Saturday, 28 December 2013

History is our guide

In 2006, hedge fund manager John Paulson realized something few others suspected--that the housing market and the value of subprime mortgages were grossly inflated and headed for a major fall.  Paulson's background was in mergers and acquisitions, however, and he knew little about real estate or how to wager against housing.  He had spent a career as an also-ran on Wall Street. But Paulson was convinced this was his chance to make his mark. He just wasn't sure how to do it.  Colleagues at investment banks scoffed at him and investors dismissed him.  Even pros skeptical about housing shied away from the complicated derivative investments that Paulson was just learning about.  But Paulson and a handful of renegade investors such as Jeffrey Greene and Michael Burry began to bet heavily against risky mortgages and precarious financial companies. Timing is everything, though. Initially, Paulson and the others lost tens of millions of dollars as real estate and stocks continued to soar. Rather than back down, however, Paulson redoubled his bets, putting his hedge fund and his reputation on the line.
     In the summer of 2007, the markets began to implode, bringing Paulson early profits, but also sparking efforts to rescue real estate and derail him. By year's end, though, John Paulson had pulled off the greatest trade in financial history, earning more than $15 billion for his firm--a figure that dwarfed George Soros's billion-dollar currency trade in 1992.  Paulson made billions more in 2008 by transforming his gutsy move.  Some of the underdog investors who attempted the daring trade also reaped fortunes. But others who got the timing wrong met devastating failure, discovering that being early and right wasn't nearly enough.
     Written by the prizewinning reporter who broke the story in The Wall Street JournalThe Greatest Trade Ever is a superbly written, fast-paced, behind-the-scenes narrative of how a contrarian foresaw an escalating financial crisis--that outwitted Chuck Prince, Stanley O'Neal, Richard Fuld, and Wall Street's titans--to make financial history.

Governments have long tried to help the poor own their own homes, almost always for noble reasons. Some attempts, such as Margaret Thatcher’s right-to-buy council house policy, worked as it required a real payment and targeted the aspiring, successful working class. Most other attempts, which gave homes away entirely for free or provided subsidised loans to those who couldn’t afford them, failed disastrously. One of the oldest attempts was Abraham Lincoln’s Homestead Act of 1862. Adults could simply apply and claim for free unused land outside the original 13 colonies, with the only requirement being that they improved the land and enclosed it. Around 2m homesteaders took advantage of the scheme and settled in the new West – and about 60 per cent of them eventually failed, a little-known fact dug out by Bruce Yandle, a US economist, in his fascinating paper Lost Trust: The Real Causes of the Financial Crisis, to be published in the Winter 2010 issue of the Independent Review.
The evidence is clear. The subprime problem started off as an “affordable home” program by which traditional, market-based constraints were eroded and private firms bullied and incentivised into lending badly. The impetus came with congressional strengthening of the Community Reinvestment Act, the Federal Housing Administration’s loosening of downpayment standards, and pressure exerted on mortgage lenders by the Department of Housing and Urban Development to lend to the unqualified. Democrats and Republicans are equally to blame. Bill Clinton introduced affirmative action quotas for Fannie Mae and Freddie Mac – the government-backed and created agencies which exert a massive influence in the US mortgage market, which is far from free – to buy poor-quality mortgages made to low-income families. In December 2003, George Bush signed “the American Dream Downpayment Act” to allow those who couldn’t afford deposits to buy homes.
It worked a treat. From 1993 to 2003, subprime accounted for a tenth of mortgages. In 2004, subprime’s share rose to 26 per cent; in 2005, to 28 per cent; in 2006, to 40 per cent. From 2005 to 2007, Fannie Mae and Freddie Mac bought $1 trillion in subprime and low-quality mortgages, in many cases floating rate mortgages that everybody knew would become unaffordable if rates were to rise; this intervention by Fannie and Freddie allowed the risk to be removed from the market. The government thus supported and encouraged private lenders to target poor borrowers while turning a blind eye to their inability to repay, in the knowledge that it would soon cease to be their problem.
Everybody interested in the real cause of the crisis should google Yandle’s paper. It is a breath of fresh air at a time when the abysmal quality of the present UK debate on the bubble, macroeconomic management and bank regulation is little short of scandalous.

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