Crisis2008

A phenomenal Op-Ed by Michael Burry, “I Saw the Crisis Coming. Why Didn’t the Fed?”

I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions. A week ago I learned the answer when Al Hunt of Bloomberg Television, who had read Michael Lewis’s book, “The Big Short,” which includes the story of my predictions, asked Mr. Greenspan directly. The former Fed chairman responded that my insights had been a “statistical illusion.” Perhaps, he suggested, I was just a supremely lucky flipper of coins.

Mr. Greenspan said that he sat through innumerable meetings at the Fed with crack economists, and not one of them warned of the problems that were to come. By Mr. Greenspan’s logic, anyone who might have foreseen the housing bubble would have been invited into the ivory tower, so if all those who were there did not hear it, then no one could have said it.

As a nation, we cannot afford to live with Mr. Greenspan’s way of thinking. The truth is, he should have seen what was coming and offered a sober, apolitical warning. Everyone would have listened; when he talked about the economy, the world hung on every single word.

Unfortunately, he did not give good advice. In February 2004, a few months before the Fed formally ended a remarkable streak of interest-rate cuts, Mr. Greenspan told Americans that they would be missing out if they failed to take advantage of cost-saving adjustable-rate mortgages. And he suggested to the banks that “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”

Within a year lenders made interest-only adjustable-rate mortgages readily available to subprime borrowers. And within 18 months lenders offered subprime borrowers so-called pay-option adjustable-rate mortgages, which allowed borrowers to make partial monthly payments and have the remainder added to the loan balance (much like payments on a credit card).

Observing these trends in April 2005, Mr. Greenspan trumpeted the expansion of the subprime mortgage market. “Where once more-marginal applicants would simply have been denied credit,” he said, “lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.”

Yet the tide was about to turn. By December 2005, subprime mortgages that had been issued just six months earlier were already showing atypically high delinquency rates. (It’s worth noting that even though most of these mortgages had a low two-year teaser rate, the borrowers still had early difficulty making payments.)

The market for subprime mortgages and the derivatives thereof would not begin its spectacular collapse until roughly two years after Mr. Greenspan’s speech. But the signs were all there in 2005, when a bursting of the bubble would have had far less dire consequences, and when the government could have acted to minimize the fallout.

I have to agree. Greenspan had to have known something was amiss. But remember – a significant part of US GDP Growth since 2001 came from Mortgage Equity Withdrawals (or MEWs) which is a game that works as long as housing prices kept going up. To keep them going up, you need a lot of demand. When you exhaust your regular prime demand, you wonder how you can get the poor sub-prime guy into the game….

China cut interest rates for the fifth time in three months to support the world’s fourth-biggest economy after trade growth collapsed because of recessions in the U.S., Europe and Japan.

The one-year lending rate will drop by 0.27 percentage point to 5.31 percent and the deposit rate by the same amount to 2.25 percent from tomorrow, the People’s Bank of China said on its Web site. The central bank also reduced the proportion of deposits lenders must set aside as reserves by 0.5 percentage point.

Let's say you're a successful businessman who has managed to earn $10 million this year, but who also had $10 million invested with Bernie Madoff. Obviously, you're not happy about seeing your savings wiped out -- but if I'm reading this WSJ article correctly, since your loss is a "theft loss", the whole thing is deductible, and you basically get to keep all your income tax-free!

And it gets better: because of Madoff's high-turnover investment strategy, you probably paid as much as $500,000 in taxes in each of the past three years on fictional trading gains. All those can now be refunded as well.

A week ago, then, you reckoned that you were going to have about $11 million in total earnings (counting $1 million in interest from Bernie), on which you'd pay roughly 40% in taxes, leaving you with $6.6 million after tax.

Today, you have $10 million in tax-free earnings, plus $1.5 million in tax refunds, for a total of $11.5 million in post-tax income: roughly $5 million more than you were expecting.

Which doesn't completely make up for your $10 million investment loss, of course. But it does soften the blow.

On the other side of the ledger, of course, the IRS was expecting $4.4 million from you this year, but now is going to have to pay out $1.5 million to you instead. Which works out at $6 million less money available for the public fisc. I haven't seen estimates of the total cost of the Madoff fraud to the US government, but it's surely in the billions, and quite possibly in tens of billions. Which is real money even by government standards.

Well, such is life - losses involve tax losses as well. Maybe that's why governments are so afraid of stopping bubbles; their own revenue comes down.

Ecuador has chosen to default on a 30.6 million dollar payment on its bonds.

Which is surprising, because it has 5.65 billion dollars in cash. The total amount of bonds outstanding that it defaulted on is worth only $510 million. (2012 expiry)

Rafael Correa, Ecuador's president and a leftist, has said he wants to restructure this debt. But given the debt has been restructured twice earlier, bondholders are unlikely to let Ecuador off the hook again.

Ecuador is rich in oil and commodities, both of which have taken a big hit in the recent past, and both of which are common with it's neighbour Venezuela. But that seems to be more than what they have in common - Venezuela is the biggest writer of credit default swaps, and thus, default protection, on Ecuador's bonds. Hugo Chavez is a friend of Correa, but I don't think that friendship lasts the $510 million.

And further complicating the equation: Ecuador gave up it's own currency to adopt, get this, the U.S. dollar. Which means whatever it owns is effectively attachable by the U.S., where the legal battle will be fought.

They fired their last good set of lawyers during the bond restructuring in 2000, and they're fighting well established funds like Greylock and Elliott, which supposedly know their law upside down.

Their debt trades at some 20 odd cents to the dollar. If Venezuela is paying for any default, you can bet that the bondholders love the concept - buy at 20 dollars, and get 100 cents either from Ecuador through it's dollar holdings (the only cash it will own is USD) or get it from Venezuela. Obviously the deal will be to push for the default.

But what if this is just a ruse - to push up the CDS price higher and higher that allows Venezuela to sell protection at an even higher rate, and then Ecuador doesn't default? Chavez is friends with Correa, supposedly, so a plan like this can be done over a good cup of Columbian coffee (or, over other things Columbia is famous for). Think about it: Ecuador's CDS trades at 4200 bps - 4.2m to insure 10 million. (pounds)

And they've done that before. In Feb 2007, Ecuador first refused a debt payment and later agreed to pay it all back at the end of a 30 day grace period, causing huge fluctuations in the bond prices. (btw, the 30 day grace period for the current payment ends tomorrow, on Dec 15) It might just be that Ecuador, or indeed, Columbia is buying the 21 cent bonds; stiffing someone in the process.

The eventual plan may be to keep bond prices obscenely low so they can be bought and held and to keep CDS prices high. If eventually when the oil bust and commodity depression takes its toll both countries may raise their hands; and given everyone's asking for a bailout now, it is likely to be given some consideration. If not, heck, profits will be made by either country.

That countries can default came to our notice suddenly with the news about Iceland and Pakistan. That a country can choose to default even if it has the cash is now possible with Ecuador. That banks can loot the taxpayer is also obvious. That everyone except the automakers will get away with it? Yes.

Trust - that flimsy, slimy little word.