The Hyperion Effect

Posts Tagged ‘sub prime debt’

Following on from the post last week of ‘Inside Job’, which included details of the sub-prime loans that were a significant contributor to the crisis, I stumbled on this chart in my archive.

I offer it and this quote from a banker at subsequent hearings regarding the sub prime market without comment………’the quickest and most profitable way to make loans was to steer borrowers into the new breed of sub-prime mortgages. It didn’t matter if they couldn’t afford the mortgage in the long run. All loan officers were paid by the number of loans they approved, not whether they succeeded’

Great interactive charts in the Economist a few weeks back showing a whole lot of detail about the different debt levels around the world. Click on the picture to go to the website where you can use the interactive map, but here a few highlights.

• The U.K. has the highest debt level in the world at 495% of GDP;
• They are closely followed by Japan at 492% of GDP;
• The Swiss are the most indebted households in the world at just over 120% of GDP; and
• The Poms are a close second at 100% of GDP.

The Economist also notes that Japan has the dubious distinction of topping their sovereign-debt vulnerability ranking, which orders countries based on their primary budget balance, their debt-to-GDP ratio and the relationship between the yield on their debt and economic growth (if the former is larger than the latter, the debt burden is getting steadily worse).

Pleasingly, Australia doesn’t feature anywhere.

It’s a sentence that you see everywhere there is a financial investment mentioned. It is attached to presentations, T.V. shows, advice documents and e-mails. Pretty much anytime you speak to a financial professional who recommends you invest into something you will see the words ‘Past performance is no Guarantee of Future Returns’ or some variation of it.

But have you ever stopped to think seriously about this statement?

If past performance does not guarantee future returns why do people stampede to put their money into the hottest fund of the moment or the trendy tech company who’s shares keep on going up because this time its different. If past performance did guarantee future returns then we would all be gazillionaires and there would be no financial services industry. We could just look at what did well last year and stick all our money in that……..But the reality is that the statement is very important and thats why it is there. Take a look at the chart below, which may initially blind you with its colors, but they are there for a very specific reason.

Each of the colors represents a different asset class including Large Companies, Small Companies, Value Companies, both Australian and International, along with Emerging Markets, Cash, Property and Fixed Interest. Have a really good look and tell me if you can see the pattern?……………………………

Give up yet? Well the answer is there is no pattern. The chart is sorted from highest to lowest and so if past performance did guarantee us future returns in 2001 all we needed to have done was put all of our money in the light blue asset and we would have been a winner. Unfortunately it was the third worst performer in 2001 and for the remainder of the decade never got back to number 1 or even past the 50th percentile.

Firstly, lets give credit where credit’s due, John Paulson generated some outstanding returns for himself and his investors when he correctly bet on the U.S. subprime collapse and then doubled down with foreseeing a surge in the Gold price in the aftermath. This made him somewhat of a celebrity due to the fortune amassed on these two bets. However things have taken a turn for the worse of late for Paulson and his investors with Reuters reporting in a recent article that his funds are down more than 30 percent this year, compared to a much smaller 6.1 percent decline for the average hedge fund. Paulson reportedly manages around $20 billion in ‘outside investor money’, a large proportion of which came into the fund after he became famous for making $15 billion on the subprime mortgage collapse, likely leaving them sitting on a large loss.

Past Performance is no Guarantee of Future returns but unfortunately, for many investors, they learn this lesson too late.

I have just spent the past 10 days on the Gold Coast during which time the markets suffered a correction due to concerns about high debt levels and a double dip recession and S&P downgrading U.S. Debt. Both of these events provide an interesting paradox if you look more closely into what actually occurred.

Let’s first look at the downgrade. S&P have now decided that according to them the Government of the United States is a worse credit risk than many of the shockingly bad subprime products that they themselves rated as AAA prior to the GFC. Their position is best summed up by Robert Reich, Chancellor’s Professor of Public Policy at the University of California at Berkeley, who noted that:

S&P has downgraded the U.S. because it doesn’t think we’re on track to reduce the nation’s debt enough to satisfy S&P — and we’re not doing it in a way S&P prefers.

Here’s what S&P said: “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” S&P also blames what it considers to be weakened “effectiveness, stability, and predictability” of U.S. policy making and political institutions.

Pardon me for asking, but who gave Standard & Poor’s the authority to tell America how much debt it has to shed, and how?

If we pay our bills, we’re a good credit risk. If we don’t, or aren’t likely to, we’re a bad credit risk. When, how, and by how much we bring down the long term debt — or, more accurately, the ratio of debt to GDP — is none of S&P’s business.

He then goes on to point out that had S&P done it’s job properly in rating the sub prime products prior to the GFC then the U.S would not have needed to bailout so many of the banks and try and restart the economy with borrowings…….Lets not forget that right up until its collapse S&P had Lehman Brothers rated an A!

Paul Krugman, professor of Economics and International Affairs at Princeton University and regular New York Times columnist, goes further in his opinion piece from the New York times

On the other hand, it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really?

Just to make it perfect, it turns out that S&P got the math wrong by $2 trillion, and after much discussion conceded the point — then went ahead with the downgrade.

So here we are with the Agency that arguably was a significant contributor to the debt levels that Government’s now carry telling the largest country in the world that they don’t think they are doing a good enough job in paying it down!

The downgrade has also produced an interesting phenomenon in the markets. Whilst it may have come as a shock to the non-financial community the downgrade had been on the cards for some time now and coupled with weak economic data, saw markets move down sharply. Where did all the money go from those share sales?…….into U.S. bonds of course, the traditional safe haven when markets get nervous, being the deepest and most liquid bond market in the world (there was also a move to Gold and the Swiss franc which often also occurs when people get nervous)

So despite the downgrade, and the huge debt burden, people still buy U.S. Bonds when they want a ‘safe’ investment.

So what does all of this really tell us about the relevance of the ratings agencies……..

Whilst you would hope that this  old saying is no longer applicable today, unfortunately it was alive and kicking during the mortgage binge in the U.S. that eventually lead to the G.F.C. A few months ago the U.S. Government released the long awaited report into the Financial Crisis and Jennifer Taub, a Lecturer and Coordinator of the Business Law Program at the Isenberg School of Management wrote an excellent 3 part series looking at the myths and facts around the events, some others of which we will address in further posts. However the one that jumped out at me when I read the article was what happened to the Whistle Blowers who tried to bring attention to the impending crisis.

Take a look at these examples

1. Ameriquest appointed a new person to head their Fraud Department in 2003 and after one month in the job he began reporting fraud. Initially he was scalded by management for ‘looking too closely at the loans’, then in 2005 was downgraded from a manager to a supervisor. In May 2006 he was laid off.

2. In 2007 the Chief Risk Officer at Lehman Brothers was pushed aside, whilst the head of the fixed income section left due to ‘philisophical differences’ after warning about taking on too much risk.

3. The Chief Underwriter of Citigroup, after being appointed in 2006, realized that 60% of the mortgages they were buying and selling to investors were defective. He was concerned that if the loans defaulted investors could force Citi to buy them back, costing the company millions. He raised this with members of the  Board of Directors and was soon after demoted from supervising 220 people to only 2, his bonus was reduced and he received a poor performance review.

In hindsight it is easy for these people to look back and know that they did the right thing, however at the time they must have struggled with the issue, knowing that they were conveying information that people didn’t want to hear. It is appalling that these, and probably many others, were treated so badly and had their reputations and incomes sullied and reduced all in the name of profits.

I applaud them for having the courage of their convictions and can only hope that they have moved on with their lives.

Check out the chart below, but before you do some quick background.

The chart refers to the Case/Schiller Home Price Index which is the common measure of house prices in America. There are several different indexes covering a variety of different cities and the data goes all the way back to 1890. During (and given the U.S. Is still in) the housing crisis it was the monthly figures from this survey that were most closely watched to determine how far the market was falling.

Given how fast and high the boom ran in comparison to the long term average, in hindsight it is hard to understand how people missed it. I have been doing a roadshow in a number of states last week and this week and i have mentioned a couple of times the folly of believing that house prices always go up. The chart demonstrates this shockingly and should be a warning for us all the next time we get a sniff of a property (or any other) bubble.

Its a shame I cant find the Australian chart as this would be very interesting given the current state of the market.

Case Schiller 100 year index