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Real estate landfill: Dumping grounds for toxic debt PDF Print E-mail
Written by Sidharth Wahi   
Friday, 15 August 2008
Sub-prime is this year’s hot topic. We’ve all heard and read about how Bear Stearns nearly went under, Leh­man sacked two of its top executives, and the question of Freddie Mac and Fannie Mae surviving is on ev­erybody’s mind. But what really hap­pened, why didn’t we see this coming and what’s going to happen next?

Let’s start by understanding sub-prime. Sub-prime is a market for individuals who require home loans but have been rejected by the primary market. This may be for a variety of reasons, but mainly due to poor credit ratings. So sub-prime doesn’t refer to the interest paid on these loans, but the risk associated with giving these individuals a loan. Most of the time, these loans are given to people who have been known to default on their payments. Sub-prime lenders profit from the rising prices of housing in case these people default, and then again when loans are refinanced in order to keep monthly payments low.

To recap real quick, Sub prime lenders, investment banks and hedge funds decided to profit from people with poor credit ratings. After a sub-prime loan had been given to a group of individuals, this debt was packaged into mortgage backed securities (MBS) and sold down to investment banks, who took these high risk securities and sliced them into several ‘tranches’. These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones by slicing up the MBS into what are called equity (high risk), mezzanine (middle risk) and the much sought after investment grade bonds (low risk). These CDOs were then repackaged into other securities and listed on private markets as credit swaps, hedge funds and other investment vehicles.

After using some tricky math and “empty suit” presentation skills, investment bankers did what they do best and sold these securities. When the price of houses would increase, the equity tranches would skyrocket in value. Bankers would use the performance of these junk bonds or toxic debt as collateral for more cash, which they would inject back into the system to give out more home loans. (Have you ever seen Boiler Room? A great movie!) In the last two years, it is estimated that six million sub-prime loans have been given out.

Fund managers were receiving amazing bonuses, the people who dreamt up these procedures were dubbed as geniuses and new homeowners were happy. A well -oiled machine of Wall Street capitalism could safely move toxic waste around while creating value for everybody in the chain. Unfortunately, the one thing these guys didn’t anticipate was its inevitable collapse.

Following two financially devastating wars, the downsizing of big companies and a culture uncertain of personal finance management, more and more people started defaulting on mortgage payments, thus leading to a large number of foreclosures. To make matters worse, the demand for new housing started losing steam.

Consider this: there are six million people on the street who desire a house, but do not posses the means to buy one. They also have poor credit histories and already have a certain amount of debt. However, after receiving a sub-prime loan, these people have now decreased the demand for a house; and this is where things start to get tricky.

Supply is increasing at its natural and calculated rate because real estate is known to be the safest investment and construction is still strong, but is suddenly in abundance due to too many foreclosures taking place at the same time. The combination of the two sharply reduces the value of the housing market. At the same time, demand for housing has also decreased since those who haven’t foreclosed do not require a house - they choose alternative arrangements, including moving back in with their parents. Isolating these two events can help us explain these events retroactively, but the question remains, why didn’t Wall Street see this coming?

The answer is to do with the importance and impact of the highly improbable:

Nassim Taleb’s book The Black Swan helps me highlight this point. The main idea revolves around the importance of the unknown and the increasing probability of anomalies in our daily lives. Think about 9/11, the rise of Hitler or the spread of the In­ternet. Or even the stock market crash of the 1980’s. Think of your own life where instances of betrayal that seemed highly unlikely sneaked up behind you. An outlier, according to Taleb, is a rare event with extreme impact and retro­spective predictability. That is: it is only after the occurrence of such an event that we are able to assign logical expla­nations to its existence.

My point is that we as human be­ings can assign as many mathematical models and DCFs or multi variable lin­ear regressions to try and forecast the future as we want. However, window dressing figures and arriving at valu­ation figures that we want to see both ignore and fail to account for the exis­tence of the black swan.

Firms like Lehman Brothers, Mer­rill Lynch & Co and Bear Sterns have recently been involved in fire-sales, quickly trying to offload all their ac­cumulated toxic debt, sometimes at discounts of up to 78%. Vulture funds such as Lone Star and Blackrock are taking advantage of these trying times and picking up all this debt for cents to the dollar. This, in my opinion, is go­ing to change the investment climate as we know it.

Just for a second, let’s forget every­thing we’ve learned in basic economics. Logically, people will always need food, water and shelter. Eventually, the mar­ket is going to bounce back up again and regain much of its lost value. Be­cause valuation is based on demand and supply, much of what we see today is skewed due to current economic condi­tions. In enough time, the equilibrium will be met once again, at a price level similar to today.

Practically, I feel fire-sales are not the answer. There is reason to believe that the worst has already happened and that the best way to promote long-term existence would be to raise more capital to meet short-term obligations, hold on to the real estate portfolio and wait until the market bounces back. At the end of the day, these are still the tangible assets we are talking about and they will be required in the future.

Most marketable securities follow two simple patterns of human behav­ior: greed and panic. Consider a pond filled with piranhas. Now introduce into this pond a chicken drumstick, in this case the meat being some kind of fundamental or technical analysis being introduced into the market. The pira­nhas quickly attack the meat and within seconds there’s nothing left but bone. During this time the waters have been stirred up and have become turbulent, but inevitably the waters are going to calm down and restore the status quo.

What we are going to see over the next two to five years is a major redis­tribution of wealth. If there’s some­thing we can take a way from this, it’s as simple as not placing all your eggs into one basket and always being wea­ry of the black swan. Why didn’t any regulatory body jump to examine this system’s structure? Perhaps everyone was just too happy with his or her own house of cards.


 

 
Last Updated ( Thursday, 18 September 2008 )