Making money in sub-prime mortgage lending was so easy, it looked almost too good to be true. Guess what? It was…
Probably the greatest disappointment for a man over 50 is when he looks in the mirror. We say that not as a man who has just spent his holiday in a bathing suit, but as one who has spent the last few days reading the financial press. The two are alike in that every time you look, the picture seems to gets worse. A brief summary of the sub-prime mortgage lending industry’s business model: lenders noticed that some people can’t afford houses and do not qualify for credit to buy them. But ‘sub-prime’ borrowers could be decent fish, they reasoned, as long as they could make the payments. And even if the odd client couldn’t pay, the rising housing market would lift the value of their collateral. So a new financial industry got going, and soon its hustlers, like the dotcom whiz kids who preceded them, were driving Ferraris and drinking Château Pétrus.
The Orange County (California) Register: “For Kal Elsayed, a former executive at New Century Financial, a large lender based in Irvine, driving a red convertible Ferrari to work at a company that provided home loans to people with low incomes and weak credit might have appeared ostentatious, he now acknowledges… ‘You just lost touch with reality after a while because that’s just how people were living… we made so much money you couldn’t believe it. And you didn’t have to do anything. You just had to show up’.” It was this last line that triggered our disappointment. It reminded us how each generation’s geniuses are later unmasked as frauds and fools. Recall Henry Paulson’s soothing words: “Credit issues are there, but they are contained”, the US Treasury Secretary told reporters in Tokyo during a four-day tour of Asia. The US financial sector is healthy and most institutions won’t feel “a big impact”. But a big impact is precisely what institutions are feeling.
The geniuses packaged, bought and sold sub-prime debt right up until they heard crashing noises. In theory, low interest rates gave a whole new group of borrowers access to credit. But in practice “what drove the housing-led cycle was not as much the cost of credit”, notes Merrill Lynch’s David Rosenberg, but “the widespread availability of credit… only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers”.
Now sub-prime lending is crashing and burning. Orange County reports that New Century Financial is trading below $5 a share, far below its high of $66 in December 2004. At today’s price, in theory, the lender must be bargain of the century, yielding 167%. But the report also tells us the group may be forced into bankruptcy. Yet while sub-prime lenders plunge, super-prime borrowers are flying high. In theory, hedge funds charge outsize fees for outsize performance. They ask for 2% of capital and 20% of performance for helping investors get ‘alpha’, a rate of return beyond what the general market produces, known to the trade as ‘beta’. Warren Buffett, probably the greatest investor ever, says the idea is “grotesque”. He says you can invest in his “hedge fund” – Berkshire Hathaway – and pay no management fees at all.
The compounded average annual gain of Berkshire Hathaway from 1965 to 2006 is 21.4%. In 2006, hedge funds returned 14% on average, but over the longer run, they show an annual return of about 7%. Mark Gilbert for Bloomberg concludes that hedge funds “levy outsized fees on the pretence of generating tons of clever alpha, when they are really just seizing the beta available to anyone”. In other words, hedge-fund managers, like the sub-prime lenders, are not really geniuses at all. They make their money just by showing up, just like everyone else.
And they get the same rate of return – or worse. Many hedge funds jumped into Japan after the market soared 40% in 2005. The next year the Nikkei rose barely 4%. How did hedge funds do?
As Merryn Somerset Webb reported a few weeks ago, “far from proving their ability to make absolute returns in any market conditions, [hedge funds] did particularly badly; they all fell between 5% and 20% over the year”.
Sub-prime lenders did not hedge the risk of lending to weak borrowers – they leveraged it up. Hedge funds seem to have done the same thing – reaching a little too far to grab a few extra points of yield. Now, we wonder who owns the $23bn of New Century Financial debt – and who owns the rest of the sub-prime debt? And who owned the $2.5trn of equity value that disappeared last week? Surely, there’s a ‘big impact’ there, still waiting to hit someone. We look in the mirror and hope it isn’t us.