November 7, 2018

Boomerang (Michael Lewis)

This week, we'll look at Boomerang by Michael Lewis. As usual, I've included representative quotes from the book along with finance-related lessons (in blue) that we can apply to markets today.

Lewis visits Europe to consider the aftermath of the 2008 financial crisis on Iceland, Greece, Ireland, and Germany.

Each of these countries took enormous financial risks it didn't understand. In each case, there were people who saw what was going on. Their voices were ignored until after the market began to collapse.

Iceland: The Carry Trade

For the past few years, some large number of Icelanders engaged in the same disastrous speculation. With local interest rates at 15.5 percent and the krona rising, they decided the smart thing to do, when they wanted to buy something they couldn't afford, was to borrow not kronur but yen and Swiss francs. They paid 3 percent interest on the yen and in the bargain made a bundle on the currency trade, as the krona kept rising. (p. 8)

Borrowing at a low interest rate and buying an asset that is expected to provide a higher return is known as the carry trade. It's a profitable strategy for traders who get in early. In this case, as other traders piled in - borrowing yen and buying the krona - the krona rose in value, providing those early traders with both positive carry (the difference between what they paid to borrow yen and what they made lending the krona) and the appreciation of the krona itself.

It must have seemed like a no-brainer: buy these ever more valuable houses and cars with money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the yen and Swiss francs they must repay became many times more expensive. Now many Icelanders - especially young Icelanders - own $500,000 houses with $1.5 million mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is to set it on fire and collect the insurance: Boom! (p. 9)

At some point, the carry trade runs too far, creating mispricings that will eventually be reversed. In this case, the krona became overvalued and the yen undervalued. Traders needed to exit their positions, buying yen and selling the assets they had bought, but some weren't able to because the assets they bought weren't liquid enough. If you borrow yen in the short term and buy long-term bonds to get a higher interest rate (or worse, buy houses and cars), you're counting on finding a willing buyer to eventually take that position off your hands.

That was the biggest American financial lesson the Icelanders took to heart: the importance of buying as many assets as possible with borrowed money, as asset prices only rose. By 2007, Icelanders owned roughly fifty times more foreign assets than they had in 2002. They bought private jets and third homes, in London and Copenhagen. They paid vast sums of money for services no one in Iceland had theretofore ever imagined wanting. "A guy had a birthday party, and he flew in Elton John for a million dollars to sing two songs," the head of the Left-Green Movement, Steingrimur Sigfusson, tells me with fresh incredulity. "And apparently not very well." They bought stakes in businesses they knew nothing about and told the people running them what to do - just like real American investment bankers! (p. 15)

Since the entire world's assets were rising - thanks in part to people like these Icelandic lunatics paying crazy prices for them - they appeared to be making money. Yet another hedge fund manager explained Icelandic banking to me this way: you have a dog, and I have a cat. We agree that each is worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners but Icelandic banks, with a billion dollars in new assets. "They created fake capital by trading assets amongst themselves at inflated values." (pp. 16-17)

The Danske Bank report alerted hedge funds in London to an opportunity: shorting Iceland. They investigated and found this incredible web of cronyism: bankers buying stuff from one another at inflated prices, borrowing tens of billions of dollars and relending it to the members of their little Icelandic tribe, who then used it to buy up a messy pile of foreign assets. "Like any new kid on the block," says Theo Phanos, of Trafalgar Asset Mangers, in London, "they were picked off by various people who sold them the lowest-quality assets - second-tier airlines, sub-scale retailers. They were in all the worst LBOs." (pp. 19-20)

You didn't need to be Icelandic to join the cult of the Icelandic banker. German banks put $21 billion into the Icelandic banks. The Netherlands gave them $305 million, and Sweden kicked in $400 million. UK investors, lured by the eye-popping 14 percent annual returns, forked over $30 billion - $28 billion from companies and individuals and the rest from pension funds, hospitals, universities, and other public institutions. Oxford University alone lost $50 million. (p. 23)

As a bull market ages, the deals that are done tend be less conservative, and the people participating in those deals tend to be less sophisticated.

Greece: A Subprime Government

In 2001, Greece entered the European Monetary Union, swapped the drachma for the euro, and acquired for its debt an implicit European (read German) guarantee. Greeks could now borrow long-term funds at roughly the same rate as Germans - not 18 percent but 5 percent. To remain the in euro zone, they were meant, in theory, to maintain budget deficits below 3 percent of GDP; in practice, all they had to do was cook the books to show that they were hitting the targets. Here, in 2001, entered Goldman Sachs, which engaged in a series of apparently legal but nonetheless repellent deals designed to hide the Greek government's true level of indebtedness. For these trades Goldman Sachs - which, in effect, handed Greece a $1 billion loan - carved out a reported $300 million in fees. The machine that enabled Greece to borrow and spend at will was analogous to the machine created to launder the credit of the American subprime borrower - and the role of the American investment banker in the machine was the same. The investment bankers also taught the Greek government how to securitize future receipts from the national lottery, highway tolls, airport landing fees, and even funds granted to the country by the European Union. Any future stream of income that could be identified was sold for cash up front and spent. As anyone with a brain must have known, the Greeks would be able to disguise their true financial state for only as long as (a) lenders assumed that a loan to Greece was as good as guaranteed by the European Union (read Germany), and (b) no one outside of Greece paid very much attention. Inside Greece there was no market for whistle-blowing, as basically everyone was in on the racket. (pp. 82-83)

Greece bundled up and sold off tomorrow's income in order to have cash today. That would have made sense if they had invested the money in assets that would have provided a higher return and allowed them to pay the money back. Instead, they spent the money - after having paid fat fees to do the borrowing.

Ireland: An Even Bigger Housing Bubble

Kelly saw house prices rising madly, and heard young men in Irish finance to whom he had recently taught economics try to explain why the boom didn't trouble them. And the sight and sound of them troubled him. "Around the middle of 2006 all these former students of ours started to appear on TV!" he says. "They were now all bank economists and they were nice guys and all that. And they all were saying the same thing: 'We're going to have a soft landing.' "

The statement struck him as absurd on the face of it: real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than people's expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become, and flee the market, and the market will crash. It was in the nature of real estate booms to end in crashes - just as it was perhaps in Morgan Kelly's nature to assume that if his former students were cast on Irish TV playing the financial experts, something was amiss. "I just started Googling things," he says.

Googling things, Kelly learned that more than a fifth of the Irish workforce was now employed building houses. The Irish construction industry had swollen to become nearly a quarter of Irish GDP - compared to less than 10 percent or so in a normal economy - and Ireland was building half as many new houses a year as the United Kingdom, which had fifteen times as many people to house. He learned that since 1994 the average price for a Dublin home had risen more than 500 percent. In parts of Dublin rents had fallen to less than 1 percent of the purchase price; that is, you could rent a million-dollar home for less than $833 a month. The investment returns on Irish land were ridiculously low: it made no sense for capital to flow into Ireland to develop more of it. Irish home prices implied an economic growth rate that would leave Ireland, in twenty-five years, three times as rich as the United States. ("A price-earnings ratio above Google's," as Kelly put it.) Where would this growth come from? Since 2000, Irish exports had stalled and the economy had become consumed with building houses and offices and hotels. "Competitiveness didn't matter," says Kelly. "From now on we were going to get rich building houses for each other." (pp. 90-1)

Their real estate boom had the flavor of a family lie: it was sustainable so long as it went unquestioned and it went unquestioned so long as it appeared sustainable. After all, once the value of Irish real estate came untethered from rents, there was no value for it that couldn't be justified.... 

"There is an iron law of house prices... the more house prices rise relative to income and rents, they more they will subsequently fall." (pp. 91-2)

As it happened, Kelly had predicted the future with uncanny accuracy, but to believe what he was saying, you had to accept that Ireland was not some weird exception in human financial history. "It had no impact," Kelly says. "The response was general amusement. It was what will these crazy eggheads come up with next? sort of stuff." (p. 93)

Kelly wrote his second newspaper article, more or less predicting the collapse of the Irish banks. He pointed out that in the last decade the Irish banks and economy had fundamentally changed. In 1997 the Irish banks were funded entirely by Irish deposits. By 2005 they were getting most of their money from abroad. The small German savers who ultimately supplied the Irish banks with deposits to re-lend in Ireland could take their money back with the click of a computer mouse. Since 2000, lending to construction and real estate had risen from 8 percent of Irish bank lending (the European norm) to 28 percent. One hundred billion euros - or basically the sum total of all Irish bank deposits - had been handed over to Irish commercial property developers. By 2007, Irish banks were lending 40 percent more to property developers alone than they had to to the entire Irish population seven years earlier....

This time Kelly sent his piece to a newspaper with a far bigger circulation, the Irish Independent. The Independent's editor wrote back to say he found the article offensive and wouldn't publish it. Kelly next turned to the Sunday Business Post, but the editor just sat on the piece. The journalists were following the bankers' lead and conflating a positive outlook on real estate prices with a love for country and a commitment to Team Ireland. ("They'd all use the same phrase, 'You're either for us or against us,' " says a prominent Irish bank analyst in Dublin.) (pp. 94-5)

As a bubble inflates, there are always people who point out how irrational the market's behavior is, and they're almost always ignored. In practice, it's hard to tell if they're wrong or simply calling the end of the bubble too early. 

Objective quantitative approaches may help here: are valuations currently high relative to history, relative to other asset classes, and relative to other countries? Have trend-following indicators begun to suggest that the bubble may be popping?

A banking system is an act of faith: it survives only for as long as people believe it will. Two weeks earlier the collapse of Lehman Brothers had cast doubt on banks everywhere. Ireland's banks had not been managed to withstand doubt; they had been managed to exploit blind faith. Now the Irish people finally caught a glimpse of the guy meant to be guarding them: the crazy uncle had been sprung from the family cellar. Here he was, on their televisions, insisting that the Irish banks' problems had nothing whatsoever to do with the loans they'd made... when anyone with eyes could see, in the vacant skyscrapers and empty housing estates around them, evidence of bank loans that were not merely bad but insane. (p. 98)

It would have been difficult for Merrill Lynch's investment bankers not to know, on some level, that, in a reckless market, the Irish banks acted with a recklessness all their own. But in the six-page memo to Brian Lenihan - for which the Irish taxpayer forked over to Merrill Lynch 7 million euros - they kept whatever reservations they might have had to themselves. "All of the Irish banks are profitable and well-capitalized," wrote Merrill Lynch advisers. (p. 112)

"At the time they were all saying the same thing," an Irish bank analyst tells me. "We don't have any subprime." What they meant was that they had avoided lending to American subprime borrowers; what they neglected to mention was that, in the general frenzy, all of Ireland had become subprime. Otherwise sound Irish borrowers had been rendered unsound by the size of the loans they had taken out to buy inflated Irish property. That had been the strangest consequence of the Irish bubble: to throw a nation that had finally clawed its way out of centuries of indentured servitude back into indentured servitude. (p. 113)

Experts aren't always right. Do your own research, and turn off the financial news.

Germany: It's Risk-Free. Right?

The curious thing about the eruption of cheap and indiscriminate lending of money between 2002 and 2008 was the different effects it had from country to country. Every developed country was subjected to more or less the same temptation, but no two countries responded in precisely the same way. Much of Europe had borrowed money to buy stuff it couldn't honestly afford. In effect, lots of non-Germans had used Germany's credit rating to indulge their material desires. The Germans were the exception. Given the chance to take something for nothing, the German people simply ignored the offer. "There was no credit boom in Germany.... Real estate prices were completely flat. There was no borrowing for consumption. Because this behavior is totally unacceptable in Germany. This is deeply in German genes. It is perhaps a leftover of the collective memory of the Great Depression and the hyperinflation of the 1920s." The German government was equally prudent because, he went on, "there is a consensus among the different parties about this: if you're not adhering to fiscal responsibility you have no chance in elections, because the people are that way."

In the moment of temptation, Germany became something like a mirror image to Iceland and Ireland and Greece - and the United States. Other countries used foreign money to fuel various forms of insanity. The Germans, through their bankers, used their own money to enable foreigners to behave insanely....

They lent money to American subprime borrowers, to Irish real estate barons, to Icelandic banking tycoons, to do things to German would ever do. The German losses are still being totaled up, but at last count, they stand at $21 billion in the Icelandic banks, $100 billion in Irish banks, $60 billion in various U.S. subprime-backed bonds, and some yet-to-be-determined amount in Greek bonds. (pp. 145-6)

He'd created the bank when the market was paying higher returns to bondholders: Rhineland Funding was paid well for the risk it was taking. By the middle of 2005, with the financial markets refusing to see a cloud in the sky, the price of risk had collapsed: the returns on the bonds backed by American consumer loans had collapsed. Rothig says he went to his superiors and argued that, as they were being paid a lot less to take the risk of these bonds, IKB should look elsewhere for profits. "But they had a profit target and they wanted to meet it. To make the same profit with a lower risk spread they simply had to buy more," he says. The management, he adds, did not want to hear his message. "I showed them the market was turning," he says. "I was taking the candy away... instead of giving it. So I became the enemy." When he left, others left with him, and the investment staff was reduced, but the investment activity boomed. "One-half the number of people with one-third the experience made twice the number of investments," he says. "They were ordered to buy...."

As long as the bonds offered up by the Wall Street firms abided by the rules specified by IKB's experts, they got hoovered into the Rhineland Funding portfolio without further inspection. Yet the bonds were becoming radically more risky, because the loans that underpinned them were becoming crazier and crazier. After he left, Rothig explains, IKB had only five investment officers, each in his late twenties, with a couple of years' experience: these were the people on the other end of the bets being handcrafted by Goldman Sachs for its own proprietary trading book, and by other big Wall Street firms for extremely clever hedge funds that wanted to bet against the market for subprime bonds. The IKB portfolio went from $10 billion in 2005 to $20 billion in 2007, Rothig says, "and it would have gotten bigger if they had had more time to buy. They were still buying when the market crashed. They were on their way to thirty billion dollars."

By the middle of 2007 every Wall Street firm, not just Goldman Sachs, realized that the subprime market was collapsing, and tried frantically to get out of their positions. The last buyers in the entire world, several people on Wall Street have told me, were willfully oblivious Germans. That is, the only thing that stopped IKB from losing even more than $15 billion on U.S. subprime loans was that the market ceased to function. Nothing that happened - no fact, no piece of data - was going to alter their approach to investing money. 

On the surface IKB's German bond traders resembled the reckless traders who made similarly stupid bets for Citigroup and Merrill Lynch and Morgan Stanley. Beneath it, they were playing an entirely different game. The American bond traders may have sunk their firms by turning a blind eye to the risks in the subprime bond market, but they made a fortune for themselves in the bargain, and have for the most part never been called to account. They were paid to put their firms in jeopardy, and so it is hard to know whether they did it intentionally or not. The German bond traders, on the other hand, had been paid roughly one hundred thousand dollars a year, with, at most, another fifty-thousand-dollar bonus. In general, German bankers were paid peanuts to run the risk that sank their banks, which strongly suggests that they really didn't know what they were doing. (pp. 160-2)

The Germans were blind to the possibility that the Americans were playing the game by something other than the official rules. The Germans took the rules at their face value: they looked into the history of triple-A-rated bonds and accepted the official story that triple-A-rated bonds were completely risk-free....

Perhaps because they were some enamored of the official rules of finance, the Germans proved especially vulnerable to a false idea the rules encouraged: that there is such a thing as a riskless asset. After all, a triple-A rating was supposed to mean "riskless asset." There is no such thing as a riskless asset. The reason an asset pays a return is that it carries risk. But the idea of the riskless asset, which peaked about late 2006, overran the investment world, and the Germans fell for it the hardest. I'd heard about this, too, from people on Wall Street who had dealt with German bond buyers. "You have to go back to the German mentality," one of them had told me. "They said, 'I've ticked all the boxes. There is no risk.' It was form over substance...." 

IKB had to be rescued by a state-owned bank on July 28, 2007. Against capital of roughly $4 billion, it had lost more than $15 billion. As it collapsed, the German media wanted to know how many U.S. subprime bonds these German banks had gobbled up. IKB's CEO, Stefan Ortseifen, said publicly that IKB owned almost no subprime bonds at all - which is why he's now charged with misleading investors. "He was telling the truth," says Rothig. "He didn't think he owned any subprime. They weren't able to give any correct numbers of the amounts of subprime they had because they didn't know. The IKB monitoring systems did not make a distinction between subprime and prime mortgages. And that's why it happened." Back in 2005, Rothig says, he proposed to build a system to track more precisely what loans were behind the complex bonds they were buying from Wall Street firms, but IKB's management didn't want to spend the money. "I told them, You have a portfolio of twenty billion dollars, you are making two hundred million dollars a year, and you are denying me six point five million. But they didn't want to do it." (pp. 163-5)

People can be spectacularly wrong. It's a particularly bad sign when they can't make well-thought-out arguments for their views and ignore contradictory evidence.

At some point, you'll be tempted to capitulate and change your views because it feels like you're the only one in the world who's willing to stand against the crowd. As we've seen, it's good to question your beliefs and consider new evidence, but that evidence is probably not going to come from experts who are all trading in the consensus direction. Do your own research whenever possible.

ISBN 978-0-393-08181-7
Lewis, Michael. Boomerang: Travels in the New Third World. Norton, 2011.


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