Liars' Loans

The Daily Reckoning PRESENTS: What will happen when the Hindenburg of derivatives meets a spark from the housing bubble blow-up? We don’t know. But we had a ringing sound in our ears earlier this week. We thought we heard bells. Bill Bonner explains…

by Bill Bonner

On Tuesday came news that the house of Goldman continues to prosper. The company announced record profits. It also announced that its 25,647 employees would make more than half a million dollars a piece this year – a 19% increase over last year.

On that very same day, a headline proclaimed the latest milestone in another, possibly related, trend: the U.S. trade balance hit another record, at $68 billion for the month of July.

How these two bits of synchronicitous news are related would be a good subject for an issue of The Daily Reckoning, we thought. But that is not our theme today; instead, we will turn our focus to Goldman and Greenspan, along with a supporting team of millions of witting, unwitting, and completely witless accomplices have wrought.

The housing bubble in America is losing air; the papers are all over the story. While the evidence is mixed, cocktail conversation has turned from how much money people have made by selling their houses to how much money they might have made if they had sold a little earlier.

But while lips tell the stories, the message still hasn’t arrived at the part of the brain that can add two and two. Homeowners are still borrowing and spending; they have not yet cut back in anticipation of harder times ahead. And financiers are paying big money for derivatives and the companies that produce them. While the credits creak and wobble, the creditors haven’t seen so much M&A activity in 10 years. Merrill Lynch, for example, just paid $1.3 billion to acquire National City Corporation’s mortgage origination business. And, judging by profits (Goldman’s are up 16% over last year), bonuses, and prices – the masters of the financial paper shuffling business are in high cotton.

What is Goldman? Among people who package and sell debt in large volumes and at large prices it is the leading brand. Debt comes in many varieties and many forms – especially after Goldman gets finished with it. But the variety called “mortgage backed securities” is worth looking at more closely…if not for illumination, at least for amusement.

A mortgage-backed security is backed by a mortgage. But what backs up the mortgage?

We put the question to an Irishman. “These houses are so expensive…how can people afford to buy them?”

“Ah…you might wonder what the real source of this Irish Renaissance is. It is debt, pure and simple. We had interest rates of 10% or more – until we joined the European Union and got the euro. Then, all of a sudden, you could borrow money for only 3%. You can imagine what that did – the whole place went on a spending spree – mostly concentrated on property, because the Irish love owning their own houses. I think it is something left over from the British rule, when we weren’t allowed to own property. Now, we can own it…and now, with these interest rates, we can afford it. At least, as long as the lenders will keep lending on favorable terms. Right now, they practically stop you on the street to try to give you money.

“That’s the real secret. The Germans had worked and saved for decades…and developed attitudes about money and institutions…all these things that allowed them to have interest rates around 3% without going crazy on credit.

“Then, when that low borrowing rate was introduced to Ireland, it was as if the pubs were giving away free pints 24 hours a day. The party has been going on ever since.

“So you see, we have everything you have in America: a property bubble even bigger than yours…with interest only housing loans… new cars everywhere…new buildings…everything.”

The one thing the Irish do not have – a property bust – we predict they will get soon. Good and hard.

So far, the property bubble has added $30 trillion to the “wealth” of the developed countries alone. Borrowers may have been inclined to stop spending years ago, many would have gone broke, but the lenders wouldn’t let them. New ways of letting out money were developed…each one more exotic, and more tempting, than the last. Not only could the mark pay less-than-market rate interest on his loan, and make payments when and if he chose to do so, he was also allowed to borrow with no proof of income; in these “liars’ loans” whatever he stated as his income was taken down for fact.

While, down low on the economic food chain, men in cheap suits sold ARMs to people with hardly a financial leg to stand on, up higher, better dressed pitchmen derived from these dubious credits highly leveraged “securities” which they offloaded onto supposedly sophisticated financial institutions.

It is one for the financial history books. Conditions for credit expansion had never been better than they were in the last quarter of the last century of the 2nd millennium and the first few years of the next. In 1971, the world’s money lost all contact with reality. The dollar, completely freed from gold, could be stretched almost infinitely. And then, Paul Volcker crushed excessive inflationary expectations in the early ’80s, while increasing globalization helped hold down consumer prices. And then began the great bull market in bonds…in stocks…in houses…in credit generally, and credit derivatives in particular. And now the whole world floats in the biggest bubbles ever – expanded, among other things, by $236 trillion worth of [notional value] derivatives.

“We have no idea what will happen in the next 12 months,” we told our audience in Dublin. “No one seems to think these bubbles will blow up. And since they’re not worried about it, insurance against a blow-up is fairly cheap. Put options, for example, are a bargain. Gold at less than $600 is a bargain too.

“Not that we expect gold to soar. Gold may go up. It may go down. But it won’t go away. When the credit expansion turns into a credit deflation a lot of other credits will disappear.”

That is when the liars default on their loans. And Goldman’s bonus checks get smaller.

Bill Bonner
The Daily Reckoning
September 15, 2006

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:

The Most Feared Book in Washington!

Bond prices have been going up [yields have been going down] for the last four months.

Oil…gold…commodities generally…housing – all seem weak.

The stock market has generally taken these trends as good news. We’re not so sure. What we could be looking at is the leading edge of a credit deflation. Debt has been in a bull market ever since Paul Volcker brought inflation under control in the early ’80s. Along with debt lower interest rates and higher asset values…a huge explosion in credit derivatives.

A credit deflation must come sometime. Why not now?

More news:


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“You see what’s happening don’t you? Global Growth, fuels inflation, which fuels higher interest rates around the world, and that should help currencies gain on the dollar, who has had the two props supporting it in 2005 removed.”

For the rest of this story, and for more insights into the currency markets, see today’s issue of The Daily Pfennig


And more views…

*** After a very dry summer, it’s been raining in Baltimore pretty much nonstop for the last couple of weeks. But that’s not the case for the majority of the country.

“More than 60% of the United States is abnormally dry or experiencing drought conditions,” reports Capital and Crisis’ Chris Mayer. “Life-deadening heat blows its hot breath across the woodlands of Georgia to the suburbs of Arizona, from the ‘Big Sky’ country of Montana to the dairy farms of Wisconsin.

“Paul Smokov, an 81-year-old South Dakota farmer, called conditions this summer ‘the worst since the 1930s.’ Climatologists speculate as to whether or not we should expect such higher temperatures as normal.

“In any event, the recent weather affects many agricultural commodities. Consider:

“U.S. peanut farmers will produce their smallest crop since 1915.

“Oklahoma is having its worst drought in its history, which is taking a toll on crops and livestock. The USDA estimates half of the state’s cotton crop and a third of its sorghum plantings are in poor or very poor condition. Livestock is mostly in fair or poor condition, with three-quarters of the state’s pastures and ranges in poor to very poor condition.

“Another headline reads, ‘Drought Expected to Cut Minnesota Crop Yields.’ Lower soybean harvests will cost Minnesota farmers about $300 million.

“The USDA says we’ll have the worst wheat harvest in 18 years – this has pushed up wheat prices to 10-year highs.

“More than just drought go into these numbers, but it is a contributing factor in all cases.
And as with Europe, the drought conditions simply highlight how poorly we manage our water resources. In some places, water supply is tight, and it should remain tight for decades – regardless of the disturbing predictions of climatologists.”

*** Yesterday, we were wondering why the War on Terror must go on. Today, as promised, we turn back to Niall Ferguson’s piece in TIME magazine for more clues…

“For the Bush Administration, 9/11 was as much an opportunity as a crisis,” writes Mr. Ferguson in his piece titled, “The Nation That Fell to Earth.”

“Bush had not been elected on the basis of his foreign policy expertise, but his gut instinct was to go beyond mere retaliation. The idea that the U.S. should respond to the attacks by fundamentally changing the status quo in the Middle East originated with the so-called neoconservatives whom Defense Secretary Donald Rumsfeld had gathered around him at the Pentagon. If Rumsfeld and Vice President Dick Cheney saw 9/11 as an opportunity to settle accounts with Saddam, the neocons had loftier ambitions. They saw a chance to achieve a political transformation of the Middle East. What nobler goal could there be for U.S. military might than a democratic revolution?

“By the fall of 2003, just two years after the 9/11 attacks, doubts had begun to creep back in. The most striking manifestation of American miscalculation was the refusal of Iraqis to peacefully embrace the nascent democracy created for them by U.S. arms. Far from abating, violence in Iraq increased over time.

“…by the time of the fifth anniversary of the 9/11 attacks, the U.S. military was distinctly overstretched. To maintain manpower levels, the Army was forced to increase its maximum enlistment age from 35 to 42. The Commander in Chief insisted that the U.S. would not withdraw from Iraq until its mission–the establishment of a stable democracy–was completed. But it seemed increasingly likely that when Americans finally went home, there would be no Iraq left to withdraw from–just three warring mini-states. As they bade farewell to the Green Zone, some Americans remembered the evacuation of Saigon in 1975, a generation earlier, which had sounded the death knell for South Vietnam.

“Iraq’s disintegration was the harbinger of a wider regional meltdown. The irony was that terrorism thrived more readily in the new Middle Eastern democracies than in the bad old dictatorships. It was no coincidence that, outside Iraq, the terrorist organizations causing the most trouble in the region were operating out of southern Lebanon and the Israeli-occupied Palestinian territories of Gaza and the West Bank.

“Worse, by breaking up Iraq, the U.S. had unwittingly handed a belated victory in the earlier Iran-Iraq war to the fundamentalist regime in Tehran. No state stood to gain more from democracy in Iraq, since the country’s Shi’ite majority felt close ties of kinship to Iran. And no state in the region was more explicitly committed to the destruction of America’s ally Israel.”

*** “Bonner…Bonner…good Irish name…reminds me of something. Oh yes! Who can forget that day? There wasn’t a man in Ireland who wouldn’t have bought Packy a pint that day.”

We felt at home last night. We were among our people.

“We must buy you a pint of Guinness,” was how the evening began…and how it ended. We don’t remember much of what happened in between.

Guinness is a foul-tasting concoction.

“Oh, you mustn’t sip your Guinness,” our host explained. “It won’t go down well. You have to gulp it down.”

Even gulping it down took willpower…at first. Later, it went down as smooth as an interest rate cut.

“Oh yes, you know you could almost go back to that day to mark the beginning of the Irish resurgence…the beginning of Ireland’s new pride.”

What happened on that day?

“That was the day that Packy Bonner made a save. Well, you Americans don’t know anything about football [soccer], but Packy made a dive for the ball and caught it. I can still remember what that looked like. The scene was famous in Ireland…still is. We all remember the image…and where we were when it happened. Because it kept Ireland in the game. We didn’t win the World Cup that year…but tiny little Ireland made a good showing.”

“Yes, I suppose you could say that was the beginning of it in a way,” said another Irishman. “Before that we had a victim mentality. We were always losers…the poorest people in Europe. We were backward in every way…a pretty little patch of earth, fit for tourists from America, but otherwise we were nothing. But let’s be honest – what really caused it was credit…”

The “it” is what keeps Irish eyes smiling…and tongues wagging all over the Emerald Isle. Everybody talks about it. Everybody thinks about it. And everybody should wonder when it will come to an end.

But after a while people begin to take it for granted.

“I thought it was crazy four years ago,” said one of our companions. “I wanted to sell my house. Fortunately, my wife wouldn’t go along with me.”‘

In the great scheme of things, about all you can count on is that nothing stays the same. Ireland, once the poorest country in Europe, is now the richest. The Dubliner no longer goes abroad in search of work. He now travels looking for investment opportunities. And he no longer drifts in Boston Harbor with an empty pocket. Now, he shows up in Miami ready to make a bid on a condo.

“Once you’ve been in Dublin for a few years, the rest of the world looks cheap,” said one of our drinking companions last night.

We looked in the paper. Turning to the real estate section, we saw photos of very modest houses…some so modest that they might properly be described as hovels. There are grander chicken houses in France, and trailer parks in California look more elegant that the neighborhoods in which they sit.

But there is nothing humble about the prices. Even the most forlorn little grey-cement cottage, near to Dublin, seems to sell for more than a million dollars.

While the U.S. housing boom raised prices 57% over the last 10 years, reports the Washington Post, the housing boom in Ireland drove up prices five times as much. Average house prices rose 270% over that period.

One woman sold a cowshed out in the country for $50,000…while an ordinary, detached single-family house near Dublin can be worth millions. The average house in Ireland is now worth $450,000 according to the Post. The U.S. average, by contrast, is only $231,000. Houses that changed hands in the ’80s for nothing can now fund a luxury retirement.

Rising house prices – in Ireland as in America – have a salutary effect on the whole economy. Based largely – but not entirely – on its real estate wealth, the Micks and Paddies have prospered. Now they are the second richest people on Earth; only the Japanese are ahead of them.

“How the world turns, doesn’t it?” After a few pints, you can count on the Irish to become sentimental. “Everything is so much better than it was. You know, we have immigrants now – imagine that – people coming to Ireland to work. The restaurants are full of them. Well, even the restaurants are new. Before, there were almost no good restaurants in Ireland. Restaurants were places you could get a meal. But it was nothing fancy. Now, there are fancy, expensive restaurants, with chefs from France and Italy, all over town – and they’re full. It’s nothing like it was…

“No, it’s not like it was. Even in the last few years Dublin has changed a lot – and not all for the better…

“Now, everyone’s busy…either earning money or spending it. A few years ago, we didn’t have any money, so people had more time to just talk…you know…spend time at the pub…relax at home.

“And now people aren’t quite as relaxed or as sociable. And you used to be able to do what you wanted…nobody particularly cared what you did. Now, you’ve got to be careful. You can’t even smoke in the pubs anymore…can you imagine that? Who would have thought that the Irish would go for something like that. Of course, we’re not as bad as America…not yet. We don’t put you in jail for jaywalking. But that free spirit that used to be Ireland has gone. People take themselves more seriously.

“Yes, having money is better in some ways…but I remember how it was…and I miss it.”