. But, he
says, that was nothing compared with the private jets that executives at
other companies had.
"You just lost touch with reality after a while because that's just how
people were living," said Mr. Elsayed, 42, who spent nine years at New
Century before leaving to start his own mortgage firm in 2005. "We made so
much money you couldn't believe it. And you didn't have to do anything. You
just had to show up."
It was this last line that caught our attention and triggered our
disappointment. It reminded us how each generation of geniuses are later
unmasked as frauds and fools. It reminded us too of what weak-minded
simpletons we humans are; we are always falling for our own line of guff.
Modern Homo Sapiens Economicus believes in capitalism.
He believes in it as he once believed in the Holy Trinity or the Virgin
birth - as dogma. And so, he takes up its tenets and excesses without
question or arriere pensees. And, he makes as big a mess of it as his
ancestors did of the Crusades.
This is as true of the lumpen as it is of the masters of the universe.
Recall Henry Paulson's soothing words:
"Credit issues are there, but they are contained," the U.S. Treasury
Secretary said to reporters in Tokyo during a four-day tour of Asia. The
U.S. financial sector is healthy and most institutions won't feel "a big
impact".
But a big impact is just what institutions feel - after they have flapped
their wings and taken to the air.
Typically, they come down with a thud.
The geniuses packaged, bought and sold sub-prime debt right until they heard
the crashing noises. They believed the credits were good as long as
homeowners could make their payments. And they saw no reason why homeowners
wouldn't be able to make their payments as long as they had jobs. That was
their line of guff; and they believed it. In a world of full employment
there was no reason for the mortgages to go bad - in theory. But theories
arise as needed when there is a sale to be made.
The theory was that low interest rates were giving a whole new group of
borrowers' access to credit. The reality was that what made credit available
to un- creditworthy borrowers was the kind of corruption that wishful
thinking hides but mirrors...and history...reveal.
"What drove the housing-led cycle was not as much the cost of credit," notes
Merrill Lynch's David Rosenberg, "but rather the widespread availability of
credit - irrespective of your FICO score [a measure of your ability to
repay]...only a third of the parabolic run- up in the home price-to-rent
ratio was due to low interest rates. The other two-thirds reflected other
non-price influences, such as lax credit guidelines by the banks and
mortgage brokers."
Now, despite 4.6% unemployment and a 4.7% yield on the 10-year Treasury
note...the sub-prime lending business is crashing and burning. From Orange
County comes news that the aforementioned New Century Financial is trading
below $5 a share...a precipitous fall from its high of $66 in December of
2004. At today's price, in theory, the Golden State lender must be the
bargain of a century, with a dividend yield of 167%. But, again, the reality
is different: the news report also tells us that the company may be forced
into bankruptcy.
While the sub-prime lenders are being pulled from the wreckage, the
super-prime borrowers are still flying high. In theory, hedge funds charge
extraordinary fees for extraordinary performance - 2% of capital and 20% of
performance. For what? To return to the Greek alphabet, for helping
investors get 'alpha' - a rate of return above and beyond 'bet', which is
what the general market produces.
Warren Buffett, probably the greatest investor who ever lived, says the
whole idea is "grotesque". In last week's letter to shareholders, he
explains that you can invest in his "hedge fund", otherwise known as
Berkshire Hathaway, and pay no management fees at all.
The compounded average annual gain of Berkshire Hathaway from 1965 to 2006
is 21.4%. What does the average hedge fund get? In 2006, hedge funds
produced a 14% return, almost doubling the 7.6% of 2005 and better than the
10% they did in 2004. Over the longer run, hedge funds show an annual return
of about 7%.
Mark Gilbert, summing up for Bloomberg News, concludes that hedge funds
"levy outsized fees on the pretence of generating tons of clever alpha, when
they are really just seizing the beta available to anyone".
In other words, in practice, the hedge fund managers, like the dot.com
entrepreneurs and the sub-prime lenders, are not really geniuses at all.
They make their money just by showing up...just like everyone else. And they
get the same rate of return. Or worse.
Many funds and hedge funds jumped into Japan after that market went up 40%
in 2005. The following year, 2006, was disappointing. The Nikkei Dow rose
barely 4%. How did the hedge funds do? As Merryn Somerset Webb reported
last week, "far from proving their ability to make absolute returns in any
market conditions, [hedge funds] did particularly badly; they all fell
between 5% and 20% over the year."
Sub-prime lenders did not hedge the risk inherent in lending to weak
borrowers. Instead, they sought it out and leveraged it up. Hedge funds seem
to have done the same thing - reaching out a little too far in order to grab
a few extra points of yield. Now, we wonder who owns the $23 billion of New
Century Financial debt...and who owns the rest of the debt in the sub- prime
area? We wonder too, who owned the $2.5 trillion worth of equity value that
disappeared last week?
Surely, there's some more 'big impact' lurking out there...still waiting to
hit someone.
We look in the mirror and hope it isn't us.
Regards
Bill Bonner
The Daily Reckoning
Bill Bonner in Paris:
"It seems I have a yen to lose..."
Carly Simon
Viva Recklessness! Long Live the Prom Queens!
Today, the significant news is that the European Central Bank has raised its
key lending rate to 3.75%, warning of growing inflation.
That puts exactly 325 basis points between the yen and the euro. A
speculator can still borrow in yen, convert to euro, and lend the money out
- pocketing 3.25% of gross margin yield. Using leverage unwisely he can
leverage that return up to the point where he is almost sure to go broke.
The yen carry trade lives on!
But we are not high rolling international speculators here at the Daily
Reckoning. We are low-rolling, stay- at-home plodders more interested in the
return on the local Laundromat than on yen carries.
Still, there are butterflies flapping their shiny little wings all over the
world of finance. One of them is bound to send shirt tails flying somewhere.
And thus begin some rambling reflections fit for a quiet Friday morning.
If investors think they can make money by investing in euros they should
look at the New Zealand dollar. The Kiwis raised their rates too - citing
the same zeal to declare preemptive war on inflation. The gap between a
short yen position and a long NZ$ position is precisely 700 basis points.
That looks like easy money to us...as long as nothing goes wrong.
And nothing ever goes wrong...until something goes wrong. We had our eye on
the yen, because we saw it as something that probably would go wrong. At
some point - perhaps last week - investors were bound to get a little
nervous. When they got nervous, we reasoned, they would make haste to exit
their risky speculations.
Since they are overwhelmingly short the yen, they would necessarily have to
buy it back in order to unwind their positions. This would force the yen to
rise.
And the yen has been going up. If it continues upward it will both signal
the demise of the carry trade...and bring it about.
The math is elementary. Let's say you have $1 million you want to put into
this play. You leverage it up to borrow $10 million in yen. Then you invest
the $10 million in NZ dollar bonds. If all goes well, in raw numbers, you
make $700,000 in net yield - or 70% or your original investment.
But what if it is the yen that goes up 7%? Ai yi yi...that's $700,000 more
that you have to pay back.
Now you've lost 70% of your original investment.
Yes, dear reader, it is a wicked, treacherous world, although no one else
seems to notice. While we still fly our 'Crash Alert' flag...and while the
world lost
$2.5 trillion in equity value last week (before recovering some of it)...and
while the yen rises ominously...we see few signs that investors have gotten
the message. Most think that today's gush of liquidity will gush on forever
and that today's investment sweethearts - stocks, bonds, art, property -
will remain prom queens forever. Eternally young.
Forever beautiful. Oh, dear reader...if only it worked that way!
And here we let you in on a little secret.
Pssst...don't tell anyone...but stocks are going to sag and fall. Especially
those cute little Asian beauties.
Bonds too. And art? Today's belles will be yesterday's news...rejected,
ignored, neglected - like the prom queen's mom!
Even housing will fade and fall out of fashion. It's already happening.
Quietly, prices are being cut...while mortgages go bad. It may not yet be
the end, nor even the beginning of the end, but it is surely the end of the
beginning for America's housing boom.
Our old friend Marc Faber says he's lived through four MAJOR financial booms
in his lifetime. There was the boom in commodities and precious metals in
the '70s...then the boom in Japanese assets in the '80s...then the mania in
emerging markets in the '90-
'98 period...and finally, the bubble in tech and telecoms in the '90- 2000
era. During each one of these booms people thought the good times would last
forever, 'because there was so much new money coming in'. Today, that is
just what people say about China, art, London property - and stocks and
bonds, generally. But each bubble popped...and its brightest stars - its
alpha companies...its go-go market leaders...its prom queens...and its
celebrity kings - all quickly vacated the headlines. When they reappeared in
the news, it was in the fine print... that is, in the notices for workout,
refinance and chapter 11.
More news:
------------------------
>From Dan Denning in Melbourne, Australia:
*** "Invest for the long-term." "Diversify." "We are in a period of Great
Moderation in volatility, so don't panic."
- The short version of today's post is that you should probably ignore all
the soothing platitudes about investing for the long-term. No one has ever
proven that an entire generation can retire by treating the stock market
like a savings account. With no evidence that it's ever been true, we have
no reason to believe this time will be any different. It's a big gamble to
take with a life time's worth of capital at stake. But it should be fun to
watch!
- Our suggestion is to panic now and avoid the rush later. Soothing axioms
barely disguise the truth that markets today are more volatile, not less,
and that what you saw last week is a taste of what you'll have to get used
to from now on. Depending on the goodwill of "the market" to see you through
to retirement is like depending on the goodwill of a cannibal to not to eat
you once he's got you in a boiling pot. A cannibal can't help what he is.
And the market can't help doing what it does best, separating a fool from
his money.
There are millions of fools out there, although some are bigger than others.
- "An investor's two best friends," writes American financial guru Ben
Stein, "are time and diversification. Get the broadest possible market
indexes. Spread yourself out over large and small caps.
Have a large dollop of the developed foreign and a goodly chunk of the
developing market. Yes, it'll be a rocky ride in China and Brazil, but over
long periods you'll do great.
- Exactly what portion of your portfolio is a dollop?
How do you tell a goodly chunk from a badly chunk? And over the long-term,
aren't we all dead?
- We don't mean to be petty or quibble. But man, if anyone walks into the
Old Hat Factory and starts mentioning the word diversification as a
bear-market survival strategy, he had better duck. There will be coke
bottles and curse words flying, unless he can explain himself, and quickly.
- Here's our beef with the word: the idea of diversification is based on the
existence of negative correlations between sectors or asset classes. When X
zigs, Y tends to zag. And diversification makes sense if some things go up
while others go down. And it used to be that some things went up while
others went down.
Bonds went down in inflation, commodities up. Cash is more valuable when the
money supply shrinks. Shares and property don't always move in tandem.
Emerging markets move up faster in bull markets than blue chips, but fall
faster in bear markets.
- Pre-Greenspan, there were certain inter-marker relationships that made
sense and that you could prove with real performance data. There were, for
example higher yields on foreign markets and emerging market bonds than on
U.S. savings bonds. Perhaps it sounds naïve today, but those higher returns
- those risk premia - were the reward you got for taking a bigger risk with
your capital. If you wanted a safe savings account, you weren't going to
make much money in it, maybe a few percent above inflation. But if you were
willing to buy Brazilian stocks or Icelandic bonds, well that was another
matter entirely. You might be crazy. But you might also be right. And you
deserve an extra few hundred basis points for being crazy, brave, and
correct.
- But for the last four years, risk premia have nearly vanished. These days,
everyone is crazy, no one is brave, and many people are wrong. We say no one
is brave because bravery requires some knowledge or appreciation of the
nature of the risk you're taking.
Yet no one seems to think investing in shares is all that dangerous.
- "Corporate balance sheets are in good shape. There's been a sustained
decline in macro-economic volatility over the past decade, thanks to
structural changes that have improved the ability of economies to absorb
shocks and better monetary policy. It is, as then-Federal Reserve Governor
Ben Bernanke said in 2004, the era of "the Great Moderation". Such an
extended period of calm probably explains investors' bold, risk-happy
behaviour," writes Corinne Lim in today's Australian Financial Review.
- Such an extended period of calm usually precedes all hell breaking loose.
Stability breeds instability, as economist Hyman Minsky famously pointed
out. There has been a ton of breeding going on in the last few years.
We saw the first birth-pangs of instability last week.
But not the last.
- All of this happens for a simple reason, there is too much money chasing
too few assets. This doesn't mean the risk has vanished from certain types
of assets. It just means you no longer get compensated for taking it, which
seems like a bad bet to us. And with money charging around the globe buying
up things willy nilly, the art and science of valuation itself appears to be
temporarily worthless.
- Can diversification save you? What does that word even mean in a world
flooded with liquidity and cheap money? How is it possible to truly
diversify in a market where there's so much money chasing so few stocks that
everything is going up regardless of traditional methods of valuation?
- If diversification is based on the observation that some asset classes are
inversely correlated (that x goes up when y goes down and y goes up when x
does down), what happens in a liquidity-driven market (say one where super
contributions are increasing while the supply of assets is not)? When all
asset classes start moving up because of excess liquidity, there is no
longer any negative correlation. X and Y move up along with A, B, C, D, E,
and F. And they all move down at the same time too, right?
- How, then, is it possible to structure a portfolio in the modern world
where you are compensated for the decline in one asset or sector with the
rise in another? With everything rising in lock-step over the last few
years, isn't the risk now that everything will fall in lock-step too?
- No! We read that real diversification is possible, but at a price, in an
article called "Special strategies come at a high price," by Jonathan
Barrett in today's Australian Financial Review. To achieve it, you must
expect to pay a 2 per cent fee, an adviser trailing commission of 0.3 per
cent, and an annual management fee of 1.85 per cent. And for that pretty
penny you will buy a fund which, "has the potential to generate positive
returns in market conditions that are adverse to traditional asset classes,
thereby providing diversification benefits within higher risk traditional
growth portfolios" says firm Researcher Lonsec.
- Also featured in the article were steps on how to eat chocolate without
getting fat, cheat on your taxes without getting caught, and make more money
by doing less work and drinking only single-malt scotch for breakfast and
lunch, and red wine for dinner.
- Does anyone really believe this anymore, that you can generate positive
returns in market conditions that are "adverse to traditional asset
classes," without taking more risk? How exactly would that get done? What
non- traditional asset classes out-perform when stocks, real estate, gold,
oil, and bonds are all getting hammered?
Figurines? Pin ball machines? Does e-Bay count as an asset class?
And more views from Bill:
*** "You're wrong about that," said a new friend earlier this week. Paul
Tustain runs something called BullionVault.com. It allows investors to buy
gold at the lowest-possible markup and store it at the lowest- possible
price.
We replied that we knew a cheaper way to store gold - simply bury it.
"Not a good idea", he replied. "You are either storing it so that you'll be
able to make a profit on it when it goes up in price...or you're storing it
for when society breaks down and you really need cash. In either case,
you're better off storing it with a reputable, reliable storage company -
like Brinks - where the chain of title is clear. If you want to sell it, you
can sell it at a better price and without ever touching it.
"And if you think you'll be better off with coins in your hand, I have news.
I met a guy who'd gotten his family of Iraq. He was trapped in a remote area
and needed to buy supplies and transport from the locals to get across the
border. He had gold coins so he thought he would be all right. But they
didn't want gold coins.
They didn't trust them. They wanted dollars. He had to sell the coins at
huge discount...and he said he felt lucky to get out at all.
"Today, not many people will recognise a gold coin. In extremis, you might
be able to use a coin to buy a loaf of bread, but you'll get much less for
your coin than it is really worth."
*** Last week, one of the biggest jackasses in the U.S.
Congress took his leave of the free parking, free travel, and luxury dining
facilities provided at the capitol and checked in to the more Spartan
comforts of the federal pen in Morgantown, West Virginia.
The crime that landed Bob Ney in the hoosegow was conspiracy and making
false statements in the Jack Abramoff Indian lobbying scandal. But what gets
him notice in these pages is his meddling with the menu at the Capitol Hill
eateries. Readers will recall the occasions. It was when George W. Bush made
known his intention to invade Iraq and French president Jacques Chirac
shrugged, 'Not a good idea,' adding that it would probably turn into a
bloody mess.
If they had had any sense, the jacks and the knaves running the U.S. at the
time would have thanked the French - who have far more experience fighting
Arab insurgents than we have - and side-stepped the calamity. (Footnote: It
was not the first piece of good advice from the French. When the Kennedy and
Johnson administrations were gearing up for war in Vietnam, Charles de
Gaulle advised against it. There too, France had just had a recent and
sobering experience.
'You'll never win in that rotten country,' said the French president.)
Nonetheless, the Bush administration thumbed its nose at Chirac and rolled
out its campaign of shock and awe - with the results we see in the daily
papers today.
But the aforementioned Mr. Ney took the French demeure particularly hard. It
seemed to stick in his craw. So, he ordered the lawmakers' restaurants,
cafeterias and snack bars to halt all reference to 'french fries' or 'french
toast.' That would show 'em!
He announced: "This action today is a small, but symbolic, effort to show
the strong displeasure many on Capitol Hill have with our so-called ally,
France."
The poor buffoon. What's a friend for...except to try to stop you from doing
something stupid?
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