Blowback
Capital Thinking • Issue #579 • View online
Government, leaders, voters often have the best intentions but don’t realize consequences that could come years later.
Watch out for student loans and watch out for future bubbles in this bailout. There WILL be a crisis two to five years down the road created by current good intentions.
-James Altucher
MY TWITTER CLASS ON THE REAL CAUSES AND SOLUTIONS OF THE GREAT RECESSION
1994 – Clinton used an executive order to create the National Homeownership Strategy, with the very good intention that everyone should be able to afford a home. This began reducing borrowing standards so more people could get loans.
1995 – Presidential executive orders forced banks to establish a lending quota of up to $6 trillion to people who were not able to afford a home. Again, very good intentions. I don’t blame Clinton. Owning a home was considered a source of pride. But good intentions often lead to very BAD outcomes.
Seemingly unrelated… 1998 – The hedge fund Long-Term Capital Management (LTCM), set up by top investor John Merriweather and two Nobel Prize winners, was hit by disaster. It was so leveraged that it almost tanked the world, until all of the major banks joined together to bail out LTCM and save the financial system. Well… all of the banks except two: Lehman Brothers and Bear Stearns (this is relevant later).
1999 – The Glass-Steagall Act was passed, deregulating banks, and also allowing banks to form hedge funds that could invest more aggressively than the bank normally would. This also allowed banks to lend more. Good intentions again…
2000–2001 – The internet bust and recession. 9/11. The market collapsed. Interest rates were deeply cut to restimulate the economy, allowing more subprime borrowers to take out no-money-down, interest-only loans. Again, good intentions. Until…
2002–2006 – Low interest rates + more lending + more investors allowed banks to lend to make interest-only, no-money-down loans to subprime borrowers. Many subprime borrowers bought homes. Anyone who wanted to could own a home. Good intentions…
1999–2006 – The government promised to backstop the loans (reduce risk for the banks so they could lend more): Fannie Mae would “buy” the loans as soon as they were made and the banks were simply paid to collect the money (exactly like PPP loans today, with the Federal Reserve buying the loans).
2000–2006 – As a result of the above, banks had zero risk in lending. So they lent as much as possible, would resell loans to the government, service the loans, take a fee. EXACTLY how the PPP loans today will work. But then derivatives…
2000–2005 – Hedge funds (often run by the banks) started buying the loans, since the mathematical models showed that risk of default in a diversified portfolio of mortgages had never failed. Then mortgages were bundled together to create “mortgage-backed securities.”
Note: The mathematical models hedge funds and banks were using never considered subprime borrowers. Hedge funds were borrowing at 1% and buying as many mortgage-backed securities as they could at 4%. Banks, funds, brokers… making money. People buying homes, homes going up in value…
As a result, the economy heated up. So the Fed started raising interest rates, from 1% to 5%. Now people who borrowed “interest-only” loans at 1% had to pay 5x more per month in payments. Subprimes started to default…
2006–2007 – Housing actually bottomed. It would’ve come back quickly — but nobody counted on the disaster of mortgage-backed securities, and a small unnoticed change in the banking laws…
2006–2007 – Hedge funds started to crack. The mortgage-backed securities started to default. If a hedge fund were leveraged 100:1 (as some bank hedge funds were), then a 1% drop in MBS meant the hedge fund had a 100% (!) loss (because of the 100:1 leverage). But it gets worse…
2005–2007 – Credit default swaps were created. If a lender was nervous that a borrower would default, a credit default swap acted as “insurance” that the lender would get paid in full. The lender would have to BUY the credit default swap from someone.
Hedge funds got involved… They would SELL the credit default swaps). It was free money for the hedge funds since, up until then were, defaults basically zero if you sold a basket of diversified credit default swaps. This was a ton of free money for the hedge funds. But HUGE, HUGE leverage…
2006 – A few hedge funds (John Paulson, Michael Burry) got smart and started buying tons of credit default swaps from hedge funds. The sellers (the hedge funds acting like insurance companies on subprime loans) were laughing all the way to the bank until…
The hedge funds that were buying the insurance (John Paulson, Michael Burry) were losing money every month. Their long-term bet was that the system would collapse. John Paulson pitched me on his fund and I left his office thinking, “Holy fuck, we are screwed.”
Paulson only had one worry… He told me in 2006 (way before the top of the market) that he was afraid the banks would go out of business before he could get his money out. Two years later, this almost came true.
*Featured post photo by Maxime Lebrun on Unsplash