Alphas, Betas, Scamps, and Scalawags
As the subprime industry continues its steady decline into the bowels of bankruptcy, we can’t help but wonder what these lenders were thinking. Bill Bonner explores this industry’s business model, and finds out that sometimes, thinking isn’t necessary – just showing up to work is enough. Read on…
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 subprime 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 ‘subprime’ 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 new ‘go-go’ financial industry got going…and pretty soon, its hustlers and entrepreneurs – like the whiz kids of the dotcoms 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, 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 subprime 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 that 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 4.7% yield on 10-year Treasury notes…the subprime 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 subprime lenders are being pulled from the wreckage, the superprime 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 ‘beta,’ 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 could 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 pretense 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 dotcom entrepreneurs and the subprime 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."
Subprime 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 subprime 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.
The Daily Reckoning
March 9, 2007
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:
"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 shirttails flying somewhere.
And thus begins some rambling reflections fit for a quiet Friday morning.
If investors think they can make money by investing in euro 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 New Zealand dollar 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 on 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, or 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, and 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.
Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…
"The Bank of England (BOE) kept the dust covers on their rate hike machine yesterday… But don’t think for a minute that they’re finished either! I would have to believe that BOE Governor King is chomping at the bit to get rates higher."
For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig
And more views:
*** Panama wins again. Our sister publication, International Living, recently published their Global Retirement Index, and Panama was again at the top of the list. Here’s what they had to say:
"This is still the developing world, no question, but in Panama City you can enjoy all the amenities and conveniences of First World living. A friend in the country for the first time as I write reports, ‘The grocery store where I shopped this morning is better than my grocery store back home in the States. It had everything…including special French cheeses…even French butter…and an impressive selection of wines from around the world.’"
*** "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 – somewhere safe, offshore, like Switzerland – where the chain of title is clear. If you want to sell it, you can sell it at a better price, 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 was in 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 would recognize 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 noticed 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 United States at the time would have thanked the French – who have far more experience fighting Arab insurgents than we do – 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?