The Big Short via Hussy

Over the holiday, we went with a group of friends to see The Big Short, based on the book by Michael Lewis about the global financial crisis. The film is deeply critical of Wall Street and weak banking regulation, most of which I see as valid. The one thing missing was that the film didn’t clarify why the mortgage bubble emerged in the first place, which I would have liked Margot Robbie to have mentioned while she was explaining mortgage-backed securities in the bubble bath.

The answer is straightforward: as the bubble expanded toward its inevitable collapse, the role of Wall Street was to create a massive supply of new “product” in the form of sketchy mortgage-backed securities, but thedemand for that product was the result of the Federal Reserve’s insistence on holding interest rates down after the tech bubble crashed, starving investors of safe Treasury returns, and driving them to seek higher yields elsewhere.

See, the Fed reacted to the collapse of the tech bubble and the accompanying recession holding short-term rates to just 1%, provoking yield-seeking by income-starved investors. They found that extra yield in seemingly “safe” mortgage securities. But as the demand outstripped the available supply, Wall Street rushed to create more product, and generate associated fees, by lending to anyone with a pulse (hence “teaser” loans offering zero interest payments for the first 2 years, and ads on TV and radio hawking “No income documentation needed! We’ll get you approved fast!”; “No credit? No problem! You have a loan!”; “Own millions of dollars in real estate with no money down!”). The loans were then “financially engineered” to make the resulting mortgage bonds appear safer than the underlying credits were. The housing bubble was essentially a massive, poorly regulated speculative response to Federal Reserve actions.

The current, obscenely overvalued QE-bubble is simply the next reckless response to Federal Reserve actions, which followed the global financial crisis, which resulted when the housing bubble collapsed, which was driven by excessively activist Federal Reserve policy, which followed the collapse of the tech bubble. As my wife Terri put it “It’s like a rolling tsunami.”

As one of the few who anticipated both the 2000-2002 and 2007-2009 collapses (and having shifted in 2003 to a constructive outlook in-between), what I thought the film particularly got right was just how excruciatingthe wait was before the crisis unfolded, even for those who expected it (see, for example, my November 2007 weekly comment Critical Point). Though I don’t take leveraged positions in credit default swaps, or sell bank stocks short, even refusing to take equity market risk in the later stages of that bubble was excruciating enough. One had to suffer fools parroting things like “being early is the same thing as being wrong” until the collapse demonstrated that, actually no, it’s really not. The 2007-2009 collapse wiped out the entire total return of the S&P 500, in excess of risk-free Treasury bills, all the way back to June 1995. I love that the line made it into the movie.

The film also nicely depicted how entangled financial professionals were in facilitating, cheerleading, and denying the bubble. As I noted in Foxes Minding the Henhouse in April 2007:

“One of the disturbing features of the final advance to the 2000 bubble peak was that it involved much more than just uninformed speculation by individual investors. As those of you who’ve known me since then will remember, I was troubled by the fact that professional advisors and Wall Street analysts – people who I was convinced had both the duty and capacity to know better – had also abandoned their grip on the basic fundamentals of investing.”

During the runup to the global financial crisis, I noted that the same complicity was infecting not only the housing market but also the stock market. In February 2007, for example, the Financial Accounting Standards Board effectively reversed its post-Enron ban on the practice of booking future profits as current earnings; a reversal that was immediately seized on by private equity firms, who then went public at the top of the bubble. Like the speculation in housing, the feverish leveraged buy-out activity at the time was essentially tied to yield-seeking encouraged by a Federal Reserve that remained negligent about the speculative impact of its actions, and the fact that much of the speculation piggy-backed on the good faith and credit of Uncle Sam. As I observed at the time:

“Meanwhile, leveraged buyouts continue to be a source of excitement in the market. These are essentially being driven by the willingness of investors to buy risky debt without demanding any premium for the risk. The valuation ratios (most commonly enterprise value / EBITDA) on such deals have never been higher. And if the deals go belly-up, well, it’s other people’s money. And talk about other people’s money. Has anybody noticed that the favorite leveraged buyout targets are increasingly ones tied to governments that can’t afford to let them fail? This is a recipe for government bailouts. Don’t investors realize how much of this LBO activity is implicitly being done on somebody else’s dime?”

The other major failure was one that we see again today – a striking willingness of the financial community to ignore a simple question: what is the historical relationship between the valuation measure you are using, and the actual subsequent return on the investments you are encouraging other people to hold? Two bubbles, two crashes, and at the peak of the third bubble, the answer hasn’t changed at all. From my April 2007 comment:

“Of course, it’s still on the issue of ‘operating earnings’ and the ‘Fed Model’ where the complicity and irresponsibility of Wall Street analysts is most apparent. What’s happened over the past several years is that the whole definition of “earnings” has been changed from what it has been historically, while a simplistic ratio – ‘forward operating earnings yield compared with the 10-year Treasury yield’ has taken the place of all serious valuation effort… The valuation tools upon which Wall Street analysts increasingly base their analysis are, in fact, pure unadulterated garbage. Over time, investors will discover this along with a good deal of pain. Over the short-term, unfortunately, there is no assurance that investors or analysts will quickly recognize that this market is trading on the basis of false premises about earnings and valuation (though my impression is that those who wake up based on reasoned argument and evidence will be better off than those who wake up based on investment losses).”

Since two crashes weren’t enough to teach the lesson, here we are again, at what’s likely to be seen in hindsight as the last gasp of the extended top formation of the third speculative bubble in 15 years. Themedian stock actually peaked in late-2014. That’s when the median buyout multiple for leveraged buyouts (LBOs) hit the highest level in history, as did the percentage of those deals being financed with debt, rather than buyers using their own capital. The valuation firm Murray Devine observed “Cheap credit is having a significant impact on the deal-making environment. As mentioned previously, the median debt percentage for 2014 deals has hit 72%… Leverage use has skyrocketed since 2011, when the median debt percentage for PE deals was around 55%. Median debt percentages in 2013 and the first half of 2014 both outpaced the percentages seen during the buyout boom; for context, the median only reached 63% in 2007.”

Full article via Hussy