‘It is all put on the expense account as a £60 bottle of wine, but what the waiters are selling is a wrap of cocaine,’ said Daniel. ‘These bars are run by criminal syndicates where the food and drink is incidental. They are fronts for drugs.’3
According to the same report, addiction problems have increased since financial markets became more turbulent. I’m not sympathetic, however. Why should drug laws be enforced vigorously in the South Bronx and Tottenham, but not on Wall Street and in the City of London? It’s yet another case of double standards.)
Turning to the text itself, the slogan ‘I’m short your house’ is Wall Street jargon meaning that I’ve taken a bet which will pay off if the value of your house falls. The greater the loss of value, the more money I make. That’s the joke at the heart of the email. And it’s a nasty one. The humor is spiteful. Nor was it a one-off aberration. A little later in the same package of documents, there’s an email from Lippmann describing a customer as ‘a CDO guy puking up a pig [that] he bought.’ Nice.
Naturally, we all say things like this from time to time, but mostly we try to act with a little courtesy and consideration; a little dignity. We certainly try to act that way if we’re dealing with major clients in the course of important business. Wall Street, however, comes to disregard such niceties, because every transaction, every bet, comes down to a simple play of numbers, a spin of the roulette wheel. The fact that houses, mortgages, personal debts are at stake—or, indeed, that companies, jobs, wages, and investments may be—shrinks to almost nothing. It all boils down to a lame, slightly spiteful joke.
Yet having said all that, Greg Lippmann and his colleagues called this right. There was a housing bubble. Lippmann and others saw it coming and made a ton of money by placing the right bets at the right time. If that strikes you as an utterly unhelpful response to the mass insanity of a housing bubble, I’m afraid to say I disagree. The bigger bubbles become, the more damage they do. Short-sellers help prick those bubbles. Funnily enough, one of the things the world needed most in the years running up to 2008 was more people like Greg Lippmann. They couldn’t singlehandedly have stopped the bubble expanding, but they’d have moderated its extent and its ultimate destructive impact.
So you’ll forgive me, I hope, if I confess that I too am negative on the housing market. I’m not, right this moment, short your house but—well, I’m in that general camp. Sorry.
The facts are these. In my opinion, one of the best indices of US house prices is the national Case–Shiller index. If you take January 1, 1995 as representing 100, the index rose to 114.5 by January 2000. From that point, house prices began to climb and climb. The index grew nonstop until the start of 2006, at which point it stood at 183.9, having almost doubled over little more than ten years. Bear in mind that the index is so constructed as to track like-for-like sales. So it doesn’t climb because houses are getting larger or better; it climbs as a result of inflation, pure and simple.4
And from early 2006, the index collapsed. It fell in every quarter until spring 2009, when it stood at 118.3, or approximately where it had been at the start of the decade. After a flickering, uncertain recovery, prices dropped again and are still falling as I write. The index currently stands at 110.1—that is, close to its long-term norm. In relation to ‘owner’s equivalent rent,’ prices are also in line with historic norms for the first time in years.5 These facts are of comfort to many. They would seem to prove that house prices have, after their lengthy high-altitude mountaineering trip, finally returned to base camp. They’ve normalized.
Which is my point. House prices have more or less normalized at a time when every single feature of the domestic economy is calling for them to be well below the norm. Unemployment is higher than it’s been for almost thirty years—and thirty years ago, the spike in joblessness was fierce, but brief. Today, the jobless figures are high and settling there, a new and frightening combination.6 Soon the various elements of the government’s emergency response to the credit crisis are going to start dropping away. Although our politicians have not shown vision, leadership, or muscle in bringing the deficit under control, the bond markets will bring their own brutal discipline to bear. The wall of government money which is keeping economic activity as high as it is will have to crumble eventually. When it does, spending will fall, unemployment will rise, and house prices will come under pressure again.
Meantime, the crisis in the housing market itself shows no signs of abating. Although, at the time of writing, house prices are somewhat stable or trending only a little downward, the FHFA reports that around 30% of all house transactions are arising from distressed sales of some sort. That is a stunning statistic. In a way, it says as much as our unemployment statistics do about the crisis that is gripping America. Just think for a moment of the trauma of repossession, what it would feel like. Right now, almost one-third of all home sales feel something like that. That’s how bubbles feel as they pop. The 2,000,000 construction workers who lost their jobs were among those injured by the popping.7 Meanwhile, despite a collapse in the number of new houses being built,8 the stock of homes available for sale is still well above its historical average.9 In America, in 2010, some 23.1% of homes were in negative equity,10 and more than a quarter are currently in negative equity or near-negative equity.11 Every tick downwards in house prices will drag ever greater tranches of the US population into that frightening and unwanted position. Perhaps most scary of all, there are between 1.5 and 2 million homes not yet on the market but where the mortgages are delinquent or foreclosure proceedings have taken place. Those homes will, one day, need to be sold.12 When that great dam of selling activity finally bursts, the effect on house prices will be catastrophic.
Finally, all this—the negative equity, the distressed sales, the unsold homes, the falling prices—is happening while the Fed desperately attempts to keep the great American Ponzi scheme alive for as long as possible. Interest rates are at historic lows. Mortgage rates have tracked them down. In our inflationary times, this monetary laxity cannot be maintained for ever. Interest rates will have to rise. When they do, the results will be grim. At present, the collapse in the housing market has been initiated by a collapse in the subprime market. Subprime mortgages have turned delinquent in huge numbers. Prime mortgages have remained relatively unaffected.13
I’m not certain that it will happen—no one can predict the future with perfect accuracy—but the likelihood is that gathering economic pressures will start to place the prime housing market under pressure. Delinquencies will rise. Distressed sales will rise. Prices will fall. Negative equity will become even more common. As interest rates increase from their historic lows and as ‘teaser rate’ mortgages click through to their full-price level, things will only get worse. In more and more households across the country, wives and husbands will look at each other across the dinner table, asking why the heck they’re struggling to pay the mortgage when the loan is worth tens of thousands more than the house. Housing markets are volatile. We’ve known that for eons, but on Planet Ponzi that knowledge came to be translated into the notion that prices were volatile in one direction only: upwards. And that’s not true. Volatility means prices can surge crazily upwards and lurch sickeningly downwards. We’ve ridden the first of those curves for a decade or so. The full depths of the descent may only now be opening before us. (And, of course, those depths are likely to add a crashing extra burden to the federal government’s debt. In 2011, some 96.5% of all new US mortgages were guaranteed by Uncle Sam, up from a still-staggering 90% a couple of years earlier. So when those mortgages go bad, Uncle Sam is going to be find himself picking up the lion’s share of the tab.)
The same goes for commercial real estate. Prices have plummeted, but the crisis here has felt somewhat static, in large part because when financial distress affects commercial real estate, you don’t get hard-luck stories of families being forced out on to the street. But the situation is di
re all the same. As long ago as January 2010, Richard Parkus, the head of commercial real estate research at Deutsche Bank, commented: ‘It’s a train wreck in slow motion. Because it’s in slow motion, people get this sense that it’s really not happening. It is happening.’14 Parkus is absolutely right. Bear in mind that commercial mortgages generally refinance every three to ten years. That means that loans made during the boom are coming up for refinancing now. Since prices have fallen and—at last!—lending standards have risen, there will be countless borrowers unable to roll over their debt. That means more bankruptcies, and yet another source of fear and uncertainty for the economy at large.
These are hardly comforting thoughts, so permit me to cheer you up with a little splash of Schadenfreude. The American housing market looks dire, but it’s in much, much better shape than most of its foreign counterparts. According to data compiled by The Economist, the US market has already adjusted far more than most. Figure 12.1 presents The Economist’s estimates of over- or undervaluation for some selected international housing markets, using long-term ratios of house prices to rent by way of a valuation benchmark. Housing markets in Europe, Hong Kong, and Australasia are still gripped by overvaluation on a massive scale. Canada’s housing bubble has been kept inflated by the strong performance of its economy.
Figure 12.1: The coming house price crash
Source: ‘Rooms with a view,’ The Economist, July 7, 2011.
The three final bars in the chart hold up a mirror to the possible future for those markets. The two different estimates for the US market arise because of the lack of a single agreed measure for US house prices. A reasonable guess would place the truth at somewhere between the FHFA measure and the Case–Shiller one. Yet, in a way, the crucial entry is the very last one. It explains why I’m not comforted by the idea that the US market has ‘normalized.’ It reminds us that volatility cuts in two directions. Two decades on from the collapse of its own bubble, the Japanese property market is more than 35% below its own ‘normal’ value. My own guess is that the US market will need to touch those levels before it will truly shake off the effects of the last decade.
I’m not alone in thinking so. Robert Shiller himself said that a further fall of 10–25% ‘wouldn’t surprise me at all,’ commenting that, ‘in real terms, there has never been a bust of this proportion.’15 He’s right. We’re in new territory, desolate and hostile. We’ll talk about the implications for the banks in another chapter. Needless to say, those implications aren’t going to be pretty. And the greater the pressure on the banks, the more they’ll seek to conserve their liquidity position by refusing mortgage request applications. Which means the housing market will come under yet greater pressure. Which means …
Well, you get the picture. If you own a house, it’s probably not the picture you wanted to see, but truth isn’t about what you want or hope, it’s about what is. The desire to see things some other way is at the heart of the thinking that gave us Planet Ponzi, that gave us all these insane housing markets worldwide. What we’re experiencing now and what we’re about to experience is the slow elimination by fire of that way of seeing the world. If that’s not what you signed up for when you started this chapter, remember I did try to warn you. I’m not short your house, but still …
Sorry.
13
A brief flash of reality
One of the most important papers in the history of the social sciences reported the results of a strange little experiment conducted by researchers Amos Tversky and Daniel Kahneman. It’s a paper which, ideally, every investor and every regulator should read. Everyone with an interest in the financial markets, in fact—a group which includes all those who have money and all those who would like to.
The study was simple and emphatic. It took a group of subjects and asked them various questions—for example, the percentage of African countries among the United Nations member states. Since, naturally, people often didn’t know the answers, they were obliged to guess. But the questions weren’t presented in an altogether open way. The process worked a little like a game show. The experimenter would spin a ‘wheel of fortune’ in the subject’s presence. If, let’s say, the number 10% came up, the subject would be asked to guess whether the percentage of African nations in the UN was more or less than that 10%. They were then asked to supply their own guess as to the correct figure. If the number 65% came up instead, it worked the same way. People had to guess if the percentage was more or less than 65%, then make their own guess.1
If humans were genuinely rational, the spinning wheel would make no difference to the guesses people made. Why should it? Not only could it have nothing to tell anyone about the correct answer, but its essential randomness was completely visible to the subjects of the experiment. They could see the wheel being spun. But you’ve already guessed the punchline. People’s guesses were hugely biased by the spin of the wheel. Those given the number 10% by the wheel guessed that the correct number was 25%. Those given the number 65% guessed 45%. Even when subjects were given a reward for giving (approximately) correct answers, the bias persisted. The spin of a wheel had them hooked. The name given by Tversky and Kahneman to this weird little phenomenon was ‘anchoring bias.’ People found themselves transfixed by the anchoring they were given by the questioning, even when they knew the anchor was random.
A second well-studied phenomenon is our so-called ‘optimism bias.’ That bias produces precisely the effects you’d guess. We humans expect to live longer than average, to be healthier, to have a lower chance of divorce, to be more successful.2 There are paunchy middle-aged men who honestly think they’d stand a chance with Angelina Jolie. There are plump middle-aged women who honestly think that Brad Pitt would be entranced, if only he’d just get to know them. These things are so well documented by now that the British Treasury, for example, sets out guidelines for how project appraisers need to adjust their cost and timing estimates to overcome their own involuntary optimism.3
These things matter because they affect us all, and those who live on Planet Ponzi most of all. Take a look at figure 13.1, which graphs the S&P 500 stock market index from January 2000 to date. On August 26, 2011—the day I’m writing this page—the S&P opened at a level of 1159. How long do you guess it will take the index to recover the 1500 level that it first achieved in the early part of 2000? It would be good if you paused to answer that question before reading on. Take a look at the numbers. Have a think. How long before we get back to 1500?
Figure 13.1: The return to 1500
Source: S&P.
If you’re like most of us, your train of thought will have run something like this: ‘Well, I can see we’re due a little downturn—that’s the argument of this book after all and I can see it makes sense—but then again we were at 1500 around twelve years ago. That’s a heck of a long time to be treading water and the economy does grow, after all. So let’s say, we’ll have another bad year or two, then climb back to 1500 and start to make progress from there.’
You were thinking something like that, right? And if you were, you’re in good company. In December 2010, Goldman Sachs published its thoughts on the economic and market outlook for the coming year. The firm took a broadly positive view of economic and monetary developments, commenting:
Growth is likely to accelerate, but there is plenty of spare capacity to keep policymakers on the sidelines. This is typically an environment in which equities and credit do well, and we think the continued removal of US recession risk will remain a major market theme early in the year. Indeed, our strategists are fairly optimistic. Our Portfolio Strategy team’s end-2011 index targets envisage 14%–29% returns across the major equity markets.
Specifically, the firm estimated that the S&P 500 would end the year at 1450.4
We know already that that happy outcome is not looking probable now. We know now that ‘removal of US recession risk’ is not a phrase that would seem particularly wise even si
x months after it was written. The people who wrote that Goldman Sachs report were extremely smart people with a deep knowledge of the financial markets. Nevertheless, they—and nearly all their fellow commentators on Wall Street and in the media—look at the markets with a buyer’s eye. The assumption common to almost all of us is that the equity markets will make money over the long run, that setbacks are temporary, that growth is the natural order of things. Given that the most influential commentators on these markets are firms like Goldman—which make money by selling the securities they’re commenting on, which profit by encouraging investors to trade—our natural biases are liable to run rampant. We’re hardwired to look at financial data with an optimistic bias, then strongly encouraged to do so by firms whose job is to sell us the underlying securities.
So let’s seek to overcome those biases. Let’s recall that only once in the past decade has the world come close to recognizing the reality of Planet Ponzi. In the winter of 2008–9, investors took a cold, hard look at the world that was collapsing around them and they saw it for what it was: insolvent banks, overleveraged corporations, wasteful governments, unrelenting competition from the emerging markets. That winter, markets were lit by a brief flash of reality—and, for the first time in a decade, they got things right. In March 2009, the S&P index traded at 683 points, less than half that fantasy 1500 level I used to ‘anchor’ your response a few moments ago. Less than half the level that Goldman Sachs was projecting for 2011. In March 2009, markets were frightened, but they were sane. They priced the world as they saw it, not as they wanted it to be.
That moment of reality did not endure for long. The sheer weight of government and monetary interventions eventually persuaded markets to close their eyes again and dream. In March 2009, the MSCI index of world equities—an index which includes all markets, developed and emerging—touched 175 points. Little more than two years later, that index had more than doubled, reaching over 350. No sane individual could believe that the value of the world economy had doubled in the space of two terrifying and depressing years. On the contrary, and as we’ve already seen, that torrent of government and monetary interventions has simply compounded the original problem. The credit crisis arose because of weak lending, excessive debt, inflated expectations, and overgenerous monetary policy. Worldwide, governments have chosen to respond by running huge deficits, bailing out failed investors and lousy investments, adding to the pile of debt, and printing money. You might just as well seek to fight a fire by hosing it with gasoline. It’s no coincidence that the developed world’s most successful governments—currently Canada, Sweden, and Germany—have consistently resisted these temptations. If anything, the world economy (or at least the American, European, and Japanese parts of it) has lost value over the past two years. At the very least, the hole we’re in has just got a few trillion dollars deeper.
Planet Ponzi Page 18
