Missteps to Mayhem

house-illustrationIn predicting when and how America’s financial collapse would occur, my focus was on the growing importance of the housing sector, the actions of our government, and the response of the private sector. This was not simply a case in which a few early adopters made a lot of money or a few venture capitalists acted badly. The entire economy—consumer spending, jobs, securities market—all depended on home price appreciation.

The amount and types of leverage, the generations-old assumption that housing prices always went up, and broad societal participation in home ownership (with greater than 60 percent of Americans owning a home) all called out to me. Soon I would see financial Armageddon with housing as its trigger point.

The idea of an American dream being related to home ownership has been around for nearly a century. Nearly every modern U.S. president has promoted it. The government helped returning GIs buy homes after World War II, and the government was the first to securitize mortgages in the early 1970s. Private securitized mortgages followed shortly thereafter. Under President Reagan, the Secondary Mortgage Market Enhancement Act allowed insurance companies and pensions to invest in these securitized mortgages. A short time later, Reagan signed a law that made these types of products more tax-efficient.

Securitization of mortgages means there is virtually no limit on mortgages that can be originated by an institution; they just get sold through Wall Street to investors. For decades this was considered harmless—a good thing for the American dream.

The desire to satisfy this dream, however, needed a tool—something that would make home loans more affordable to those without the income, credit or assets to afford one. In 1982 the Depository Institutions Act legalized adjustable-rate mortgages for the very first time. These adjustable-rate mortgages, or teaser-rate mortgages, would be at the heart of the collapse of our economy two and a half decades later.

Adjustable-rate mortgages did not take off immediately, but additional regulatory and legislative changes in the 1990s and early 2000s jump-started the market. During the 1990s the Community Reinvestment Act of 1977 was reinterpreted several times by then-Secretary of the Treasury Robert Rubin and then-President Bill Clinton.

The crisis, in my view, would start in 2007, by which time teaser-rate periods would expire or reset. On the way down, housing would take consumer spending, jobs—everything—with it.

The intent was to increase pressure on banks to make loans to less credit-worthy customers—and they did. Subprime issuance bloomed in the 1990s. Then in 1999 the Gramm–Leach–Bliley Act repealed the Glass–Steagall Act of 1933 and officially removed the increasingly leaky separation between the activities of Wall Street banks and depository banks.

This freed banks to expand into new lines of business—none more fateful than the experiment with derivatives and subprime asset-backed securities. The private market gained the ability to mount a massive response to the government’s efforts to stimulate housing.

Our global village underestimated many risks throughout the 1990s, as is typical of a generally good economic time. As we faced 9/11, the stock market crash of 2002, the Enron and WorldCom scandals and eventually war, the Federal Reserve Board stepped in, cutting the discount rate it charged lenders from 6 percent to roughly 1 percent in order to stave off recession. Other key short-term interest rates followed.

Not coincidentally, from 2001 to 2003 we saw American home prices, which had largely moved in line with household income through the decades, suddenly accelerate up and away from the household-income trend line. Rapidly declining short-term rates hit lows not seen since the aftermath of the Great Depression, inducing a boom in adjustable-rate mortgages.

The homeowner’s dollar went further during that teaser-rate period, so home prices rose unnaturally. Risk would be low as long as home-price appreciation was strong under this paradigm, thanks to refinancing options.

It was a positive feedback loop with the full blessing of the U.S. government. Amid early fears that the housing market was getting ahead of itself in 2003, Federal Reserve Board Chairman Alan Greenspan assured everyone that national bubbles in real estate simply do not happen.

I disagreed. As I surveyed the national trends in housing, I wondered whether common sense ought to rule against the application of precedent to the unprecedented. But Greenspan went on to advise in 2004 that new types of adjustable-rate mortgages were being underutilized. In 2005 he allowed technology used by subprime lenders to get subprime borrowers into homes. Tragically for all of us, the Federal Reserve had authority to block lending activity it deemed unworthy of such treatment, but it had no will to do so.

“Our leaders in Washington either willfully or ignorantly aided and abetted the bubble,” Burry wrote in a 2010 <em>New York Times</em> op-ed piece.
“Our leaders in Washington either willfully or ignorantly aided and abetted the bubble,” Burry wrote in a 2010 New York Times op-ed piece.

In any event, by 2003 mortgage rates stabilized at 40-year lows. Plain vanilla adjustable-rate mortgages had come into widespread use, creating a big problem for public lenders with a growth mandate. They needed to stimulate more loan volume despite stable mortgage rates and inadequate income growth. At this point, if home prices were to rise significantly, they would have to float almost entirely on the back of the type and quality of mortgage credit provided to the buyer. Critically, interest rates alone would no longer determine affordability.

In my letter to investors at the time, I termed this “credit extension by instrument.” And it took our housing market into a new paradigm. It was the private market’s time to overreact.

The instrument chosen by lenders for subprime borrowers in 2003 was a relic of the 1920s: the interest-only adjustable-rate mortgage. Lenders, by implementing a tool they had long avoided, showed that they were more interested in growth than in maintaining credit standards. They were no longer checking excess credit risk at the door.

By fall 2004, I noted for my investors that Countrywide Financial, a very large national mortgage lender, was reporting subprime mortgage originations up 158 percent year over year, despite a 24 percent decline in overall loan originations. Evidence was manifest: Banks were chasing bad credit, inclusive of housing speculators. The only question was how far they could go.

Ominously, fraud jumped. The point at which the provision of credit was most lax, in my mind, would mark the point of maximal price in the asset. I imagined the top end of the housing market would be marked by a climate in which borrowers of subprime quality were enticed to buy with teaser-rate monthly payments near zero. I was very aware lenders would take this to the nth degree. Banks could sell loans they did not want to keep through Wall Street, to investors who were ravenous for yield.

Importantly, because subprime mortgages were being turned into securities, there were mandatory regulatory filings—and that’s how I educated myself about the sector. At times I felt I was the only one reading these filings.

By summer 2005 these documents revealed that interest-only mortgages had taken a substantial share in the subprime market. Just a year or so after they were introduced, more than 40 percent of subprime originations were passing through Wall Street on their way to investors. This was up from 10 percent a year earlier. At the same time, second-lien mortgages ramped up significantly. Stated income options available to borrowers inspired a new vernacular: the “liar loan.” In some mortgage pools, 40 percent of subprime loans were for second or vacation homes.

At times I felt I was the only one reading these regulatory filings. As late as 2005, Moody’s and Standard & Poor’s—so crucial to the securitization process—were not reacting at all.

Yet as late as 2005, Moody’s and Standard & Poor’s—so crucial to the securitization process as the ratings agencies everybody watched—were not reacting at all.

The peak, I realized, soon would be upon us.

As the subprime interest-only adjustable-rate mortgage started to touch maximum sales-channel penetration, we saw the introduction of yet another more extreme teaser-rate mortgage called the pay-option adjustable-rate mortgage, or cash-flow ARM. With this new type of mortgage, never before seen in a widely standardized format, borrowers could pay next to nothing each month, and unpaid interest would simply amortize negatively into the growing mortgage balance.

Rampant cash-out refinancing had already made the home a magical ATM for most Americans. And now, housing had its credit card. This was what I had been waiting for: peak credit. Such a mortgage product would exist only as long as home-price appreciation was a central assumption. And home-price appreciation was not long for this world, precisely because these mortgage products existed.

Incredibly, Washington Mutual and Countrywide, two national home-loan giants, began to load their own balance sheets with pay-option adjustable-rate mortgages. Facing yet another slowdown in loan volume, these companies saw the negative amortization feature as a way to show loan growth in a slowing market. But these companies, in doing so, also expressed confidence in home-price stability in the event of a slowdown in loan origination. That’s what the ratings agencies, Federal Reserve, Congress, the president, and all the president’s men believed as well.

I disagreed. I saw no chance of home prices going sideways or stabilizing for any length of time. Once home-price appreciation was no longer a given, these new types of mortgages would simply disappear. Home prices, starved of peak credit, would fall steeply as mortgage and refinancing options crumbled away.

The crisis, in my view, would start in 2007, by which time teaser-rate periods for these new types of mortgages would expire or reset for a population of homeowners trapped in mortgages they no longer could afford. And on the way down, housing would take consumer spending, jobs—everything—with it. A positive feedback loop of a very damaging variety was set up.

Realizing the economy was on the verge of collapse, I did the logical thing: I sought to profit from it. I set out to buy credit-default swaps on subordinated tranches of subprime residential mortgage-backed securities. In March 2005, I began calling Wall Street firms and banks with which I had prior relationships because of my trading of distressed debt, and tried to convince them to trade in this market with me. The credit-default swaps I was intent on buying would rise in value as mortgages were written off and the value of these tranches fell.


Initially I found no takers, but in May 2005 we agreed to our first trade, shorting the subprime mortgage market with Deutsche Bank. We would ultimately use nine different Wall Street dealer counterparties. Goldman-Sachs featured prominently early on. In late June 2007 credit spreads started marching higher, and then took off.

Incredibly, it would be reported later that more than $60 trillion in credit derivatives were in effect at their peak. To use a bit of hyperbole: That is roughly equal to the gross product of the entire world. How could that be? Credit derivatives on an underlying asset could be worth multiple orders of magnitude more than the asset itself because all asset-backed derivative securities are settled in cash—pay as you go. That was the secret sauce of the Doomsday Machine.

And so the crisis unfolded, with the market providing a signal far too late. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson continued to underestimate the situation. I was apoplectic.

Paulson now claims that even if he had known what was going to happen, he couldn’t have done anything about it. He had just joined the U.S. Treasury in the summer of 2006. But he came from the top job at Goldman-Sachs, and once he was treasury secretary, he orchestrated government takeovers of AIG, Fannie Mae and Freddie Mac—absolutely unthinkable actions just a few years ago. Paulson was anything but an impotent tool, but if he actually felt that way, it is a devastating commentary on how our government works.

As books and articles about the crisis proliferate, it becomes clear that at nearly every failed institution and every relevant department of government, someone had insight every bit as good as mine, and in many cases better. However, none of these people was in the top job. That our CEOs, our governors and our chairmen did not see this coming, did not adequately prepare their constituencies, is an indictment of the manner in which we choose and enable our leaders.

Such would not be the conclusion in 2008. The crisis was seen as the hedge fund’s fault. By the second half of the year, the government targeted commodity hedge fund managers with punitive subpoenas. We saw a global attack on so-called speculators and evil hedge funds, as well as nationalization of Fannie, Freddie, AIG—and, very important, their liabilities, which are now a special-purpose vehicle of the government, the Troubled Asset Relief Program.

I worry about the future of a nation that would refuse to acknowledge the true causes of the crisis. A historic opportunity was lost. America instead chose its poison as its cure, and the second “Greatest Generation” would never be born.

Today I expect the U.S. government to attempt continuing an easy money policy into the next presidential term—past the meat of the foreclosure crisis, and past the corporate and public financing humps that are upcoming. Junk bonds, incredibly, again are at all-time highs. Quantitative easing seems to be working for now. But this is an invalid validation of what America is doing, a Pyrrhic gamble. As we continue to debase our currency, Bernanke says he is not printing money. Yet I receive an email every day from the Fed saying we just bought another $7 billion or $8 billion in treasuries, monetizing the debt. The scope and breadth of quantitative easing raise severe questions about the Treasury’s needs.

Government borrowing of money for the purpose of injecting cash into society, bailing out banks, brokers and consumers, is an easy decision for a population that has not yet learned that short-sighted easy strategies are the route to long-term ruin. We never quite achieved the catharsis necessary to stoke a deep reevaluation of our wants, needs and fears.

Importantly, the toxic twins—fiat currency and an activist Fed—remain even more firmly entrenched with the financial reforms of last year. The Federal Reserve, having acquired new powers of regulation, has insisted that nothing in the field of economics or finance was of any help in predicting the crisis—period, no more comments. It’s a worthless conclusion that guarantees we’ll make the same mistake again and again.

We need better leaders, but frankly this isn’t going to happen. A problem cannot be solved if it is never acknowledged.

Realizing the economy was on the verge of collapse, I did the logical thing: I sought to profit from it.

Taxes need to be raised, spending needs to be cut, and loopholes need to be shut if we are to have any hope of returning to a stable base. Home ownership should not be a policy of the U.S. government. The banking system needs substantial reform and bank breakups. Glass–Steagall needs a second run in a strong form. And 22.5 million public workers have no business unionizing against the taxpayer. The list of things that won’t happen—but should happen—goes on and on.

By 2020, interest expense on our national debt could very well exceed $1 trillion. All personal income taxes collected in the U.S. in one year do not total $1 trillion. Our country’s math is scary big, but even scarier is that it simply doesn’t work.

Arguments about blooming economic recovery must be considered alongside the fact that all this debt, and all the money being printed, amount to a very real bill, a real tax on our future. This bill has not yet come due, except for savers and those on a fixed income. But it’s a debtor’s prison for our children.

Sober analysis on the part of the individual is paramount. We must remember that entire societies can follow the wrong path for a very long time and run aground.

Nothing is wrong with breaking from the social norm to ensure good outcomes. Legacies are a terrible and sometimes fatal burden in a rapidly changing world, and common sense must rule when it comes to career paths and life choices. This is not a time for responsible individuals to tolerate blind faith directed toward any man or woman. This is not a time to follow.