Saturday, June 7, 2008

Worm Ouroboros

Sometimes, something is so glaringly obvious that you ignore it. It's right in your face, you know there is something wrong, but you're distracted by other wilder, crazier things.

I've felt that we were building too many houses in Bend for several years; actually, I think I was saying that even before the actual bubble. My concern was that Bend didn't have an underlying industry, or economic base, to justify all the housing. I didn't think minimum wage tourism jobs could pay for them, and there were only so many amenity rich transplants we were likely to convince to move here. I'm not even sure I was all that conscious that it was a national problem, I just could see what was obvious here in Bend.

I never felt that retired people were big spenders. The number of stores in Bend seems wildly excessive. It seemed that an awful lot of the newcomers were involved in real estate or building or support industries. More and more, it appeared to me that growth was the industry of Bend, and the industry of Bend was growth, a big Ouroboros Worm eating it's tail.

I wasn't really very aware of the credit/liquidity problem until it burst. I don't remember too many people talking about it, or reading very many stories about it.

In hindsight, that too was obvious. I'd heard plenty of troubling stories over the years about people borrowing money that I didn't think they could afford to pay back. But subprime and Alt loans and other guaranteed to make you 'house poor' schemes have been around for years.

Was it the cause or the effect of too many houses? Whatever, it was the precipitating factor in bursting the bubble. The curtain was drawn back, and the wizard behind the screen was naked as a jaybird.

I've begun to see the whole housing thing as a true pyramid scheme.

At the top, the fewest and the biggest, and probably the ones who scammed most of the money, were the big financial firms; the Bear, Stearns, the Lehman's. Right underneath of them, a bit more numerous, were the big banks. Both of these found loopholes in the relaxed regulations to bundle problematic schemes into 'investments.'

Next level under, more numerous, were the national builders, the national chains, and the big box developments. Again, I've felt too many commercial buildings were being built, especially locally. All done, in my opinion, in money borrowed from the future. A vast pool of liquidity that seemed 'free'; but will have to be paid.

Just below them, the regional banks, builders, and mortgage companies; the wannabes and the followers.

Under them, in much bigger numbers, a crazy number of local mortgage and banks and other financial services. And an even crazier number of local builders and construction firms.

Working for them, a vast pool of real estate agents, and construction workers, and mortgage agents, and clerks working at stores supplying the bubble, and so on.

And finally, in at the base, the home buyers themselves. Prime, alt-loans, and subprime.

In most pyramid schemes, the top walks off with all the money. Whats unusual this time is that the problem first appeared at the top. The level of greed and graft and stupidity was so massive, that once we saw the wizard's big, red, hairy butt, we wanted our money back. After the collapse of Bear, Stearns, the government rushed to reassure us that they are buying the other financial services some fine pants. Don't worry, we'll take care of it!

But, as usual in a pyramid scheme, the biggest number at the bottom are bearing most of the brunt.

Do you see the part of the pyramid that hasn't really been talked about much?

Except for a few high profile national builders, it seems to me that most of the developers and big builders, both regionally and locally, haven't really been punished yet. Even when a company seems to run into problems, someone else comes along and bails them out. Randy Sebastian is given another lease on life, albeit with his nuts firmly clamped.

It has been commented in passing, that building just seems to keep going on, despite the glut of housing and the lending problems.

Yesterday, the Wall Street Journal had an article that partly explained what's been going on:

In "Real-Estate Woes of Banks Mount," Michael Corkery, Jonathan Karp and Damian Paletta of the Wall Street Journal: (Italics are mine, to highlight the role of the developers.)

"Federal regulators warned Thursday that banking-industry turmoil would continue as financial institutions come to terms with piles of bad loans they made to finance the construction of homes and condominiums.

"Until now, most of the damage to banks from the housing crisis has come from homeowners defaulting on their mortgages. But amid a dismal spring sales season for new homes, loans to home and condo builders are looking increasingly shaky..."

"...banks that aren't diversified, or those with high exposures to residential construction and development, are of particular concern..."

"Home builders are falling behind on loan payments, and the value of the land and housing developments that serve as loan collateral is plummeting."

""We believe this period of procrastination is nearly over," says Ivy Zelman, chief executive of Zelman & Associates.

"The prospect of a new wave of losses worries federal regulators, given the large proportion of loans to housing developers held by many banks and thrifts. The problems are worse at small banks that can't easily absorb losses, and at banks with big exposure in states hit hard by the housing crisis..."

'Real-estate lenders had been hoping for a decent spring sales season for new homes, which would have helped builders stay current on their loans. But the selling season has been a bust.'

"..."Finally the banks are capitulating and saying, 'Let's mark to market and flush this all out.' The market is going to get worse. We don't want to hold on to this stuff."

For me, this is the final piece of the puzzle. It both explains why frenzied building continues by developers, and the response of the banks. It finally let me see the whole thing as the pyramid scheme I detailed above. It also appears to me that problems are starting to ricochet through the different levels -- the government steps in to try to firm up one problem, but it breaks out on another level and so on. Which mean, it probably can't be controlled.

I'd thought most of the bad news would be put on the back burner during the spring and summer, and the accounting would take place in the fall. Now, I'm wondering if even locally, they'll be able to hold off taking the developers out of play.

If you don't mind, I'd like to repeat one of the above quoted paragraphs, in Capital Letters and Italicized.



IHateToBurstYourBubble said...

Awesome. Hope you don't mind if I reprint... :-)

Unknown said...

this is exactly what has me worried about bank of the cascades. so far their delinquency rate on the real estate portfolio ($700 million!!!) is less than 1%. if that rises to 10% (which i have hypothesized and the article suggests is a reasonable forecast) their viability will be brought into question....

Duncan McGeary said...

Please do, Paul-doh,

(he said, sycopantedly...)

Duncan McGeary said...


It's not a bad loan unless they're forced to declare it's a bad loan, right?

How long can they carry these guys on their books? Hoping for the best?

"...this period of procrastination is nearly over..."

Duncan McGeary said...

I wonder if we'll see the usual Bend time-lag, or because everything is already in play, we'll catch up sooner.

Are we going to hear about developers in Cal. and Florida having their loans yanked, and going bankrupt first?

For sure, there will be a time lag in the commercial area. Anything already started is probably fated to complete -- anything not started, is probably fated to never get started.

Even Wal-Mart and Target have pulled in their horns.

So we've got the completion of projects like the Oxford Hotel in Downtown Bend to complete...and then?

Bewert said...

Dunc, the builders are whinely really loudly, see the May 29 BULL article about Palisch, etc. wanting a million in SDC money back from the city because they feel they were overcharged for townhouses.

Jesse, CACB has most of its exposure in commercial. According to it last quarterly earnings PR, they had 2.05 billion in outstanding loans, 29% commercial, 32% commercial RE, 33% construction/lot, 4% mortgage, and 2% consumer. It only has $34M in its loan loss provision, and charged off $4.6M last quarter alone. If 10% of their construction and commercial RE loans go bad, thats a total of $130M, which will sink them.

I was trying to find some way out there put options to sit on, cause I don't think they are long for this world. But there are none.

Duncan McGeary said...

They're privileged, don't you know?

There has been quite an incestuous relationship between government, builders, bankers and real estate.

Government is going to see the hand writing on the wall, eventually, and begin to cut their political losses.

When the developers are no longer the producers of cash and growth, why stick with them?

I'm not charging corruption, just that everyone saw it as beneficial to Bend to keep the ball rolling.

Unknown said...

"According to it last quarterly earnings PR, they had 2.05 billion in outstanding loans, 29% commercial, 32% commercial RE, 33% construction/lot, 4% mortgage, and 2% consumer."

i was referring to the quarterly SEC filing in which they disclose roughly $700 million of the portfolio is dedicated to residential real estate.

as of Q1, they have only labeled $5.5 million (less than 1%) of that part of the portfolio "non-performing." if this residential part of the portfolio sees a 10% default rate, as both the article and local default trends suggest, i would think they would be in trouble.

ps - it's a bad loan, dunc, if it's 90 days past due - period.

RDC said...

Actually you are quite wrong on this.

What you call the top of the pyramid are losing far more money then they ever saw as income.

The group that is actually made out the best is the group at the bottom or middle. The middle is the brokers who collected all of the fees for initiating the loans.

The bottom are those that took out massive loans without putting any of their own money into the mix, and then proceeded to take cash out refi's, and now that the money is coming due are walking away. or living in the house they could not afford for 6 - 12 months rent free during the foreclosure process.

I find it amazing that you put all of the blame on the investment banks and none anywhere else.

There was enough blame to go around at all levels.

The bottom line is the wealth was never really there to begin with.

The people should not have borrowed it, the brokers should not have coordinated it, the banks should not have lended it, the investment banks should not have securitized it, and the investors should not have purchased the CDO's.

You were real pissed when the banks realized just how dumb of an indea it was to lend up to full price with home equity loans and started canceling them. Now you are putting the blame there for making such loans. to begin with

Duncan McGeary said...

Well, now. That sure was nice of them. All that money flowing down to the little guy.

Why'd they do that, by the way?

Duncan McGeary said...

So on one hand we have tens of thousands, hundreds of thousands of on the bottom of the pyramid losing their homes and one the other hand -- Bear, Stearns? Sure looks like an equal loss in my eyes.

Human scale vs. Corporate Loses.

Unknown said...

well, the top of the pyramid should really be the fed, aka sir alan greenspan, who almost single-handedly inflated the credit bubble by taking real rates (inflation-adjusted rates) below zero. he benefited by taking credit for saving the economy (british knighthood?!?) and none of the blame (publicly) for the mess we're in now.

Duncan McGeary said...

As they say in the crime stories -- follow the money. Who's getting hurt? Where is the money going?

Bear, Sterns assets simply get transferred to J.P. Morgan, and the debts are covered by the federal government.

Think my neighbor being foreclosed down the street can get the same deal.

You make me tired, RDC.

Duncan McGeary said...
This comment has been removed by the author.
RDC said...

Take a look at Bear Sterns, you had billions wiped out over night. Who exactly at Bear Sterns made out?

The CEO was worth has a net worth that is over a billion less than he had before the bubble ever started. The employees of Bear Sterns lost most of their retirements, over half lost their jobs. So who exactly at Bear walked away with all of the money?

RDC said...

So lets take a look at those people losing their houses to foreclosure. For all of the sob stories that are in the news, the majority are people that borrowed money they could not afford to borrow, because they expected to make a killing because of the rapid run up. You say the investment banks are the cause and greedy, yet you ignore the greed on the part of the others in this problem. You also ignore all of the nice folks that everytime their house value went up did a cash out refi. So now they are saying that they cannot afford the 500k they owe and they are losing the house they originally paid 250k for.

RDC said...

Bear Sterns was a company. Filled by individuals. How did those individuals make out. Unlike you I know some of those individuals. The primary holder of Bear Sterns stock was the employees.

As far as the assets that got transferred the value at the time of the purchase was zero, actually below zero since there were more liabilities that value. What JP Morgan got was some employees that they wanted to keep (note half lost their jobs), a customer base, and some business areas that Bear Sterns had a strong presence that they did not. They also incurred substantial liabilities. The only reason the deal wnet through was because the Fed was willing to take 30 billion of Bear Sterns paper, reducing JP Morgans risk. Paper that if it had to have been liquidated at the time would have been nearly worthless, but because the Fed does not have any urgency to sell it, will most likely result in a profit for the Fed when they do sell it.

Not unlike the Chrysler "bailout"

Duncan McGeary said...

If I remember rightly, the CEO was left with mere millions. Certainly, the guy who founded the company, and who was probably there when many of the transactions were taking place, had cashed out.

I would bet that upper management is more likely playing golf right now than working at McDonalds.

The other workers at Bear, I would include at the second tier from the bottom "....the vast pool" of workers for financial agencies. I don't believe anyone who was invested with Bear lost money, simply had it transfered to J.P. Morgan. (The people invested IN Bear did lose money.}

I reread your earlier message, and I would agree there is blame enough to go around.

And I reassert that it appears to me that the bottom of the tier is suffering the most, which is why I call it the Bottom of the Pyramid.

Duncan McGeary said...

Like I said, I don't consider the worker bees at Bears to be the top of the pyramid, but the larger group at the bottom, who suffered because of decisions made by those on top.

Bewert said...

Jesse, I take it you are referring to this under Real Estate:

Construction/lot $668,190

I would add:

Commercial $633,995

I think that's the next thing going down.

Unknown said...

in dunc's defense, i worked at bear stearns and i can't imagine anyone there who's hurting like the one million foreclosed homeowners...

Unknown said...

i agree, bruce, that commercial will get much worse - it's already showing signs.

but for CACB the first shoe (residential) has yet to drop...

RDC said...

The CEO was worth over a billion before the housing boom ever started. Yes, he ended up with millions, after starting with over a billion well prior to the housing boom run up.

Yep, really a way to make money. kind of like what they say about horse racing, the best way to make a million in horse racing is to start with 2 million.

As far as the person that started Bear Sterns, it is one of the older of the investment banks.

The person who started it is probably not even still alive. Again the value of the organization prior to the entire housing buble was significantly more that it was at the end.

As such they really made out. The losses on the CDO's wiped out the value of their brokerage, M&A, etc lines of business.

RDC said...


You indicated that you worked at Bear? Which section. Most of the people I know are in their M&A business.

There is not an insignificant number of them that have lost most of their retirement, that have lost their jobs, and in some cases going through foreclosure themselves.

Now when you make the comment not as worse off.

Now who would you consider to be worse off by the problem

Someone that started with a 2 million plus retirement account and an income of 200k per year, prior to the bubble even starting, that ended with a retirement account worth less then 100k and no job. A net change in net worth of over 2 million.

or someone that took out a full value loan, never made a payment, and then proceeded to live in the house rent free for 6-9 months prior to the foreclosure being complete.

Who made money in that case?

In the majority of the cases, the problems with the loans occured at the origination end. Falsified house values, falsified income, cash back transactions on inflated housing prices, etc.

Situations where the people took out loans that they could not afford, that were willing to take out any loan that they could get because the value would go up and then they could sell and make their money, without any concern for the future, because real estate was the place to make money. People who willing went in and over stretched. They were aided by brokers that did not care if they could pay or not, the originating institutions who also were not concerned.

The level of blame of the investment banks is that they 1. used models showing historic default rates, and did not take into account just how much the controls in the loan origination process had broken and 2. used mark to model instead of mark to market in their values which allowed the problem to go on longer than it should.

The incorrect use of the historic norms was also compounded by the bond rating agencies or the regulators also following the same logic

RDC said...

So how many people out that:

1. used a fixed rate loan
2. actually put money down
3. honestly stated their income
4. read the the docs prior to signing
5. took a reasonable look at their own finances to be sure that they could afford the house they were buying.

How many of those folks are losing their houses? You know those that actually did a reasonable degree of diligence and caution in what was probably the largest financial transaction of their life.

Instead of the who cares the value will go up so I need the absolute largest house I can get and in 12 months I can make the most money on.

The person who did the former and lost their houses due to job loss, illness or some other unexpected crisis, those I feel sorry about.

Those that were the later I feel no sympathy for what so ever.

Over the past 9 months I have gone through 3-400 houses. Most of them foreclosure or short sales. 90% of them fit into either the category where the buyer purchased no money down and then proceeded to cash out refi at every opportunity, or where they purchased and stopped paying after a few months at most. In a large number of cases they made no payments at all.

I was surprised and some taken back by some of the short sale situations (in process of leading to forclosure) where they were still owner occupied, where the house was over flowing with stuff. Closets jammed, all kinds of modern electronics (flat screens, home theaters, etc). New cars in the driveway. Yet they could not make their mortgage payments.

Yep it draws out a lot of sympathy and makes one feel that they should be held blameless.

tim said...

This time around, I think rdc has it right and Duncan has it wrong.

Unknown said...

who would you consider worse off, RDC: a bear stearns broker who made multi-millions per year for the past 20 years (i know plenty of them so you can guess where i worked) and now has to sell his book of biz to morgan stanley for $5 million up front or the old retirees in prineville who committed suicide so they wouldn't have their house repossessed by the bank?

you can speak in anecdotes all you want. they're sure interesting... BUT they don't prove s#!%.

the bottom line is this: bear had 14,000 employees. in comparison there are one million homes in foreclosure right now (figure a family of 3 that means 3 million people). 14,000 versus 3 million? it's no comparison who's really getting hurt.

however, i agree with you that the investment banks deserve less of the blame than the flippers, mortgage brokers and ultimately the fed. read my blog; i've been writing about it for over 3 years now.

i also have no sympathy for the speculators who got caught with their pants down and i sure as hell don't want my tax dollars going to bail them out.

(great discussion here. way to go, dunc...)

Duncan McGeary said...


You can't win them all.

And it was such a beautiful construct.

So, we have the first inverted pyramid scheme in history. The mass of hoi poi at the bottom (pardon, the top) somehow outsmarted and scammed the well-educated elite at the top, (I mean, those poor victims at the bottom point.)

In aggregate, the money may have flow to to the greater numbers, among who were speculators and some people just wanting a house. But the people loaning them that money were taking a slice, which per capita was huge. They may not have known it was a bubble, but I'm betting a bunch of them knew it wasn't quite right.

It may be a political orientation of mine. I don't tend to believe that money flows downward (trickles down.)

I don't think I'm generally conspiracy minded, either, but I'm very doubtful that the money was loaned to people without a way to milk them of it. My guess, as I said, it that the faceless institutions will survive, mostly, and the people within them will have made a bunch of money, saddling the government and the population with huge debts.

Duncan McGeary said...

Kind of reminds me of the recent weather argument. I can't prove that this year has been cloudier and cooler than normal with the available statistics.

But I know I have a very green lawn and have only watered once so far this year.

I'm not an economist. So points to RDC. I believe if I spent some time researching it, I could do a better job of arguing the point, and I don't like resorting to political or emotional arguments.

I know that when I went in late 2003, ready to buy a house, that I was more or less a babe in the woods. You don't expect to be misled by the real estate community. (Yes, yes. Naive, I know.)

I even researched it. I knew I wanted at least 10% down, that I wasn't afraid of a higher proportion of my income toward housing, that I wanted a fixed rate 30 year mortgage. (which I knew were historically low.)

The second time I went in, to borrow money to replace the rotting decking and steps, I had a figure in mind. But the Countrywide agent started throwing options and terms at me I didn't fully understand.

I should have walked out.

But I wanted that loan, and while my instincts was that it wasn't quite right, I thought my circumstances were so good that I could just pay it off before it became a problem.

Multiply me by the millions.

Sure, it's buyer beware. But I think that the system broke down. If the financial community weren't the perpetrators, they were at the least enablers.

Duncan McGeary said...

As far as the HELOC is concerned. I've never argued they had a legal right to withdraw the loan. Only that they broke a good faith agreement without cause.

If, for instance, I had a customer ask me to set aside an expensive item for them, I have the right to say yes or no.

But if I agree, and set it aside, and someone else comes in and wants to buy it, I would be breaking a good faith agreement by selling it to the second person.

The first person did not pay for the item, and has no legal recourse, just my word.

Perhaps I was in dire need of the money I could get from that expensive item, and it was in my best interest to sell it. Maybe the second person offered me more.

But I still broke the deal.

So pardon me if I don't think much of Countrywide.

RDC said...

No Duncan. It is not an either or situation. It is not an upside down or a right side up pyramid.

It is a situation where the ground rules changed and it exposed errors at all levels.

Just as banks and investors that used good diligence avoided much of the problem, borrowers that also used reasonable diligence generally avoided the worse impacts of the problem.

As such what I was reacting to was your basically saying that it was mostly the investment bankers fault and that they reaped money from it.

Basically the faults were at all levels and the losses are incurred at all levels. Those that speculated the most and through caution to the wind also got hurt the most at all levels.

Most of the cases of outright fraud occured at the level of the individual transaction (house valuation, money back to buer on inflated price, falsified income, etc.)

The only real case of fraud that one might argue against the investment banks have nothing to do with the borrower, it is the arguement that they misrepresented the quality of the bonds to the investors.

By the way as far as the home equity loans. Consider it part of the education process. When a line of credit sales that it can be canceled by the bank, consider that it can in fact be canceled. That the language is there for a reason and make your purchasing decisions accordingly.

Maybe you should stop accepting credit cards in your store and only accept cash, because a percentage of your customers might end up in trouble and have to declare bankruptcy because of over use of credit cards and clearly the person selling the product is more responsible for their financial health then the person buying is.

RDC said...

Rules to live by:

1. Never sign anything you haven't read
2. Never sign anything you don't understand
3. Even if you think you understand it, get a second opinion before you sign.
4. If there is a sense of urgency being created by the other party to get you to sign immediately be even more cautious.

When in doubt walk out.

RDC said...

I will agree with you that if one were to look for the single company most deserving of blame Countrywide is the one that would be at the top of my list.

The concept of giving information in good faith does not exist with how their brokers were compensated and that actively put people into the loans that generated the highest compensation for the borker instead of the best loan for the borrower.

Duncan McGeary said...

Probably no one still paying attention to this argument, but his guy is kinda saying what I was trying to say.

From the Financial Times, Fri. June 13, 2008.

When you hear ‘new paradigm’ head for the hills

By Ian Morley

Published: June 12 2008 18:46 | Last updated: June 12 2008 18:46

In financial markets, as soon as you hear the words “new paradigm” you know the next cata­strophe is not far away. The reasons are not complex nor are the observations opaque. It does not matter whether it is dotcoms or subprime mortgages. Sooner or later in market cycles the main participants, and especially the banks, become carried away with a Wildean belief in their own, oft-declared genius.

The gains get magnified by leverage and the egos inflate in direct correlation to the paper profits. At this point, the Darwinian principle that he who makes the profit must be both protected from the rules applied to the rest and rewarded irrespective of risk start to apply. In the recent case of subprime mortgages, bankers lent money to anyone, irrespective of their credit history, because the risk was securitised and the financial equivalent of explosive pass-the-parcel ensued. When the game ended, bankers walked away with much of the gains while the parcel exploded in all our faces. The paper gains disappeared and the losses were added to our tax bill.

This is real moral hazard. It just happens more quickly in bear markets. In the midst of this the regulators tinker with the safety rules of the Titanic (it always sinks, regardless). What they cannot change is greed and stupidity.

Moral hazard is when risk and reward have an asymmetrical relationship – usually a lot of reward for one person and most of the risk for the other. This is the root cause of the subprime and credit crisis. And it is at the heart of most financial meltdowns. They just manifest themselves differently and therefore catch us unawares. It is like generals planning for the next war based on the experience of the last one; and just as failed generals get medals, bankers get bailed out.

As Mervyn King, governor of the Bank of England, put it this week: “If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder.”

When an Enron, or even a Barings, fails in isolation and there is no general market failure, the regulators get sanctimonious about the dangers of systemic moral hazard, because collateral market damage is not perceived as a great risk. But when a Northern Rock or Bear Stearns is about to fail in the midst of a market crisis, they have to be bailed out irrespective of moral hazard. Until we can think of another source of mass access to paper and electronic debt that we call money, then every time the banks mess it up they will always be bailed out. This is a problem not just for banking; it is a moral question for society.

Do not look to politicians for solutions. There are too many examples of egregious moral hazard in that group. But if banks are to be supported with generous liquidity or guarantees underwritten by the taxpayers – or even recapitalised with taxpayers’ money – they should use part of the money to try to prevent defaults on mortgages by all but their most delinquent customers. Short-term support from the public authorities may prevent a complete meltdown but in the long term it creates dependency. If the banks do not behave properly as the credit crisis turns to economic grief – the precedents are not good – then when markets return to normal it may be necessary to take the cheap loan benefits back in special taxes.

There are also things the banking sector can do to help itself. Strong, independent non-executive directors must control remuneration so that talented executives are properly rewarded in a competitive market, but not by allowing them to bet the banks’ and shareholders’ money while themselves sharing only in gains but not losses. If executives share the risks as well as the rewards, moral hazard reduces in proportion.

Times like these are cathartic. Bubbles of overpriced assets collapse along with the egos of many investors. The wannabe stars in, say, hedge funds and private equity will go to the wall but the genuinely talented will survive. Some senior banking heads have rolled – and more will no doubt need to roll – but the danger is that the banks learn nothing, only to repeat it all in a few years’ time.

So when you are having a conversation and some banker tells you that this time there is a new paradigm, you know it is just moral hazard on the horizon. And you should run for the hills. You have been warned.

The writer is the chief executive of Dawnay, Day Brokers. The views expre

Unknown said...

ps - it's a bad loan, dunc, if it's 90 days past due - period.

i guess i was wrong, whoops.