[BretLudwig]

The Sand States

"Here are excerpts from €œThe End€� in Portfolio by Michael Lewis,
author of Liars Poker, on the financial collapse. His article is based
on the recollections of Wall Streeters who shorted subprime mortgages:

The juiciest shorts€”the bonds ultimately backed by the mortgages
most likely to default€”had several characteristics. Theyd be in what
Wall Street people were now calling the sand states: Arizona, California,
Florida, Nevada.

Last I checked 50% of the number of defaults were in the four sand states.
I havent seen any estimates of dollars defaulted in those four states,
but I imagine it was 70% or higher.

Still, Im not sure that €œsand€� is the truly relevant common
characteristic of the sand states.

The loans would have been made by one of the more dubious mortgage
lenders; Long Beach Financial, wholly owned by Washington Mutual, was a
great example. Long Beach Financial was moving money out the door as fast
as it could, few questions asked, in loans built to self-destruct. It
specialized in asking homeÂ*owners with bad credit and no proof of income
to put no money down and defer interest payments for as long as possible.
In Bakersfield, California, a Mexican strawberry picker with an income of
$14,000 and no English was lent every penny he needed to buy a house for
$720,000.

More generally, the subprime market tapped a tranche of the American
public that did not typically have anything to do with Wall Street.
Lenders were making loans to people who, based on their credit ratings,
were less creditworthy than 71 percent of the population. Eisman knew some
of these people. One day, his housekeeper, a South American woman, told him
that she was planning to buy a townhouse in Queens. €œThe price was
absurd, and they were giving her a low-down-payment option-ARM,€� says
Eisman, who talked her into taking out a conventional fixed-rate mortgage.
Next, the baby nurse hed hired back in 1997 to take care of his newborn
twin daughters phoned him. €œShe was this lovely woman from Jamaica,€�
he says. €œOne day she calls me and says she and her sister own five
townhouses in Queens. I said, €˜How did that happen?€‰€� It happened
because after they bought the first one and its value rose, the lenders
came and suggested they refinance and take out $250,000, which they used
to buy another one. Then the price of that one rose too, and they repeated
the experiment. €œBy the time they were done,€� Eisman says, €œthey
owned five of them, the market was falling, and they couldnt make any
of the payments.€�

This small hedge fund started shorting big investment banks, then found
out they could short the securitized bonds directly.

But the scarcity of truly crappy subprime-mortgage bonds no longer
mattered. The big Wall Street firms had just made it possible to short
even the tiniest and most obscure subprime-mortgage-backed bond by
creating, in effect, a market of side bets. Instead of shorting the actual
BBB bond, you could now enter into an agreement for a credit-default swap
with Deutsche Bank or Goldman Sachs. It cost money to make this side bet,
but nothing like what it cost to short the stocks, and the upside was far
greater.

The arrangement bore the same relation to actual finance as fantasy
football bears to the N.F.L. Eisman was perplexed in particular about why
Wall Street firms would be coming to him and asking him to sell short.
€œWhat Lippman did, to his credit, was he came around several times to me
and said, €˜Short this market,€‰€� Eisman says. €œIn my entire life,
I never saw a sell-side guy come in and say, €˜Short my market.€‰€�

And short Eisman did€”then he tried to get his mind around what
hed just done so he could do it better. Hed call over to a big firm
and ask for a list of mortgage bonds from all over the country. €¦

In retrospect, pretty much all of the riskiest subprime-backed bonds
were worth betting against; they would all one day be worth zero. But at
the time Eisman began to do it, in the fall of 2006, that wasnt clear.
He and his team set out to find the smelliest pile of loans they could so
that they could make side bets against them with Goldman Sachs or Deutsche
Bank. What they were doing, oddly enough, was the analysis of subprime
lending that should have been done before the loans were made: Which poor
Americans were likely to jump which way with their finances? How much did
home prices need to fall for these loans to blow up? (It turned out they
didnt have to fall; they merely needed to stay flat.) The default rate
in Georgia was five times higher than that in Florida even though the two
states had the same unemployment rate. Why? Indiana had a 25 percent
default rate; Californias was only 5 percent. Why?

Why? Because the bubble was worse in Florida and California than in
Georgia and Indiana. In the sand states in the fall of 2006, there were
still Greater Fools around who believed that Hispanicization meant an
unending increase in home values. The idea never gets fully articulated
€” are home prices high because Hispanics can pay high prices? Or are
home prices high because non-Hispanics are desperately paying high home
prices to get their kids away from public schools full of Hispanics? When
you spell out the logical alternatives, neither one sounds terribly
sustainable, but the point is that political correctness keeps people from
thinking it through. Young Wall Streeters just all emotionally believed
Diversity = Goodness = Money.

Its one of those ideas €” that a constant influx of Hispanics meant
ever growing property values €” that people get in their heads vaguely,
but arent allowed to interrogate under our reigning worldview and our
reigning EEOC regulations, under which Malcolm Gladwell makes a fortune
and Charles Murray makes nothing lecturing corporations.

Moses actually flew down to Miami and wandered around neighborhoods
built with subprime loans to see how bad things were. €œHed call me
and say, €˜Oh my God, this is a calamity here,€‰€� recalls Eisman.
All that was required for the BBB bonds to go to zero was for the default
rate on the underlying loans to reach 14 percent. Eisman thought that, in
certain sections of the country, it would go far, far higher.

The funny thing, looking back on it, is how long it took for even
someone who predicted the disaster to grasp its root causes. They were
learning about this on the fly, shorting the bonds and then trying to
figure out what they had done. Eisman knew subprime lenders could be
scumbags. What he underestimated was the total unabashed complicity of the
upper class of American capitalism. For instance, he knew that the big Wall
Street investment banks took huge piles of loans that in and of themselves
might be rated BBB, threw them into a trust, carved the trust into
tranches, and wound up with 60 percent of the new total being rated AAA.

But he couldnt figure out exactly how the rating agencies justified
turning BBB loans into AAA-rated bonds. €œI didnt understand how they
were turning all this garbage into gold,€� he says. He brought some of
the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a
visit. €œWe always asked the same question,€� says Eisman. €œWhere are
the rating agencies in all of this? And Id always get the same
reaction. It was a smirk.€� He called Standard & Poors and asked what
would happen to default rates if real estate prices fell. The man at S&P
couldnt say; its model for home prices had no ability to accept a
negative number. €œThey were just assuming home prices would keep going
up,€� Eisman says. €¦
Thats when Eisman finally got it. Here hed been making these
side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB
tranche without fully understanding why those firms were so eager to make
the bets. Now he saw. There werent enough Americans with ****ty credit
taking out loans to satisfy investors appetite for the end product. The
firms used Eismans bet to synthesize more of them. Here, then, was the
difference between fantasy finance and fantasy football: When a fantasy
player drafts Peyton Manning, he doesnt create a second Peyton Manning
to inflate the leagues stats. But when Eisman bought a credit-default
swap, he enabled Deutsche Bank to create another bond identical in every
respect but one to the original. The only difference was that there was no
actual homebuyer or borrower. The only assets backing the bonds were the
side bets Eisman and others made with firms like Goldman Sachs. Eisman, in
effect, was paying to Goldman the interest on a subprime mortgage. In fact,
there was no mortgage at all. €œThey werent satisfied getting lots of
unqualified borrowers to borrow money to buy a house they couldnt
afford,€� Eisman says. €œThey were creating them out of whole cloth. One
hundred times over! Thats why the losses are so much greater than the
loans. But thats when I realized they needed us to keep the machine
running. I was like, This is allowed?€�

Still, this leaves open the question of why the financial engineers chose
strawberry pickers with $720,000 mortgages to replicate in order to place
double or nothing bets. Why not replicate your bets on Steve Jobs? Why
build mountains of leverage on top of the pebble of probability that the
strawberry picker was going to pay back his mortgage or find an even
greater fool wanting to pay a fortune to live among strawberry
pickers?"

http://blog.vdare.com/archives/2008/...e-sand-states/

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