Knaves Turned Fools
By Adrian Ash
August 14, 2007
All financial bubbles need the rabble to pile in before the bubble goes bang...
DAY TRADERS in spring 2000, shoe-shine boys in 1929, the "meaner rabble" in 1720's London...
Glancing at the history of speculative bubbles, as we do all too often here at BullionVault, we find the ordinary sort in fact acts as the very pin itself.
The one thing needful at the top of each bubble, the rabble also take on the role of greatest sucker, too. Piling in as the smart money runs for the exits, the common-or-garden investor pays top price. He or she is then left holding the "asset" as its price collapses. And by this time, the Lear Jets have long since cleared the tarmac...taking the money with them.
Think of it as the classic "life cycle" pitch from your financial advisor, only with a side-splitting twist. There, you'll find a retirement hopeful moving from "accumulation" to "distribution" and then "legacy". In a market-wide bubble, by contrast, the smart money first accumulates assets, before distributing it to the dumb money, which is then left holding a legacy of wipe-out losses and debt.
Ha! It's a laugh-a-minute when the poor schmucks find the "wealth" that they've gathered is evaporating in the sell-off.
Something's amiss with the pattern of the latest financial bubble to burst, however – the bubble in cheap home loans. Yes, "Every fool aspired to be a knave," as a broadside noted of the South Sea Bubble nearly 300 years earlier. No-doc and low-doc aren't known as "liar's loans" for nothing.
But rather than the fools merely failing to turn knave now they're losing their homes, they have also succeeded in pushing the foolishness far higher up the food chain. The greatest excesses have come at the top, up in the marble-topped kitchen of haute finance – where the MBS, CDS and CDOs still can't be served, mercifully, to ordinary investors calling their broker direct.
Driven by the "liar's loans" of 2003-2006, in fact, this last gasp of air into the US housing boom saw the mortgage lenders and their creditors – the investment banks – playing the fools at every chance they got.
Between 1998 and 2006, reports First American Financial, US mortgage underwriting changed beyond recognition:
- Adjustable rate mortgages as a percentage of new mortgages rose from 0.7% to 69.5%
- Negative Amortization loans – where the principal owed actually increases over time – rose from 0% to 42.2% of the market
- Interest Only home loans – where the borrower only has to cover the interest due, leaving the principal for repayment sometime in the far future – rose from 0.1% to 35.6%
- Silent Seconds, issued on the back of outstanding loans to the most vaguely-related people, rose from 0.1% to 38.7%
- Low Documentation – where the greater the lie, the greater the loan – rose from 57% to 79.8%
But what is most interesting, notes Robert Rodriguez of First Pacific Advisors, "is that the origination volumes for the last two years, when the most egregious deterioration in underwriting standards occurred, total more than the previous seven years of originations combined."
In other words, and just as in every bubble before it, the value of cash taken out by the smart money at the top of the US home-loans scandal was greater than the entire accumulation preceding it. But this dumb money pumped in at the top came from hedge funds and Wall Street insiders, rather than flowing to them. This time around, they played the sucker – lending money to the home-lending market by buying mortgage-backed bonds with no hope of repayment.
A victory for us poor fools at the bottom, perhaps? Trouble is for the "meaner rabble", of course, the knaves and the fools at Bear Stearns, Queen's Walk, Basis Capital and elsewhere were using our retirement savings to inflate that last gasp.
According to a June 18 report from Greenwich Associates, says Paul Gallagher in the Executive Intelligence Review, "24% of all the hyper-leveraged assets managed by large hedge funds ($1 billion or more) internationally, belong to pension funds and endowments. This average is just below the 25% limit at which an individual hedge fund, under the [US] Employee Retirement Income Security Act (ERISA) as modified in 2006, becomes an investment advisor with fiduciary responsibility for the pension fund doing the investing – something hedge funds obviously do not want to do."
More than that, pension funds have also stumped up one-fifth of the money held in 'hedge funds of funds', the aggregating super-funds run by many large banks. In first-half 2007, around 40% of current flows into the hedge fund industry has come from pension funds. And "as pension fund money is coming in," says Gallagher, "it's allowing 'smart' money to get out.
"The overall flow of capital into hedge funds has dropped dramatically – from $40 billion each quarter over January-September 2006, to just $12 billion in fourth quarter 2006, and $20.7 billion in first quarter 2007. Numerous reports, including a new one from Chicago-based Hedge Fund Research, Inc., have shown 'high net-worth individuals' reducing their net hedge fund investments by half, between 2006 and 2007 – investing instead into real property and stocks. They now account for only about 20% of the assets of hedge funds, which were supposedly made for them."
As late as May this year, Jean Fleischhacker – a senior managing director at Bear Stearns – was telling fund managers gathered in a Vegas ballroom that they could generate 20% annual returns from un-rated mortgage-backed credit derivatives. The largest bank in the United States, Citigroup, has now sold $140 million in just this kind of un-rated toxic waste to the California Public Employees' Retirement System alone.
Members of the Calpers scheme have just got to wonder, along with the rest of us: How much is that $140 million worth today? Because the "meaner rabble" really did climb on board this mega-geared bubble in liars' loans.
It's just that in this money-bubble scam, most people had no idea they were even involved – let alone put at risk.