How to Make a Fortune from the Biggest Bailout in U.S. History Hardback - 2009

1
The Sub-Prime Primer

As I said, I do not have much interest in looking back and agonizing over what has transpired during this most recent period of boom and bust, or in working out how it relates to prior periods of excess and greed.

That will be handled by others, and it will be the stuff of countless Ph.D. papers for countless years to come. This was the biggest credit, real estate, and financial market bubble to burst in the history of mankind, as market historians Jeremy Grantham and Marc Faber have suggested and documented. It is also the most complex episode in financial market history, so it will no doubt merit, and produce, countless tomes examining the origins, impact, and behavioral aspects of this bubble.

For my own account, I'd like to reduce the experience to something somewhat more simple, just as a point of reference for you to use as a reminder when preparing to reenter the marketplace.

The recent bubble was the result, as all bubbles are, of efforts by policy makers to limit the damage that was done when the Internet bubble burst in 2000 and the attacks of 9/11 threatened to hurl us into a very serious recession.

To keep that from happening, the Federal Reserve quickly slashed interest rates to a forty-five-year low of 1 percent. President George W. Bush passed a $1.4 trillion tax cut to revive the economy. Other nations, fearful that a recession could affect them, followed the Fed and the Bush administration by adopting similar economic policies.

Quite suddenly the world was awash in cash. The combination of rate cuts and tax cuts proved quite powerful. The U.S. economy, and the world economy, rebounded very quickly. From 2002 to 2007, every country in the world except for Zimbabwe and Venezuela grew at a faster than normal pace. It was the first synchronized global expansion in modern economic history.

With the excess cash building up, investors, burned by the Internet bubble, decided to invest in something more stable, such as real estate. As demand for housing grew, real estate prices started to advance rather quickly, creating a virtuous circle of rising prices, increasing demand, and still higher prices. This occurred as the economy grew rapidly and credit was both abundant and affordable.

Individuals who previously could not afford to own homes were given access to so-called liar or NINJA (no income, no job, no assets) loans. Everyone who wanted a mortgage could get one, regardless of their ability to pay. Some of the availability of this newfound credit rested on the Bush administration's philosophy of creating an "ownership society," in which all who wanted a home should be able to get one.

Some of it, however, was the result of predatory lending practices that took advantage of people without the economic literacy required to understand that the loans they obtained had features that would eventually trap them in a spiral of delinquency, default, and foreclosure. The rest was the result of outright greed and speculation.

As we grew rich on real estate, so did the rest of the world. Some countries also profited from the run-up in the prices of commodities, such as oil, copper, and other industrial materials…; even commodities as unusual as uranium.

As their resource-related wealth grew, even more cash and credit were created. From Great Britain to Greece and from Chile to China, similar booms were taking place in real estate, commodities, stocks, and other asset classes.

So easy was the money that Wall Street created a new class of investment vehicles known as derivatives. Derivatives are investments based on underlying assets, such as stocks, bonds, commodities, or real estate. Some of them had strange acronyms such as CDOs, CDS, RMBS, CMBS, among others.

It was an alphabet soup of impossibly complex instruments that investors bought with enormous amounts of borrowed money, or leverage.

The trading in derivatives was just another way to take advantage of the credit boom and the bull markets around the world in real estate, commodities, and stocks.

With respect to the derivatives based on real estate loans, particularly sub-prime loans, financial engineers jumped on the opportunity to package these poor-quality loans and sell them as " high-quality" investments.

With the help of a nonstop Wall Street marketing machine and the complicity of the big credit-rating agencies, derivatives experts managed to gain triple-A ratings on loans that were, essentially, created from junk debt.

They sold these collateralized debt obligations, or CDOs ( sub-prime loans served as the "collateral"), to many willing buyers, from banks and brokerage houses to pension funds and hedge funds.

The trouble was that the lousy loans remained lousy loans no matter how they were packaged or what ratings they were given. Once the real estate market went bad, so did the derivatives. The crash in real estate and real estate derivatives caused over $2 trillion in write-downs among financial institutions holding these once highly coveted CDOs.

Trading in derivatives grew to be a business worth hundreds of trillions of dollars, an enormous multiple of the size of the world economy.

At its peak, the derivatives business was valued at about $750 trillion, compared to the global economy, which is $45 trillion in size!

With all that as background, the run-up in real estate became a cause for concern for policy makers who sensed that "irrational exuberance" had gripped home buyers and real estate investors, much as it did the buyers of dot.com stocks in the 1990s.

Home values during the earlier part of this decade increased at unsustainable rates, causing the Fed, and other policy makers, to fret about "asset inflation."

Eventually, the Fed, by raising interest rates and making money less available, caused the asset bubble in real estate to deflate. As real estate began to decline, it put pressure on the derivative investments that relied on rising real estate prices to maintain their values. That led to a death spiral in a variety of similar investments around the world.

From sub-prime real estate to sub-prime securities, and from crude oil to soy oil, markets for hard assets crashed around the world. That led to a bursting of all the related bubbles on the planet.

The credit markets collapsed. Real estate values plunged and, for the most part, continue their decline today. Global stock markets fell between 40 and 70 percent. Banks, brokers, and investment funds that trafficked in derivatives either went bust or nearly did.

Governments stepped in to save the financial system from ruin and their economies from sinking into a 1930's style depression. As a result, never-before-attempted tricks of financial levitation were tried, creating trillions of dollars in emergency stimulus and insurance programs designed to stabilize individual markets and entire economies.

While we are not out of the woods yet, there are signs that the worst is over and that the historic actions taken by policy makers to fight this historic speculative episode are bearing fruit.

All that means is that it is time to follow the Fed, or certainly not fight the Fed, as the saying goes on Wall Street, and start investing where values have been created in the wake of this epic bust.

Diamonds are made from coal, and some investment jewels have been formed under the rubble of this collapse.

2
DON'T LOOK BACK!
(Well, Look Back a Little)

As I mentioned in the opening pages of this book, I think, from an investor's perspective, at this moment in time, it is almost irrelevant to rehash the details of a crisis that we all witnessed and experienced, in real time, and around the clock, over the last two and a half years. There was no escaping the grim news put before us every minute of every day. And much of it bore striking similarities to a couple of key crises of more distant vintages.

And yet most of it does not bear repeating or reliving, right here or right now.

That may come as a surprise to those of you who know my work on CNBC, have read my last two books (Mom, put your hand down!), have heard me on the radio, or have seen items I have published recently.

Over the last twenty-five years, I have developed something of a reputation for being a market history buff. I have been called CNBC's resident "market historian" both inside and outside the shop. It's true that I have dedicated countless hours to the study of financial market history. I find it a fascinating topic that can shed a great deal of light on current events, generally, and on current market conditions, more specifically.

Indeed, it may comfort you to know that, among my most important findings, and this is not unique to me by any means, the "boom and bust cycle" is among the most repetitive features of human behavior. The market pendulum, they say, swings between extremes of greed and fear, always going too far in either direction. So, in other words, this is just the down part of the cycles we experience on a regular basis in a market economy.

In modern times, we have had a financial market "crisis" about once every three years. In each case, most of us have emerged from it in good enough shape to go on with our lives as if it were just a bad dream. That's not true for everyone. The down cycles affect many, many lives for the worse. But, on average, almost all of us survive, and even thrive, despite these frequent financial setbacks.

While I normally recommend that most investors, even the least sophisticated among us, engage in a thorough study of market history before they begin investing, I'm not sure that it is time well spent right now.

What's done is done, and I will leave it to market historians to chronicle the details of our most recent crisis and to pass judgment on Wall Street's "bad" behavior, Main Street's "mania" for housing, and Washington's erratic and ad hoc policy responses to the "Great Recession" of this decade. (Okay, so I slipped some personal judgments in …; sue me…; everyone is suing everyone today, anyway!)

Still, it is helpful to know that we've been in this situation before, or at least some semblance of it. There are records of speculative episodes that date back to ancient Sumeria, where grain futures were bought and sold like crazy, just as they are in Chicago today. (Take two clay tablets and trade with me in the morning.)

In first-century Rome, citizens of the republic were found to have engaged in an orgy of speculation in publicly traded stocks.

In the 1630s, the Dutch, in a well-known cautionary tale about market manias, planted the seeds of a tulip "bubble" that has been the stuff of market lore for centuries.

The South Sea Bubble, the Mississippi Scheme, and the Roaring Twenties are the names given to manic speculative episodes in Britain and France in the eighteenth century and in the United States in the twentieth century. They each had serious but not fatal consequences for the society involved. True, the aftershocks affected many, and in each case caused market and economic setbacks of serious import, but still the world continued to turn.

Japan's "lost decade" is the result of the bursting of their twin stock and real estate bubbles in the 1980s, leaving Japan in recession for ten of the last twenty years. Japan has yet to emerge from the longest bear market of modern times, but if one travels to Japan, as I have, a depression is not readily apparent on the streets of Tokyo.

The "dot.com craze" here at home describes our own, very recent frenzy for Internet and technology stocks. The 1990s were known as the "decade of greed," as Internet billionaires calculated their net worth with every tick of their stock prices. But after the inevitable crash, Silicon Valley suffered through a virtual depression, though the rest of the economy—post Y2K, post-crash, and post 9/11—held up surprisingly well.

It is important to be aware of market history and of the events that led us to our most recent bout of speculative excess in real estate, in credit, in commodities, and in emerging markets.

But it makes no sense to dwell on it. The world now moves far too quickly to reflect on what went wrong. There is time for that, in due course.

But this is not the time to sit idle if you expect to catch the next wave. Indeed, it's already begun. And it's certainly possible that the next craze will also lead to a buying frenzy in distressed assets that also ends in a bust. But it will be better to have invested now than never to have invested at all.

This has been true at the end, or near end, of every crisis prior to this one.

By the way, at the very moment I was writing the first chapter of this book, on May 29, 2009, the New York Times gave careful consideration to this point of view:

SOME SEE AN ECONOMY IN CRISIS, BUT THE INTREPID FIND BARGAINS

by Paul Sullivan

May 29, 2009 | Stanford L. Kurland, the longtime president of Countrywide Financial, once one of the biggest mortgage issuers in America, is now running PennyMac Mortgage Investment Trust— the firm that announced last week that it was raising money to buy more distressed mortgages. Not surprisingly, Mr. Kurland's critics accuse him of trying to profit from the downside of what Countrywide and other lenders wrought.

One thing is certain, though: Mr. Kurland is not alone in looking to invest in assets that were the hardest hit in the downturn, namely debt, private equity and securitized bonds.

The reasoning is straightforward, even if the timing is risky. Last fall, the financial crisis was so all-encompassing that many otherwise good investments were sold at steep discounts as people moved their money into the safest investments.

Now that a clearer picture of the economy is forming— albeit not a rosy one— affluent investors are among the first to look at areas where losses were made worse by excessive borrowing. Still, those who are investing are doing so cautiously.

Cautious or not, large institutions, professional investors, and high-net-worth individuals are buying varied classes of distressed assets that are appropriate for their level of sophistication, risk appetite, and degree of affluence. And remember, the "investor class" has historically been "first in and first out," and then first in again.

You can be doing the same thing, right here and right now.

Individual investors need not be excluded from earning their share of profits in distressed investments. There are many, and varied, vehicles appropriate for you to invest in. They include, but certainly are not limited to, physical real estate, such as new and existing homes, undeveloped land, and partially developed tracts of land, upon which developers will eventually build new structures.

If you look in the papers or on the Web, you'll find deeply discounted new homes, financed by the builders themselves, at extremely low mortgage rates. You'll also find bank-owned sales of existing homes, short sales of homes by their owners, and government-run foreclosures.

There are mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITS), and some vehicles that have yet to be created that will allow you to return to the investor class and use professional money managers to select more complex investments in the distressed arena, which will offer you attractive rates of return without your having to select the securities yourself.

Compared with prior crises, this time around individual investors actually have a fighting chance to take advantage of the distress in the markets.

As I mentioned, there are many more ways today that allow you, and empower you, to participate in an inevitable rebound in the markets, be they real estate, stocks, bonds, or commodities.

The following chapters will explore the many opportunities that await you in the financial markets.

First, though, let me introduce you to a few individuals whose actions you may want to emulate. You may have heard of them, or you may not have. But in my experience, these are the pros who can guide your investment decisions by leading you along the same path they have followed over the course of their long and successful careers.

While I believe it always pays to study the past, a quicker way to profits, in this market, is to simply follow the pros…; in the present.