The Subprime Mess

The current catastrophe illustrates several traps and delusions that come up frequently, even though they are fairly obvious… Enough so, indeed, that I have pointed them out in my books:

1. First trap/delusion: The end of every great bull market is accompanied by that time’s version of a margin account, different enough from the previous time so that is not easily recognizable.  See page 81 of The Craft of Investing:  “It’s like a seedy nightclub:  The jaded customer watches the different acts going by, and may or may not realize that they are all the same girls, in different costumes.  One time they are cowgirls with leather boots and revolvers, next time a tango team.  Always the same old troupe, in slightly altered form.  In just this way, the market serves up a series of disguised margin accounts as part of every great top.”  Previous extravaganzas were the extreme margin mania before Black Thursday in 1929, the postwar conglomerate boom with its “Chinese paper,” and the more recent leveraged buyout craze.

This time two variations are going simultaneously, private equity and the mortgage bubble.  Buyout funds are huge direct margin accounts.  Suppose Gargantua Partners L.P. buys Fidotronics International. Gargantua intends to slap a lot of debt onto Fido (and take out a bundle for itself) and then sell it again for more, with banks putting up most of the purchase money.  Gargantua believes that the cost of the bank money will be lower than what it hopes to earn on the deal.

A while back, the Fed’s Niagara of cheap money to bail out the dot-com collapse created the resulting real estate boom.  So the public naturally reasoned that rising house prices justified vast speculation on still higher prices.

2. Second trap/delusion:  I have often written that the words “XYZ can only go up” are a firebell to the experienced investor.  It means that everybody who can buy has already bought.  See Page 3 of Preserving Capital and Making it Grow: “The dangerous purchase is when the crowd is queuing up to buy regardless of price, having been told that truly first-class works of art (or IBM, or land, or diamonds) can only go up.  Remember those words.  They are the early warning signal of much lower prices.”  A while back that was said of the dot-coms, gold, real estate, and today art.  The relevant delusion now is of course, houses.  They were so sure to rise that there was (and is) a TV program called “Flip that House,” among others.

An expression I coined is, “Nothing exceeds like success.”   A good idea goes up and up and up until it must collapse of its own weight.

3. Third trap/delusion:   On Page 73 of The Craft of Investing I cite the old Wall Street maxim, If the ducks quack, feed em.  “In a bull market, an unlimited volume of securities can be manufactured, enough to satisfy everyone’s desire to invest, however strong.”  This time, the housing bubble, based on the “can only go up” principle, created an intense yearning on the part of domestic and foreign institutions to take advantage of the high yields generated by wormy mortgages. Quack, Quack!  Often, no study whatever was made of the buyers’ creditworthiness, and often there were in effect no down payments at all. One study showed that when not checked, “stated income” was 50% exaggerated.  A recent British study showed that on occasion loans were granted for 125% of purchase prices!

These mortgages were then bundled into packages that somewhat disguised the junk within. The head of a Paris law firm, Roy Archibald, once described such a confection to me as “a fart in a bottle.”  Coarse, but true.  Or in the interest of respectability, one might call it a cowflop in a Tiffany box.  The trade called them neutron loans, after the neutron bomb, which killed people but spared structures.  Under any handle, a lousy “investment.”  The subprime market has risen to over a trillion dollars, roughly 57% owned by Europeans.

*     *     *

 Everybody is at fault in this wretched situation: the greedy and mendacious homeowners, the unscrupulous bankers, the mortgage companies and brokers, and perhaps most of all, because they had not a commercial but a fiduciary responsibility, the bond rating agencies.  They knew what was in the fake Tiffany boxes, but maintained their excessively favorable ratings – that the cowflop was a diamond – until much too late.

Some of the guilty are being harshly punished.  Big banks and hedge funds have dropped billions.  Some have been subpoenaed; some will go out of business.  Many, many homeowners, not guilty but gullible, are being evicted.

Is the Fed among the guilty?  Perhaps.  Greenspan may have turned the spigot on too far.  The Fed thinks markets should teach their lessons, since mankind only learns from bitter experience.  Pathe mathos, said the Greeks, “learn through suffering.”  Fine in theory.  But in a pre-election year, the wails of the miserable householders rise to heaven… and to the Fed. ■

See also The Subprime Mess, Continued