Web Note: The following short story is hypothetical in nature, but is based on what was, what is and what will be.
J. Gordon Grecko Flies Home
The plane flight home from Positano was long and fretful. Grecko was unable to concentrate and that was starting to bother him. He could not afford to lose his nerve just now. He needed to focus and keep his wits about him. He had been in similar straights before and had always managed to pull himself out of a jam.
The fund's Achilles heel was leverage. Over the last two years leverage in the fund had increased substantially as spreads narrowed. With financing so accessible it had been easy to leverage up. Leverage enabled Grecko to trade on a larger scale, squeezing nickels and pennies long after others had abandoned the field.
However, debt is a two-edged sword. Debt enhances returns when things are going your way in the markets. It becomes a deadly force when markets turn against you. The key to being a player in this market was to cut your losses short and maintain liquidity, but many of the fund's positions were illiquid. There is nothing wrong with being illiquid'unless you are forced to sell in a hurry. That is when you find out the real price of things.
At all costs, Grecko wanted to avoid being forced to sell the fund's illiquid securities, because the losses could accumulate with terrific speed due to leverage. Over the last few years as yields fell, the fund had pushed the investment boundary further out on the risk curve. In addition to exotic emerging market debt, junk bonds, mortgage backs, and gold and silver shorts, the firm had ventured heavily into many other illiquid areas of the market like convertible bonds. As a hedge, WedgeBook had been shorting the stocks. The GM debt downgrade and the Kerkorian bid for GM had cost the fund tens of millions on both sides of the trade. WedgeBook Partners had similar losses in Ford.
The convertible arbitrage trade wasn't the only segment of the portfolio that was hemorrhaging. Selling credit default swaps was a no-brainer. The fund's real estate positions'although small at no more than 2% of the portfolio'were also illiquid. WedgeBook was succumbing to problems brought on by its own success. It had been getting harder to sniff out profitable trades where they could come out on the winning side. Head traders had yielded to the fatal temptation to put money anywhere they were confident the pastures they plowed would produce crops. Hence the more exotic tundra of Russian and Indonesian debt, condominium tracks, converts, and gold and silver shorts. Now many of those chickens were coming home to roost.
To make matters worse the gold and silver markets weren't acting the way Grecko expected. The strength of the bullion market even as the U.S. dollar rallied was beginning to worry him. The Swiss franc was also showing strength along with bullion. This was a warning to Grecko that something was afoot. He needed a better assessment of the bullion markets'especially since the fund had sold 500 tons of gold short at $420 an ounce. The silver shorts were making money, but it wasn't large enough to offset the fund's gold short position. Grecko's instincts told him that with both the Swiss franc and gold showing strength in a dollar rally, it was time to cover.
Source: stockcharts.com
As he thought things over, he kept reverting back to the lessons learned at Solomon: ride your losses until they turn into gains. Even though credit spreads had widened recently, he believed they would eventually narrow. The key was the bankers. If he had access to enough capital to stay the course, he would be rewarded in the long run. Spreads eventually narrowed. He'd seen it happen over and over again throughout his career.
He made a mental note to call Trevor Jones at Piedmont Bank to make sure the fund's line of credit was still good. He might need it if losses continued to mount. Grecko felt he could count on Piedmont as they'd been behind him ever since he left Solomon. He was sure he could instill confidence in his bankers with his long track record of success and especially with his history of coming through in a clutch.
Grecko had always made money for his partners. He knew them all. He played golf or tennis with most of them and their kids attended the same private schools. They were all part of America's elite financial aristocracy, a close and chummy group. They not only belonged to the same country clubs, they also attended the same social functions, their sons and daughters intermarried and everybody had a stake in each other's businesses through credit lines or hedges. Each one of the major banks had a major stake in Grecko's fund either as a lender or as counterparty in the other side of a derivative position. Besides his track record there was the Grecko name and the fact that his father was the senior senator from New York.
By the end of the flight home Grecko was regaining his confidence. Perhaps it was the wine. His steward Jasper, sensing Gordon's pensiveness, had opened a bottle of '99 Chateau Lafitte Rothschild. The fine wine was having its effect. By the time of descent into JFK, Grecko was feeling like himself again. He now had a plan. It was time to be bold. He'd phone his bankers on Monday to make sure the credit lines were in place to carry him through. He put in a phone call to Tony Shapiro. He wanted his senior trader's input before he sold any of the fund's assets. He left a message on Shapiro's answering machine to join him at his beachfront estate in the Hamptons for brunch on Sunday. Grecko wanted to have a plan to execute when the markets opened on Monday.
To his relief the press reported the White House announcement that the five carrier battle groups in the Persian Gulf was nothing more than a naval exercise. Perhaps it was a warning. The Iranians seemed to get the message. The threats from both sides subsided, which made Grecko hopeful that this latest tempest would end up being nothing more than a temporary squall. The terrorist bombings in London and Sharm el-Sheikh actually ignited the markets in his favor.
The Summer Reprieve
Everyone was calling it a soft patch, a temporary low in the economy that would quickly turn around. In June, the Fed had raised interest rates as expected. Initially, long-term interest rates went up, but after the June Fed meeting, the 10-Year Note quickly went down again. This generated a wave of refinancing. It also helped to bolster the local real estate market in San Diego. The ISM Manufacturing Index turned up.
Monetary aggregates were heading north again. Since flattening in April and May, M-3 had risen by 8 billion by the end of June. M-3 growth was expanding at an annual rate of 5.2%. That was plenty of money to keep the markets and the economy liquid. Commercial and industrial loans had increased by 22% over the last three months and commercial bank credit had expanded by almost 15% in the same period. Foreign central banks continued to buy U.S. debt with many Asian central banks moving into mortgage-backed securities. The ample liquidity and the drop in long-term yields set off another round of refinancing and spurred on the real estate boom.
A new theme, 'disinflation,' began to emerge in the financial market at midsummer. The CPI rate remained unchanged in June and the core rate fell, despite the up-tick in energy. The statistical wizards at the BLS were working miracles in the inflation indexes. This seemed to appease the bond bulls. Furthermore, after rising for several months, the spread on junk bonds over Treasuries began to reverse and head back down. Grecko's hold decision was correct. Eventually the markets were mean-reversing. He was about to be proven right again, a fact that would make him even bolder.
Let's Go Shopping! John and Terry Wheeler
At first it was barely noticeable. In fact it was subtle when it began. But when it hit, the revived boom simultaneously brought good fortune to the Wheelers. Construction activity at Big Sky Ranch began to pick up after a brief downturn. Sales activity was brisk throughout the whole Ranch. Several builders completed their models and were reporting record sales activity.
Interest rates were the magic elixir. The interest rate 'conundrum,' which brought lower long-term rates while the Fed was raising short-term rates, had sent a message to potential homebuyers: Get in on the market while you still can. Rates won't remain low forever. This became the new selling pitch of every real estate agent. It worked. Buyers came back into the market after the initial shock at the end of the first quarter. John's boss asked him to work Sundays again at time and a half. The overtime money would come in handy once more.
Business at the restaurant also began to pick up with the summer's blockbuster movies like Star Wars, Batman Begins, War of the Worlds, Madagascar, and Charlie and the Chocolate Factory bringing in the movie-going crowds. Several of these movies were on their way to grossing over 0 million. Nothing approached Star Wars, but Terry was grateful nonetheless as the restaurant business'and her tips'picked up again. Last weekend had been especially good. One of the big real estate offices rented one of the private dining rooms. Terry was the server and this group of 100 agents was in the mood to spend money. The tips flowed like a waterfall. The banquet netted her over ,000 in tips. It was like Christmas all over again. In the last few weeks'not counting last week's real estate bonanza'Terry's tips were back to averaging over 0. The customers were spending again and that put money in Terry's pocketbook.
The Wheelers also got good news from their neighbors, the Bensons. Jack called to tell them that if rates kept falling, they may be able to refinance again. The few homes in the neighborhood that lingered on the market for more than a month had finally sold. Furthermore, home prices were edging up again'slower than before, but at a monthly increase of 1-2% that translated into substantial buying power. Jack told them their home was now worth almost 0,000! What a relief. It was like a summer shower after a prolonged heat wave.
Terry felt confident enough in her cash-flush situation to respond to Shelly Benson's offer to head to the mall for Nordstrom's Anniversary Sale. It was a must shopping event. Her wardrobe was beginning to look dated. Besides, with their credit card balances wiped clean after the last refinance and with John's overtime and her tips back on the rise, Terry felt she had room to spend. If their home kept appreciating and if Jack was able to work his financial magic, there would be no problem. She still couldn't believe that their home was worth that much. In less than two years their home had appreciated by almost 0,000. Perhaps they should learn to be like the Bensons and take some of that equity out for a spin. As Shelly was fond of saying, 'Why wait until retirement to enjoy life? Live for today!'
The trip to the mall surprised Terry. The parking lot was jammed. Shelly had to drive around for 15 minutes just to find a parking spot. Inside the mall the breezeway was crowed with happy shoppers. These weren't 'Lookie Lous.' Everyone seemed to be carrying packages under their arms without a care in the world, which was how Terry was feeling. Nordstrom's was a zoo. For the weekend the piano player was replaced with a DJ. The sound of Marc Anthony's 'I Need to Know' blazed in the background as Shelly and Terry sashayed over to women's clothing. Terry and Shelly had a ball. Terry found a Raw 7 'Tattoo' Leather Blazer on sale for 9. It went perfectly with the Diane von Furstenberg 'Gedra' top and the Allen B. Embroidered Jeans. The whole outfit cost 5, but she felt she was worth it. Terry loved cashmere. She was ecstatic to find a Beth Bowley Turtleneck cashmere sweater on sale for 0. Terry wanted to make her money stretch, so in her opinion, she bought practical outfits. On the other hand Shelly Benson was on a roll. Within an hour Shelly had spent over ,500 on a Cirrus Single-Breasted Cashmere Topper coat and several Diane von Furstenberg tops and Anne Klein pants.
Real Estate Tycoons in the Making
After several hours of serious shopping they decided to do lunch at Nordy's caf'. They needed some peace and quiet from the pulse of the booming disco music. Besides, they both felt like talking. It was at lunch that Shelly revealed the latest Benson venture. The Bensons were branching out into real estate investing. Jack had been snooping around Big Sky Ranch. He was intrigued by the new townhomes and condos that were going up. Jack felt it was a chance to get in on the ground floor. With home prices going up double digits a year, the condo and townhomes seemed to be a bargain.
Jack cashed out their IRAs, which had done nothing but lose money since 2000. The stock funds had performed horribly. Their ,000 combined IRAs had fallen to a little over ,000. Putting aside ,000 for taxes, Jack and Shelly purchased two condos at St. Tropez. They put down ,500 deposits on both condos, which would not be ready for occupancy until March of next year. They bought in the first phase and were already making big bucks. The price of each condo had increased ,000 and they had just broken ground. Checking with their sales agent, Prestige Builders had already sold out the first three phases. The plan was to rent out the condos for one year (a builder requirement) and then flip out of them within a year. Jack planned on listing both units with Condoflip.com.
Jack and Shelly felt they were betting on a sure thing. Unlike their venture into technology funds in 1999, Jack and Shelly were looking for a solid investment. At least with real estate they would own something tangible. As Jack was fond of saying, 'They aren't making any more land.' San Diego's population growth gave him confidence that their real estate investments were destined to be a 'sure thing.'
Shelly suggested to Terry that they should consider making a similar investment. After all, John's company was doing most of the electrical work on the Ranch. Why not own a piece of it? Terry thought of the money they had made on their present home. Shelly's suggestion seemed to make sense, but where would they get the money for the down payment? How would they be able to afford the mortgage payments each month? Shelly reassured Terry that Jack had figured out all of the angles. She suggested they get together for dinner to discuss Jack's plan.
They finished lunch and headed back to the women's department. Terry bought a few extra outfits and a couple of pairs of shoes. Shelly spent more than ,800, but she could afford it with all of the money she and Jack were making in real estate. Terry had been more circumspect. She felt good about the money she had saved at the sale. By the end of the day she had spent over ,200, which she put on her MasterCard. She felt no remorse. Credit had become a way of life for the Wheelers. It was what enabled them to enjoy the better things in life. It paid for the extra niceties that an empty month-end checkbook could not provide. She figured that their home's appreciation more than made up for the add-on debt. On the way home they agreed they should have dinner together next week to hear about Jack's plan.
The Plan
John Wheeler was back to working Sundays again at time-and-a-half. The building activity around the Ranch had accelerated recently with over 1,000 condos and townhomes going up over the next year. There were over 400 units now under construction and several other builders were in the queue to break ground. By the end of the summer there would be over 500 units under construction. Most of the residential homes were selling faster than they could be put up. Pine Brothers was down to its last two phases. With home prices going up 1-2% every month, the condos and townhomes were expected to sell like hotcakes since they would be more affordable. In John's entire construction career he could never remember a boom like this. When he got into the trade in the last real estate boom in the late 80's, things had gotten a little crazy. But the '80s boom was nothing like this one. This was a real gold rush.
This Sunday John was working at St. Tropez, a 218-unit condo development. There were five models that ranged from 988 sq. ft. to the largest model of 1,457 sq. ft. He was working on the third floor of Residence Five, the largest model when he heard a familiar voice. Walking down the stairs he saw Jack Benson's big grin. 'Hello, neighbor!' Jack bellowed to John, 'Fancy meeting you here.' Jack proceeded to tell John that they were now the proud owners of Residence One and Residence Two. Jack explained to John how he had purchased his units during the first phase. Buying the least expensive units during the first phase, their investment had already appreciated ,000 a unit. They put down ,500 per unit with the final down payment not due until close of escrow next spring. They were already up 400% on their investment! Jack brought up the idea of John and Terry making a similar investment. It was a chance for them to start pyramiding their wealth, getting in on the ground floor of a real estate boom. Nothing made more sense to Jack, especially since John was in the construction business. Why shouldn't he enjoy the fruits of his labor? Jack agreed to bring Shelly over for dinner Thursday evening for a barbeque. Jack said he would bring over his laptop and show John and Terry how they could swing the investment deal of a lifetime.
John went home that Sunday night and brought up his chance meeting with Jack Benson at dinner. Terry really liked the idea of buying another property. Look at how much money they had already made on their home! Terry thought Jack was a financial genius. He had already saved them a fortune on their mortgage. If he had a plan to invest in real estate, they should definitely listen. John, being a little more practical, asked Terry where they would get the money for the down payment. Or for that matter, how would they make the monthly payments? Terry fired back, "If Jack could save us money on our mortgage, he can surely figure out a way we can buy a condo.' She already had an idea that she would spring on John at the right moment. That moment would be Thursday night when the Bensons came over for dinner.
In the back of her mind Terry was thinking of her younger sister, Angela, who had recently been given an eviction notice by her landlord. Angela's apartment was being converted into condominiums. Her sister had three months to find another apartment. She was having difficulty finding another roommate since her roommate had made the decision to move back home with her parents to save money. Terry had thought of renting their downstairs bedroom with its own bath to her sister. She brought it up briefly with Angela the last time they spoke. Angela would be willing to pay 0 a month, which was less than what she was now paying as long as her presence wouldn't be an intrusion. The downstairs bedroom was basically used for storage. Terry believed the arrangement could be the perfect answer to some of their financial needs. They would still have their privacy since the master bedroom was upstairs. Besides, the extra rent money would come in handy. It could, if things worked out well, enable them to buy another property, or have extra cash at the end of the month.
The Bensons arrived Thursday evening with Jack bringing his laptop and Shelly bringing a bottle of wine. It was a night for celebration. It could be the beginning of something big. John put the steaks on the barbeque. As everyone gathered around the grill, the topic naturally turned to Big Sky Ranch and real estate. John had to admit to Jack that he had never seen a boom quite like this before. The builders were selling homes faster than they could be built. This was a real gold rush. John couldn't remember when he had put in so much overtime. That's when Jack told them that according to his research home prices at the Ranch had been going up 1-2% per month, which translated into 15-20% annual appreciation. With most of the builders selling out of their single family home units, the next play would be the condos and townhomes. The average price in the Ranch was now close to a million dollars for a single family residence. That is why the builders were working feverishly to start development on their condo projects. There were a lot more buyers able to afford 0,000-0,000 condos and townhouses than there were buyers of million dollar homes. The profit margins were also higher on multiunit homes than they were single family units.
After dinner and wine Jack flipped open his laptop and laid out his plan to make them all rich. The least expensive units at St. Tropez started out between 3,000 for Residence One and 0,000 for Residence Two. Prestige Builders required a deposit of ,500 to secure the property. This locked in the price with the balance of the down payment due at close of escrow. They could get an Option ARM, which would keep their payments to a minimum. Since they would flip out of the condo at the end of the year, they didn't need to lock in rates and take out a more expensive mortgage. Current rates were set at 1.25% with the loan tied to the one-year Treasury securities index.
Source: MoneyCafe.com
The loan would reset at the end of one year and rise gradually. The rise in payments wouldn't matter since they would flip out of the condo at the end of one year, the minimum holding period set by the builder. Jack illustrated how the program would work.
The investment, which included a 5% down payment and loan closing costs, would amount to only ,000. With condos appreciating more than 20% a year, their first year profit would amount to ,000! That was more than triple their investment!
Jack saved the best part for last. Since the builder required only a deposit to hold the property until closing, John and Terry only had to come up with ,500. If you figure the price appreciation over the building period of 9 months John and Terry could make over ,000 before they even closed escrow. By the time they needed to flip out of the condo, they should have a profit of over 5,000! That is why he and Shelly had bought two condos. On their initial deposit of ,000 they had already quadrupled their money in the last six weeks. Just think about how much money they would make by the time it came to sell!
John was hooked. He worked hard and it was time he and Terry started to get out of their financial rut. It was time to let their investments do the hard work. John's only reservation was how they would come up with the ,900 a month in mortgage payments, property taxes, insurance and monthly association fees. Jack told John they could rent out the condo for about ,400 a month, which would cover most of their monthly costs. They would make up the difference in tax savings. The rent of ,400 a month still left them cash short, which made John uncomfortable. With perfect timing, Terry brought up the idea of renting their downstairs bedroom to Angela. Terry was surprised at John's reaction. He loved the idea. They could use the extra rent in the meantime. When it came time to take possession of the condo, the combination of the two rents would more than cover their costs. Meanwhile, they would enjoy the price appreciation.
The evening ended on a happy note. The would-be real estate tycoons toasted to their future success. That following weekend John and Terry put a deposit down on a Residence One unit. They bought the cheapest unit, which was only 988 sq. ft. Terry really liked Residence Three, which was 1,457 sq. ft., but the price was 5,000. That was too rich for John. In the back of John's mind, he was already thinking of an escape hatch. Now was not the time to bring it up. He would cross that bridge when the time came. For now he was savoring the moment. Each day he went to work he would have the pleasure of working on one of his own properties. He even knew the location of his unit. Wow! Between the value of their home and their new condo, John and Terry were becoming millionaires! He forgot about the part that the bank owned.
New Opportunities: Erica Barry's Dream Is Near
Danny Garcia was a miracle worker. As interest rates fell in June Danny was able to refinance the Specks, who openly talked of selling. Danny put together a loan package, which consolidated the Specks' credit card bills and installment debt. Instead of a 30-year fixed rate loan, he recommended a 5/1 jumbo ARM with an interest rate of 4.85%. The consolidated loan allowed the Specks to pay off their credit card bills and car loans. The ARM rate also saved the Specks over 0 a month in monthly mortgage payments'not counting the additional 0 a month in credit card and car bills. For Erica, that meant one less "For Sale" sign in the neighborhood. It always looked bad when a new development had "For Sale" signs with existing homes while still under construction. The Stuarts' home had also sold within a month. Erica had given up a potential new home sale to make that happen, but it was worth it to get rid of a potential marketing impediment. "For Sale by Owner" never looked good in a new development.
Pine Brothers began to take out quarter-page ads in the Sunday paper. Erica suggested keeping the buyer incentive package in place. However, she suggested raising the price on all models by ,000 to cover the costs. The home upgrade package along with the ,000 Bradley Furniture Mart gift certificate was a marketing success. Erica now had competition. Three other builders had completed their models, which greatly boosted sales. Two of the builders were within the same price points as Pine Brothers. But her 'lifestyle choices' were still a hit with potential buyers. The other builders' homes were priced between 4,000 and 8,900. That was a league above Traviscio. What surprised Erica even more was that the higher-priced homes were selling just as quickly. The Royal Park development sold out their 4th phase just last weekend. They wouldn't have another phase available until the end of July.
All the builders she talked to on the Ranch were experiencing a buyer's rush. The recent rise in interest rates in mid-June, combined with more Fed rate hikes, were convincing buyers to get in on the housing boom while interest rates were still historically cheap. Local real estate agents were preaching the same story to their buyers. Interest rates wouldn't remain this low for long and the price of homes would keep going up because of strong demand. By the end of July Erica had sold out phases 8, 9 & 10. She only had two more phases left to sell and she was moving aggressively to sell them. The only problem was construction delays. Their subs were working seven days a week and still couldn't keep up with the construction schedule
Erica was hoping that the buyer incentive program, combined with heavy advertising and low interest rates, would enable her to sell out of the project by the end of the third quarter. Her boss was offering her a ,000 bonus if the project was sold out by the end of September. Erica wanted that bonus. It would be enough for a down payment on Paradise Village, the company's next project on the Ranch. The company was planning to build 180 luxury condominiums within a gated community at the highest point in the Ranch. Erica had her hopes of owning her own home. She had been working with corporate on some of the designs. She had her mind set on the Bellagio, a three bedroom 1,600 sq. ft. luxury-appointed condo, complete with granite counters, top-line appliances, travertine tile, master bath with Roman tub, and large walk-in closet. Erica was prepared to move mountains to get that condo.
She was now working seven days a week. Nobody could sell homes like Erica. Beauty, brains and personality all worked in her favor. To close out the last two phases she was working with Danny Garcia at Citywide to come up with attractive financing packages. Danny suggested using the Option ARM and Fixed-period ARMs for those who wanted a fixed payment for a certain number of years. The fixed-period ARM would allow buyers to lock in rates for a 3, 5, 7 or 10-year period. At the end of the fixed period, the interest rate adjusted annually, generally tied to the one-year Treasury securities index. This type of loan would appeal to the fixed-rate buyer, but offer a lower rate than the traditional 30-year fixed mortgage.
The Option ARM loan offered homebuyers several possible monthly payment schedules in order to better manage monthly cash flows. It offered a very low introductory start rate to keep initial payments low in order to qualify for more home. The minimum payment option also allowed homeowners to switch to interest-only payments if the minimum payment was not sufficient to cover the monthly interest.
With homes prices rising almost 2% a month on the Ranch, Erica needed low interest rates to sell her homes. In the last three phases almost 75% of her buyers had been going with the ARMs package. Her marginal buyers went with the Option ARM. It offered more payment flexibility and a lower initial rate, which made it her favorite program. According to Danny's people at CitiWide, interest rates would keep rising until the federal funds rate reached 4%. The 4% rate would be the top and it would be enough to slow down the economy. The economists at CitiWide expected that interest rates would be falling by the same time next year, which would be good news for Erica's future sales position at Paradise Village.
At Monday morning's sales meeting, Erica got corporate to go along with an increased ad budget. Starting this weekend, Pine Brothers would be taking out half-page ads announcing the final two phases at Traviscio. The ads would feature special incentives as the development was expected to sell out. The ads, the incentives, and the special financing package gave Erica confidence she would reach her goals of selling out the project by the end of September.
Old Money With New Insight: Meet Morgan J. Weld, III
Morgan J. Weld, III was fourth generation money. The family fortune had been made in land and oil. His great grandfather and namesake migrated to the United States during the Crimean War. The founder of the family dynasty moved from job to job after landing in New York. He labored as a tanner, as a farrier and worked other odd jobs as he moved from New York to Boston. Eventually Morgan's great grandfather moved the family to California in the late 1850s in the hopes of discovering gold. By the time his great grandfather arrived in the Golden State, most of the gold had been discovered. He spent a few years working for the railroads before settling down in the San Joaquin Valley. His great grandfather homesteaded 640 acres alongside the Kern River and took up farming. Weld grew everything from cotton and almonds to alfalfa.
However, it was actually Morgan's grandfather, Sebastian Weld, who established the family fortune. Morgan's grandfather began buying up as much land along the Kern River as he could afford with his excess profits from farming. At the peak of his buying spree, the family owned more than 10,000 acres of prime farm land. The family's fortune truly changed at the turn of the century when 'black gold" was discovered in a shallow hand-dug oil well on the west bank of the Kern River. In 1903 grandfather Weld hired drillers to survey the property and in that same year, the drillers discovered oil. The rest is history. Sebastian Weld started Sunset Oil, which built and multiplied the family fortune. With the invention of the automobile, Sunset Oil prospered and the family grew immensely wealthy.
His grandfather died shortly after World War II. Morgan's father, Morgan J. Weld, II, took over the reins of Sunset Oil until the company was sold for a fortune in the mid '70s to Standard Oil of California. After the sale of Sunset Oil the family returned to its farming roots, retaining more than 600 acres of land in the San Joaquin Valley. In addition to farming, Morgan's parents raised, bred, and showed quarter horses. The show circuit kept his parents active socially, putting them in touch with California's movers and shakers. The family fortune attracted the political class that was always in search of donors. Morgan lost his mother to breast cancer in 1990. His dad still remained active in politics, contributing and raising funds for his favorite political causes until his death in 1998.
The Weld fortune had given Morgan a privileged life. The youngest of three children, he was pampered from birth. He went to the best schools and was well educated. Having money created its own unique problems. What do you do with your life when you have a lot of money? He didn't need to work, thanks to his grandfather who set up trust funds for each one of his three grandchildren. There was always politics, but Morgan developed a distaste for the craft especially after meeting so many senators and congressmen at his parents' home. There was always farming. The family still owned over 600 acres in the San Joaquin Valley, but Morgan was too cerebral for farming. The farming end of the family fortune was taken over by his brother, Henry'Hank for short. Hank had inherited his great grandfather's genes. He was a natural when it came to farming. Hank had turned Sunset Farms into one of the most modern and environmentally-advanced farms in the Kern Valley. From its drip irrigation systems and wind-powered water pumps to solar-powered electricity and organic farming methods, Henry T. Weld was proving that the Welds still retained the entrepreneurial spirit and the ability to make money.
While Morgan's brother took over the management of the family farm, Morgan's sister, Abigail, preferred the social circuit. Abigail hung around with the jet set crowd'the beautiful people from Hollywood'a privilege supported by a million dollar trust fund that was multiplied fivefold at her father's death in 1998. A million-dollar annual income kept Abigail independent, living a life of leisure rather than of labor.
With Hank managing the family farm and Abigail making the rounds of the social circuit, Morgan needed to find his own way. Morgan was looking for something more challenging. He needed something to match his inquisitive nature. He finally settled on finance. He got his undergraduate degree in finance at Berkley. After Berkley he went on to earn his masters degree at Pepperdine's Graziadio School of Business and Management. It was at Pepperdine that Morgan's life changed in profound ways. He studied Austrian economics under George Reisman, which gave Morgan a unique view of the markets and the economy. He saw things differently and became convinced that the present monetary and economic system in the U.S. was doomed to fail in the long run.
After attaining his masters degree in 1995 Morgan went to work as a research analyst for Robertson Stephens & Company in San Francisco. He worked as an analyst in the natural resource sector, providing input on companies for the firm's global natural resource fund. The family background in oil and farming gave Morgan a unique insight into natural resources that came from a long family tradition. He became a big believer in 'peak oil' having read the works of Colin J. Campbell and Jean H. Laherrere. His own beliefs on 'peak oil' were confirmed by what he saw taking place in the U.S. This was evident in Kern County, home to 18 giant oil fields that produced over 100 million barrels of oil each year. Four super giant fields had each produced over 1 billion barrels of oil. One of these fields had been owned by the family's Sunset Oil. However, Kern County oil production had fallen every year despite aggressive methods to enhance oil recovery. The Prudoe Bay oil discovery in 1968 helped to arrest the decline curve in oil in the U.S., but oil production fell every year after reaching a peak in 1971, thereby forcing the U.S. to import more of its energy needs.
In addition to energy, Morgan focused his research efforts on water and precious metals. With the family still involved in farming, Morgan understood the importance of water. Morgan learned a great deal at Robertson Stephens, but his time spent as an analyst was soon coming to an end. The technology mania was taking over the markets in the late '90's and the firm was involved in many high-tech start-ups. With the big banks looking to get into the investment business, the firm's founding partners sold out to Bank of America in 1997. That same year the Bre-X scandal rocked the mining industry. The Bre-X scam killed the junior exploration business and cast a shadow over the mining industry that lingered for more than five years.
In 1998 Bank of America sold the firm to BancBoston. That same year, Morgan's father passed away from pneumonia following heart bypass surgery. Morgan gave the firm his notice. It was time to attend to the family business. His father's estate was valued at more than 0 million. Half of the estate went into the family foundation, which had been set up at the time of sale of Sunset Oil. The other half was split equally among Morgan and his brother and sister. After estate taxes, each one of them received more than million dollars in cash and securities. Morgan's father had acted as co-trustee with Kern Valley Trust. The trust company took care of the more mundane matters of estate administration and was set up to handle family affairs in case of incapacity. His inheritance, along with the trust set up by his grandfather, left Morgan with more than million dollars. That gave Morgan the independence to pursue whatever interested him. At the moment it was managing his portfolio and making it grow. His brother and sister both agreed that Morgan should take their father's place as co-trustee.
Morgan didn't like what he saw in 1999. The market was getting far too speculative for his comfort. He tried to talk the bank into selling much of the trust's technology holdings, but they refused to listen. The bank was a big believer in the 'new era.' After discussing his beliefs with his brother and sister, they both agreed to pull their accounts and turn over their portfolios to Morgan to manage. By late winter 1999 Morgan liquidated most of the technology holdings, which received a stepped-up basis in cost at his father's death. He repositioned the family money into natural resources, an area he knew well and which he felt remained grossly undervalued. He began buying up integrated oil companies, water utilities, defense contractors and Treasury bonds. The Fed had begun to raise interest rates in the summer of 1999. Morgan knew from history that whenever the Fed raised interest rates, something broke in the economy or the financial markets. With the Nasdaq and Internet stocks at nosebleed levels, he felt it would be the financial markets that would break first. His hunch was right. The Dow was the first index to break in January, followed shortly by the S&P 500, and finally the Nasdaq in March. At the same time, California began to experience an energy crunch. His investments in natural gas producers began to soar as natural gas prices hit .
Morgan began to not only move into energy, but also gold and silver equities in 2001. Gold bottomed in the summer of that year and he felt it was time to load up. In addition to energy, water, and precious metals, Morgan branched out into base metals, food and alternative energy such as coal and uranium. He called it correctly. His days at Robertson Stephens convinced him that the long bear market in commodities was finally over. China and India were becoming a big factor on the demand side of the equation, while the supply side had a long way to catch up. Furthermore, after the terrorist attacks on 9/11 and the recession of 2001, the Fed began to furiously inflate the money supply. Money and credit began to flow freely within the American economy. That told Morgan that inflation would accelerate. He already saw it in commodity prices, especially in energy and base metals. The Fed had burst the technology bubble, but its inflationary policies had given way to a new boom in mortgage credit, real estate, and consumption.
While Greenspan and Wall Street talked deflation between 2001 and 2003, Morgan knew better. The deflation talk was a canard, an excuse to inflate the money supply. You can't inflate money and credit without inflation showing up somewhere. At the moment that inflation was manifesting itself in the bond and mortgage markets with the lowest interest rates in half a century. Low interest rates fed into the housing market, creating another bubble in real estate. Morgan loaded up on more gold and silver equities with concentration in junior exploration and development companies. He sold the portfolio's Treasury holdings and began to buy Canadian and Swiss government bonds.
Morgan's investment philosophy was driven by his understanding of Austrian economics, a philosophical system that gave him a better understanding of money and credit. This enabled him to see through the 'new era' myth as nothing more than an inflationary bubble. It also gave him insights into the way inflation worked its way through the economy. Mises' The Theory of Money and Credit was required reading in Reisman's economic course at Pepperdine. From Mises he had learned about the three stages of inflation. The first stage is when the public becomes aware that prices are rising. The second stage is when the public buys in anticipation of rising prices. The last stage of inflation is when the public no longer wants to hold paper money and begins exchanging their paper currency for tangible assets in order to preserve purchasing power.
By the end of the 1970s, the U.S. had reached Stage Two Inflation. A report of the U.S. Gold Commission warned U.S. leaders that unless Congress adopted monetary reform, core inflation rates would rise at an accelerating rate over the next decade leading to a major monetary crisis. Although inflation rates continued throughout the 1980s and a monetary crisis erupted between 1985 and 1987, the dire predictions of the Gold Commission never materialized. The U.S. had dodged the third stage of inflation as a result of four major changes that occurred throughout the '80s, '90s, and the new century.
- Deregulation of interest rates
- Growing use of the dollar as currency outside the United States
- Debt financing of government budget deficits in place of monetization
- Foreign monetization of U.S. debt through foreign central bank purchases of U.S. Treasury debt
All of these changes enabled the U.S. to continue to inflate without suffering the dire consequences. After turning into a net debtor nation in the mid '80s, the U.S.' main export became inflation through the export of dollars as a result of its growing trade and budget deficits. Inflation accelerated under the Greenspan Fed, but it manifested itself through the asset bubbles in the financial markets.
The financial markets became more unstable under "The Maestro's" chairmanship. The result was that the U.S. moved from one crisis to another in succession with the stock market crash of 1987, the S&L crisis of 90-91, the peso crisis in 1994, Asia in 1997, Russia and LTCM in 1998, Y2K in 1999, and the recession and the attacks on 9/11. Following each financial crisis, the standard Fed remedy was to inject liquidity into the financial markets and expand credit in the economy. The end result was another bubble or a crisis in the making.
Morgan was deeply concerned by what he now saw unfolding in the U.S. economy and financial markets. Instead of just one bubble in the stock market, the Fed's easy credit policies had created multiple bubbles in bonds, mortgages, real estate, and consumer debt- based consumption. The U.S. manufacturing sector continued to contract with more factories closing down as the sector continued to shed jobs throughout the recession and accompanying recovery. Government, corporations and households continued to go deeper into debt and large wolf packs of leveraged speculators (hedge funds) prowled the global markets looking for opportunities to leverage and arbitrage. In addition to growing leverage in the markets and the economy, there was growing evidence that oil production was about to peak globally.
Geopolitical tensions were heating up with fundamental Islam openly declaring war on the United States and the West. The U.S. and the world were reminded daily of this fact by an army of suicide bombers who carried out their attacks daily on the streets of Baghdad, the subways of London, and the restaurants and cafes of Egypt's Red Sea resort of Sharm el-Sheikh. It was beginning to look more and more like 'The Perfect Storm.'
It appeared to Morgan that the Fed was on a collision course with the financial markets. It had raised interest rates a quarter of a point at its June meeting. Furthermore, Greenspan's testimony on Capital Hill in July indicated that the Fed was not in the final inning of its rate-raising cycle. Quite the contrary, the Fed Chairman made it clear that interest rates would move higher. In fact, the Fed lifted its inflation forecast. Greenspan implied that two'if not three more rate hikes'were baked in the cake. With the economy and the financial markets heavily leveraged, Morgan couldn't see anything more than trouble for the financial markets in the months ahead. It appeared that once again'as it had done in so many previous rate-raising cycles'the Fed would overshoot and push interest rates higher than the economy and markets could tolerate. A financial storm was brewing and few people were aware of it.
Outside of energy, few sectors were performing well. Many companies warned of a profit slowdown in the next quarter. Another sign that the markets were headed for trouble was the wave of aggressive selling by insiders in the financial and homebuilding sector. Financial insiders were abandoning ship.
Higher interest rates were taking their toll on the banking sector. Citigroup's second quarter soft earnings cast a dark cloud across the entire banking sector. The banking sector was still in a hiring mode even though its loan growth and profits were peaking. Furthermore, there was a growing risk that as interest rates headed higher, many of the housing market's marginal buyers would come under financial stress as ARM payments adjusted upward.
Everywhere Morgan looked he saw trouble.
Source: BCAResearch.com
He positioned the portfolio defensively with large positions in precious metals, energy, and foreign currencies. He was confident that he had prepared the family's assets to withstand the approaching storm. That gave him the confidence he needed so that he could relax. Relaxation meant heading for his vacation home in the San Juan Islands aboard his 46-foot Nordhavn, Calypso. He was looking forward to cruising the islands and doing a little fishing. His brother Hank was planning on joining him at the end of August to get away from the San Joaquin Valley's heat and humidity.
Weekend at the Hamptoms: J. Gordon Grecko & Tony Shapiro Strategize
Tony Shapiro arrived at the Grecko South Hampton estate early Sunday morning. He had gotten very little sleep the night before and was anxious to talk to Gordon on plans to increase the fund's liquidity. Gordon was having coffee on the back patio, which overlooks the pool and the glistening Atlantic. Jasper showed him the way as he passed through the living room admiring Gordon's fine art collection. The tall living room walls were wallpapered with Monets, Degas, and C'zannes. For a moment Tony felt like he was passing through the Louvre. Gordon was sitting at a marble table reading Barron's. He looked up and greeted Tony with a big smile. That smile exuded confidence and reassured Tony that his boss had a plan.
Source: BCAResearch.com
Jasper poured Tony a cup of coffee even though he had already drunk three cups with his early breakfast. Gordon began to review the fund's holdings with Tony while he laid out a plan of action. Grecko reiterated his view that credit spreads would begin to narrow again as they were now in the process of doing. As spreads narrowed Grecko wanted Tony to close out the fund's credit default swaps. There was a window of opportunity to unwind this position.
Grecko was expecting junk spreads to widen again as the economy weakened with ongoing rate hikes. Grecko believed that the Fed would raise interest rates two more times in August and September and then go on hold. He also wanted to unwind junk bond hedges, which were the related stock shorts. The jump in GM was a profit-killer. Thank goodness Ford remained weak.
He also instructed Shapiro to begin quietly unloading their convertible bonds. Grecko was sure, given the absence of bids, that many of the fund's holdings shown in the portfolio as mark-to-market erred on the side of optimism.
He was also instructing the fund's real estate agent, Ed Sabin, to begin liquidating all of their real estate holdings. WedgeBook had been buying up residential homes and condominium tracts in Phoenix, Vegas, Miami, and Tampa for the last three years. It was time to cash in on profits.
With a looming recession, Grecko wanted to exit the fund's real estate holdings while mortgage rates remained cheap and demand for housing remained strong. His gut feeling was to take profits in the fund's silver shorts. Tony agreed and thought it best to cover their short position while they still had a profit. He also recommended covering some of their gold shorts. Like Grecko, he was worried about gold's strength in the midst of a dollar rally. Gordon disagreed. The gold loans were the cheapest source of financing he could find. He was confident that central banks would keep gold capped through their gold derivatives. One-year lease rates were still only 0.21 percent. Where else on the planet could they borrow this cheaply? The low lease rates on gold were kept that way to encourage borrowing and shorting. It was one way that the central banks made sure that the rise in gold was kept to a minimum. They stood ready to supply as much gold to the markets as needed to cap the price of gold. Gold remained in a very narrow trading range, which was the way central bankers liked it.
Shapiro also recommended taking profits in the fund's technology holdings, which had popped nicely since April. Technology stocks represented about 5 percent of the fund's position, so it would help raise additional cash. Gordon was also thinking of taking profits in oil, another 5 percent fund holding. Liquidating the fund's stocks, real estate, credit default swaps, convertible bonds, and silver shorts would raise the fund's cash position to 15%. It would also stop much of the hemorrhaging from his convertible bond position and credit default swaps. Tony was still uncomfortable with their gold shorts, but it was hard to argue with Grecko's central bank thesis.
The Big Gamble
After they finished reviewing the fund's portfolio holdings and the plan to reliquify, Gordon laid out a bold plan for the fall. He told Tony his reading of the markets was that as the Fed raised short-term rates, long-term rates would temporarily go back up. As rates backed up, he planned on taking the fund's leverage up several notches. Grecko was sure that WedgeBook's investment bankers would provide the loans. He had already made a mental note to call Trevor Jones at Piedmont on Monday. As spreads narrowed with rising short-term rates, the plan was to raise the fund's position in mortgage backed bonds where rates were far higher, thus a better spread between the costs of borrowing and the returns earned on invested capital.
Grecko was thinking of buying heavily into the subprime mortgage market where yields were much higher. Investment banks were packaging these subprime mortgage pools into various tranches. Because of their risk, the yields were higher, while the ratings were lower. But in a low-yield world, you had to shop where the yields were highest, which was usually further out on the risk curve. Most of the lower quality CDOs (collateralized debt obligations) were exported to Asia and Europe and financial institutions, central banks, insurance companies, and unsophisticated banks. Grecko had picked up on the fact that Asian central banks, like hedge funds, were looking for incremental income. They were finding it in the lower quality tranches of the mortgage pools.
Grecko liked the subprime mortgage derivative pool. The yields were higher as were the potential risks. It wasn't a large liquid market, which meant the firm's models would determine their price in the portfolio. 'Mark to model' was an aspect Grecko liked about this market. Rather than markets determining prices, the firm's computer models would price the securities. Judging by the mortgage/real estate juggernaut, the CDO market was multiplying like a virus scattering money into the hands of underwriters, investment banks and hedge funds like WedgeBook. Asian central banks were also buying into this market, which reassured Gordon there would be a market to sell to when he wanted to exit this trade.
Grecko also intended to move into Interest Only (IOs) and Principal Only (POs) bonds where risk and reward were much higher. Interest only and principal only bonds are obtained by stripping the interest cash flows from the principal cash flows of a mortgage. The interest from a mortgage becomes the IO bond, while the principal forms the PO bond. These types of mortgage bonds carry extreme risk because of prepayments and sensitivity to interest rate changes. Prepayments are undesirable for IOs because they reduce future interest payments. Conversely, they are favorable to POs, because the bondholder receives the money earlier.
Source: RiskGlossary.com
Because prepayments in a mortgage pool are sensitive to interest rates, the value of a PO can move dramatically with declining interest rates similar to a zero-coupon bond, which in effect they are. Grecko was expecting a drop in interest rates once the Fed's rate-raising cycle was through. The economy would then weaken. And once it did, the Fed would be back to lowering interest rates and injecting vast amounts of liquidity into the financial system. The risk and the volatility of this sector of the mortgage bond market was what had captured Grecko's attention. Volatility was the hedge fund's stock in trade.
This was all part of his bold plan for the fall'a plan he hoped would bolster the fund's results, finishing out the year with double-digit returns. This would mean rich incentive fees. WedgeBook was in essence turning into a credit-oriented hedge fund. That was where Grecko was able to employ large amounts of borrowed capital. The fund's assets were mushrooming in size due to leverage and the influx of new money. The more money the fund took in and the more it borrowed made it necessary for the fund to find large markets to operate in. This meant that most of the fund's bets would be confined to the bond market. Within that market he needed to find a niche to arbitrage. That is why he was steering the fund's investments into the lower end of the credit markets, a field he felt he could dominate. Already hedge funds such as WedgeBook were beginning to dominate trading in these more exotic and risk-prone markets.\
Gordon and Tony concluded their portfolio review meeting. It was now time to play. The ocean breeze was picking up and it looked like it was going to be a nice day for a sail. Gordon invited Tony to join him for a day sail. Gordon felt Tony looked a bit ragged and on edge. That seemed to him the natural state of traders, which was a bit unhealthy. They lived a high-stress life with their bodies taking terrible punishment from the adrenaline of the markets in which they traded. Gordon figured Tony could use a bit of relaxation. A good day's sail would relax both of them. It might just mean fewer Zantacs for Tony. After the weekend meeting Tony would have a busy week. He would have to orchestrate the liquidation of the fund's unwanted positions and prepare for Grecko's bold gamble into the mortgage markets. They headed down to the Sag Harbor Yacht Club where Grecko kept Ajax, his 52-foot Hinkley Sou'wester. All of Grecko's boats were named after Homeric legends.
On Monday Shapiro put Grecko's plan into action. He was having a bit of difficulty unloading some of the convertibles, but felt they could be offloaded given another week or two. The oil and technology stocks were dumped for a nice profit as were the silver shorts. The fund took heavy losses in their convertible shorts in GM. The Kerkorian bid had kept GM stock firm despite the second quarter loss of 6 million. Nobody wanted to go short against Kerkorian, so WedgeBook covered their shorts.
Grecko called his bankers on Monday. He was looking to borrow billion short-term from the fund's prime brokers. Trevor Jones at Piedmont gave Gordon a thumbs up as did the other bankers on his call list. With Tony raising cash, Grecko would be able to begin building the mortgage portfolio. Gordon felt the Fed would pause and rest after the September FOMC meeting. He was already starting to see evidence that the economy was slowing down. He instructed Shapiro to gradually begin building their mortgage positions. He was also instructed to accelerate the purchases after the August rate hikes, which were widely expected.
After August Grecko believed the Fed would begin to soften their language. They had to be aware that if they pushed things too high, they could collapse the housing market, a risk Grecko felt the Fed wasn't willing to gamble with. There was too much debt in the economy to withstand high interest rates. Grecko was also counting on foreign central banks to keep up their Treasury and mortgage back bond purchases. Last year between the Fed and foreign central bank purchases of Treasuries, the two entities ended up buying all new Treasury debt issuance. This forced the pension funds and insurance companies and other financial institutions into buying outstanding debt, which pushed down yields. These actions gave us the bond 'conundrum.' Grecko was counting on that trend to continue. It was a critical factor in his plan. It was a big gamble, but one Grecko hoped would pay off handsomely for his fund.
With his plan put in motion, it was time for a month of relaxation. His financing plans were in order, the fund was raising liquidity, and the markets were going his way again. If his plan worked, the fund would make a fortune, as would he. As he surveyed the markets, there wasn't a cloud in the sky. It was time to enjoy his annual summer holiday in the Hamptons. He was looking forward to time off with his children and new wife. At the moment he was feeling like the world was his.
Interlude
What Grecko did not know at the time was that which was unknowable. To outside observers, all appeared calm. But far off in the distance, a storm was brewing in the financial markets. Greenspan was determined to cool the housing markets and he was prepared to keep raising interest rates far beyond what Grecko could imagine. He was looking after his legacy as Fed chairman. He wanted to be remembered as the maestro and not the bubble maker. Right now he had another major bubble on his hands and he was determined to stop it before it got well beyond the Fed's control.
The Fed was blind to was the fact that collateral supporting mortgage derivatives were not what they used to be. Interest-only loans now dominated the markets, leaving little room for error and very little equity for homeowners and their lenders. Nobody'not even the Fed or a Gordon Grecko'knew what the default and prepayment characteristics were in the subprime markets. Since their popularity took over all forms of mortgage lending, they added a high measure of risk to the markets. As these loans continued to proliferate, bond prices had done nothing but fall. House prices did nothing but rise and the standard answer given by a mortgage lender was always 'Yes!' Underwriting standards had steadily fallen'and along with it, credit quality. Fed rate hikes were going to bankrupt the marginal homebuyer. Because home prices had skyrocketed over the last two years, the marginal borrower was going short-term. This meant their mortgages were subject to quicker resets. These were the buyers who would be most impacted by the Fed's tightening. The bulk of these homebuyers wouldn't have qualified for a mortgage a decade ago. Now they were driving up home prices as lenders responded with a 'yes' answer to all loan requests.
Summer Breeze: John and Terry Wheeler
The summer went by quickly for the Wheelers. John kept busy working seven days a week at the Ranch. He took great pride in the fact that one of the condos he was wiring was his own. The condominium purchase was a big step for him and Terry, but it was no bigger than buying their first home and that had turned out to be the best investment they had ever made. He couldn't believe that in just a few short years their net worth had increased by almost 0,000. Now they had the chance to make even more money by investing in the condo. Furthermore, he was relieved that Terry's sister, Angela, would be moving in at the end of the month. The extra 0 a month would come in handy to supplement living expenses. Terry reminded him that gas, food, clothing, utilities and lawn and fertilizer supplies were going up almost every month. John had even noticed that the price of his favorite burrito had gone up from .35 to .75.
The Wheelers were pleased to find out from Jack Benson that Phases 4 & 5 at St. Tropez would be released in late September. Condo prices would be raised ,000 a unit. In less than two months John and Terry had almost tripled their initial investment of ,500. Terry's tips kept up at The Steak House during August. Jack felt confident enough to take advantage of the "employee discount" at GM to purchase a new truck. He had over 100,000 miles on his old Ford.
John settled on a GMC Sierra Crew Cab Short Box truck. The MSRP was ,845. With the employee discount applied, his cost came to only ,115.78. Jack sold his old Ford for ,000 and used the proceeds as the down payment. He was able to finance the truck over a five-year period with an interest rate of 4.50%. The monthly payments came to 3 a month, which could be easily handled by Angela's rent money. The plan was to pay off the truck with the profits when they sold the condo next year.
Angela wanted to move in early, so John and Terry agreed that the last weekend in August would be a great move-in date as they planned on going to Lake Havasu with the Bensons over the Labor Day weekend. The Bensons and Wheelers had rented a houseboat and the Bensons planned on bringing their wave runners. Angela could water the plants and take care of the house while they were gone.
Angela moved in as planned while the Wheelers took a break from their hectic schedules to enjoy a weeklong vacation with the Bensons. The time went by quickly for the would-be real estate tycoons. John and Terry both learned to water-ski. It was great to have time off and John and Terry looked forward to more times like this. The couples talked about the possible payoffs to come from their real estate investments.
Having Terry's sister move in took a bit of adjustment for the Wheelers. There was no doubt that the extra income of 0 came in handy, especially since John now had a truck payment of 3 a month. The lack of privacy wasn't so bad since they had the second-floor master bedroom. However, it was the little things that bothered John. Terry was more accommodating. The first adjustment was the big screen TV. Angela loved watching reality TV shows and came home from work much earlier than John. Since there was only one TV downstairs, Angela became a little too possessive of the remote. Instead of sports and movies, they had to watch Fear Factor, American Idol, Big Brother, Survivor, Real World and The Apprentice. The baseball season was coming to an end and John was more interested in the upcoming playoffs. To make matters worse, Angela got Terry hooked on the programs. Now he was outnumbered two to one. Even worse for John, instead of watching ammo-dump movies on weekends, the girls were insisting on "chick flicks." How many times could a guy watch Sleepless in Seattle, The Princess Bride, Shall We Dance, or Ever After? He resigned himself to watching TV upstairs on the plasma screen. Unfortunately, the surround sound system was downstairs. There was also Angela's taste in music. John and Terry liked country western, but Angela was a rocker.
These were just small inconveniences. Overall, it wasn't that bad having Angela around. The rent helped to pay the bills and Angela pitched in with house responsibilities like dishes, watering the plants and keeping the downstairs dusted and vacuumed. Terry insisted it was like having hired help. In time the Wheelers got used to their houseguest. To keep the peace, it helped that Terry agreed that John could install a surround sound system for their master's plasma TV. The compromise inspired Terry with the great idea of buying John a La-Z-Boy recliner for Christmas.
Making the Close: Erica Barry & Danny Garcia
Home sales at Big Sky Ranch continued to be strong throughout the balance of the summer and into the fall. The Fed raised interest rates another quarter of a point at its August 9th meeting. There was no change in the language accompanying the meeting, which indicated another rate hike was likely in the cards for the September 20th meeting. The August rate hike and the expected September rate hike motivated prospective homebuyers to take action. By the third week in September Erica Barry nearly met her objective of selling out the final two phases at Traviscio. She was down to her last two home sites. She was pretty sure she had the last cul-de-sac lot sold to David and Sally Stanley. They were flying in this weekend after a series of emails and the Pine Brothers online virtual tour and had indicated their preference for the model. They had sold their home in Washington, D.C. and wanted to retire in San Diego to get away from the snow. This left only one more lot to sell and Erica felt it was a done deal, if Danny Garcia could swing the financing. She was meeting with Enrique and Linda Moreno on Saturday to review their financing options. The Morenos were marginal buyers, but Danny was sure he could come up with a financing package that would allow the couple to qualify for the home.
The Stanleys bought the home halfway through Erica's sales presentation. David Stanley was a retiring attorney and D.C. lobbyist. Money wasn't an issue since the Stanleys were prepared to pay cash for the home. Erica thought this was an anomaly since most of her buyers had gone with adjustable rate mortgages, interest-only loans, or Option ARMs. Even those who had money for down payments as a result of selling their homes, spent all of that money on options instead. Since early summer most of Erica's home sales had been financed with adjustable rate and interest-only loans, which allowed the buyers to buy bigger and more luxurious homes. Without the creative financing, it was doubtful whether home sales would have been this brisk.
Erica was now down to her last home sale and she was relying on Danny Garcia and corporate to make it happen. Instead of the ,000 in options and furniture, Erica was proposing that Pine Brothers rebate this money back to the Morenos as part of their down payment. Enrique Moreno was a fireman and his wife, Linda, was a dispatcher for UPS. Enrique moonlighted as a painter and paper-hanger on his days off from the fire department. Enrique's extra income wasn't predictable and wasn't enough to swing the loan. Between the two, their combined income of ,000 wasn't enough to qualify for a loan large enough to cover the cost of the home. The Morenos had sold their home and were prepared to put down 8,000. Erica's last home, a 2,700 sq. ft. Spanish Colonial model, was priced at 3,000. The Moreno's down payment of 8,000 and the ,000 rebate would mean that the Morenos only needed to finance 5,000. With one-year ARM rates of 4.89% their monthly payment would run ,313 a month. Taxes and monthly association fees would cost them another ,150 a month. Their combined PITI (principal, interest, taxes and insurance) would be about ,500 a month. Unfortunately, their ,000 annual income wasn't enough to qualify.
Danny suggested an Option ARM. Currently, the initial rate was 1.25%, the margin was 2.75%, and the MTA index was at 2.737%. The Option ARM would bring their first year monthly payment down to ,083 a month. The payment was capped at 7.5% per year unless the negative amortization limit was reached. If the low monthly payments didn't fully cover the interest charges agreed upon in the mortgage contract (usually set at 110%-125% of the original principal balance), the payment would be reset. If the negative amortization limit was reached, the minimum payment would increase immediately to an amount that would fully amortize the loan over the remaining term of the loan.
Erica thought the Option ARM was a bit risky for Enrique and Linda. Erica was concerned about what might happen to the Moreno couple when their payments were adjusted upward after a year. She had already seen a few problems develop with the Stuarts and the Specks. That's when Danny reassured her that the Option ARM'or 'Freedom Loan' as he liked to call it'was their best option. It would allow them to qualify for the home of their dreams. In southern California, where buyers were becoming increasingly frustrated by higher prices, the Freedom Loan was the only answer for couples like the Morenos. Enrique and Linda might not be able to handle a traditional mortgage that required principal payments each month, but an interest-only payment was certainly within their reach. Danny told Erica that the Freedom Loan enabled people like the Morenos to improve the quality of their lives by buying a nicer home located in a better neighborhood with better schools. Did Erica really want to deprive Enrique and Linda and their two children of that opportunity? Danny quickly overcame Erica's reservations. It was true that the low payments eventually disappeared at the end of five years. It was also true that the unpaid interest was tacked on to the loan balance each month. At the end of five years a new payment schedule would be put in place with a high probability that payments would rise each month. But, it was also true that few homeowners kept their homes more than five years. The Morenos were only putting down 8,000. With Pine Brothers homes appreciating 10-15% a year, just think of the equity the Morenos would be building!
Danny convinced Erica that the annual price appreciation would more than offset the buildup of unpaid interest. Erica hoped that Danny was right and that the Freedom Loan wouldn't turn out to be a "Prison Loan," tying the homeowner into a perpetual debt cycle. Danny closed Erica with the pitch, "You can never go wrong when you buy real estate. Just look at price appreciation within the Ranch!" Price appreciation wasn't confined to the Pine Brothers development. Other builders within the Ranch had been steadily raising prices and selling homes. With low interest rates the demand was insatiable. That was why the builders were rushing to build the condominiums and town homes, which would be more affordable for younger families.
"Besides," Danny said, "it isn't my job to manage people's budgets. I'm not a debt or marriage counselor. My job is to make people's dreams come true by getting them the credit to turn those dreams into reality.' At the end of the day, he reminded Erica, they weren't supposed to make value judgments on what a buyer was able to afford. He advised Erica to leave the emotional issues at the office. 'I never take the borrower's worries home with me nor should you, Erica. Our job is to sell. If the two of us, working together, can make a person's dream come true, then we've made the world a better place. Think about it, Erica.' The Moreno sale would make Erica's own dream come true. She'd sell out the development, receive her ,000 bonus and be able to buy her dream condo in Paradise Village. Danny painted the picture. Erica bought the canvas.
Erica resolved to help the Morenos realize their dream and in the process obtain hers as well. Corporate agreed to the ,000 rebate to close out the last home sale in the development. When Erica met with Enrique and Linda that Saturday she had a full explanation sheet of how the loan would work. She was happy to tell them about the ,000 rebate instead of the options and furniture. Enrique told her he was prepared to work on his days off from the fire department to put more money down each month, a flexibility that was available with the Option ARM. They signed the papers. The last home was sold. Enrique gave her a big hug as did Linda.
On the way home that night Erica was a little troubled. She hoped she had made the right decision in pushing for the Moreno sale. She kept running through what Danny Garcia had said. Her doubts quickly dissipated. She now began to dream about the options she would choose and the decorator scheme for her new Bellagio condominium. Danny was right. She needed to leave other people's worries at the office. Life was good and her own dreams were now becoming a reality.
Preparing for the Future: Morgan & Hank Weld
Morgan spent the majority of August cruising and fishing the San Juan and Gulf Islands. His brother, Hank, joined him at the end of August. Morgan planned on showing Hank his favorite spots around Orcas and Lopez Island. One night as they grilled a freshly-caught king salmon, Morgan shared his views about peak oil. Morgan was concerned that Sunset Ranch was still too heavily dependent on oil to survive the impact of what was coming to global economies. Oil production had peaked globally. Morgan cited the views of the world's largest oil company, ExxonMobil. Analysts at the giant oil company were predicting that non-OPEC producers would hit their peak production in less than five years. After 2010 the world would be completely dependent on OPEC. From 2010 forward OPEC would have to add 1 MBD (million barrels per day) of capacity per year to keep up with demand.
Morgan explained the significance of the ExxonMobil report to Hank. The first was an admission by the world's largest oil company that Western oil production was peaking. The second important aspect was that as Western oil production peaked, OPEC oil production would surely follow, if experts like Matthew Simmons were correct. This would mean that the majority of the globe's oil resources would reside in the Middle East. There was going to be a major power shift between the West and the predominantly Muslim OPEC countries. These countries were openly hostile toward Washington. The West must now compete with Asia for the earth's declining oil supplies.
Hank assured Morgan that he was using the most modern farming methods to mitigate this problem. He had switched over to organic fertilizers as the price of petroleum-based fertilizers skyrocketed. Most of the farm's energy requirements'other than fuel for trucks and tractors'were self-reliant. The water and irrigation pumps were wind- and solar-powered, and also provided power to his residence and outbuildings. He was also looking into the use of electric trucks and cars. The inflationary impact of rising energy prices had affected the cost of farming, but Hank had recognized this trend early on and had taken steps to make the farm as energy-efficient as possible. He had begun rotating crops and letting fields go fallow. He was producing his own fertilizer from the cattle and chicken manure on the ranch. In addition to water conservation methods, such as drip irrigation and water wheels, he was also producing his own seed.
Morgan went on to express his views that the War on Terror would continue to grow and eventually lead to World War III as the great powers'the U.S. China, and Russia'confronted each other over the issue of oil. If oil prices kept heading higher'as they were now doing'and if his assumptions about peak oil were correct, then the world's major oil consumers were on a collision course as energy shortages became more acute. For these reasons, Morgan had been shifting more of their assets into alternative sources of energy such as coal and uranium and into the Canadian oil sands (in his own opinion, one of the best sources of future oil).
Right now he was worried over the coming real estate bust. Greenspan's rate hikes would eventually burst the real estate bubble. The proliferation of ARMs that would be resetting over the next three years almost guaranteed a bust. Marginal buyers would be forced to default as their mortgages were reset to higher rates. He was building a strong position in precious metals since he expected a major reinflation effort by not only the Fed, but also by all major central banks in response to the coming economic slowdown. In the U.S. the real estate bust would have a major impact on banks and financial companies. Morgan expected the government to set up a corporation to take over failed loans and properties and dispose of them in a similar fashion to what they did during the S&L crisis in 1990-94. He also expected the Fed to reinflate the banking system with low cost loans, letting banks profit from the spread between short and long-term rates as they did during the early '90s. There would be plenty of properties coming on the market and he wanted to be sure the family had the liquid reserves to take advantage of distressed sales and cheap money. That is when Hank brought up the idea of buying large parcels of surrounding land if Morgan's assumption were correct. Unlike many of the farms in the region, the Sunset Ranch was debt-free.
Their dinner ended with fond family memories of their grandfather Sebastian and their parents. Hank was heading home the next day. Morgan planned on heading back to San Francisco by the middle of September. At the moment he wanted to take advantage of the peak season for salmon fishing. He loved cruising the islands. There was an aura of tranquility away from the hustle and bustle of the city.
WedgeBook Partners Makes Its Bold Move: J. Gordon Grecko
Grecko's August vacation went by quickly'too quickly in Grecko's opinion. The time spent relaxing refreshed him and prepared him for what he thought would be a hectic fall. The Fed raised interest rates at its September 20th meeting, as expected. What was not expected was the stiff language accompanying the FOMC meeting. The Fed projected continued strong economic growth and balanced inflation risks with a hint of worry about inflation. Energy prices had remained stubbornly strong. The hurricane season wreaked havoc in the Gulf of Mexico, which accounted for a loss of almost 25% of U.S. oil production. Interest rates continued to move up as he expected. The Fed would try to prevent the yield curve from inverting because of its negative implications for the economy and the financial markets. If the yield curve inverted, there was a real danger that bank profits would plunge, weakening the banking sector which was already overly committed to high-risk mortgage loans. There was also the risk that an inverted yield curve could force the leveraged carry trade to unwind. Gordon still felt strongly that the economy would eventually weaken. When it did, the Fed would quickly reverse course.
Source: Bloomberg.com
Despite the hike in interest rates, the housing bubble continued to inflate. The Fed had a real problem on its hands. Speculation in the housing industry was running rampant. Homebuilders continued to report robust earnings and raised their estimates for the third and fourth quarters. The hike in rates had done very little to discourage home buying. The public was mesmerized by the price appreciation in real estate and was convinced it was the beginning of a long-term trend. What disturbed economists in the government and at the Fed was the deterioration in lending standards and the proliferation of interest-only loans and other high-risk mortgages like the Option ARM and negative amortization loans. It now appeared that the Fed was prepared to keep raising interest rates until there were signs that the economy'especially the housing market'was cooling.
Interest rates could rise more than Grecko anticipated and that could become a problem for WedgeBook. The fund was carrying over 0 billion in debt. All of that debt was short-term. The hedge fund still had a positive carry. Most of their investments were earning returns 200-400 basis points above the cost to carry. The real issue was that many of the fund's positions were unhedged. Finding a perfect hedge for exotic or illiquid investments is difficult. The stock short hedge on WedgeBook's convertible bond position had turned out to be a disaster. It was one reason Grecko had limited hedging in the portfolio. Shapiro recommended covering their gold shorts and going long bullion as a perfect hedge to their bond and stock positions. Grecko ignored his senior trader's advice, convinced that central banks and their partners, the bullion banks, would keep the gold price suppressed. Lease rates were still incredibly cheap. Where else could you have borrowed money at less than 1/4 of 1%? Gordon was obstinate about not covering the fund's gold short position. He regarded the yellow metal as a barbaric relic. His obstinacy was giving Shapiro heartburn.
The hubris of Wall Street stemmed from the fact that closing prices each day were regarded as reliable predictors of future price action. A trend'once in place'was expected to remain that way for a significant period of time. However, that isn't the way markets work. Market history is full of departures from the norm. But that isn't the way traders play the markets. Everything traders do is based on consistency. Trades appear to be one-way only until they change. The 'new era' remained a 'new era' only as long as tech stocks continued to rise. When they collapsed, the 'new era' ended. Another period of falling stock prices and falling interest rates took its place. Now there was a 'new era' in real estate, cheap mortgages, perpetually falling bond prices, and perceived low inflation. Contrary to the idealized opinion that trading models were built around bell-shaped certainties, there are now too many incidents at the extreme end of those curves. In the real world the markets experience discontinuous price changes. These are the chart breakers'the rogue waves that appear out of nowhere without warning'that change the markets drastically. It is at these times that models fail'precisely at moments of unexpected turbulence, at times when their reliability is needed most.
This was such a time. Events were about to transpire that would be beyond predictability. Shock waves were coming to the financial markets. The unleveraged could ride out the storm. But a ship heavily laden with cargo (debt) doesn't easily right itself. The simple fact that it has not capsized in the past doesn't guarantee the next rogue wave won't sink it. The problem for WedgeBook, as with other leveraged speculators, was that most of their investments were illiquid. Rather than being priced by the markets, most of the firm's investments were priced by computer models. These models priced for perfection. However, in the credit markets, no such perfection existed. The growth in derivatives, the majority of which were of the OTC variety, meant that there was very little liquidity in the credit markets. Trades were liquid only as long as they were among a few players. But, when everyone wants out of a trade at the same time, the computer models misfire. Losses mount as leveraged speculators are forced to sell at prices far below what was calculated. When there are no buyers on the other side of a trade, prices run multiple standard deviations beyond the tail end of the curve. That is when the leveraged chickens come home to roost.
Jihad! Abdul al-Jabbaar
Abdul al-Jabbaar was well educated. He grew up in a deeply religious and caring middle class family in London's suburbs. His grandfather had moved the family from Egypt to England during the turbulent '70s. Abdul's dad had been a book merchant with his own specialty shop. The family wasn't rich, but it was comfortable. Abdul attended King's College where he majored in electrical engineering. After graduating, Abdul decided to pursue a post graduate degree in economics at the London School of Economics and Political Science. He had plans to enter banking after graduate school, but his life changed in 1996. That is when he met Muhammed al-Amin at the Brixton Mosque. Muhammed put Abdul in touch with members of a fundamentalist movement who converted Abdul to their cause.
Abdul was drawn to radical Islam because of its belief in righting social injustices. Radical Islam had risen in response to the decline in oil prices during the '80s and '90s. During this period, most Arab countries had experienced political polarization because of sharp distinctions in their social classes. In many Muslim countries the old rulers controlled the government and the economic wealth. The result was a widening gulf between the ruling class'which was unaccountable to the masses of people it ruled'and the disenfranchised middle classes.
In one sense, radical Islam had become a social issue concerning the distribution of income, wealth and power. It had become a belief system about ordering that power and wealth. Its central tenets were devotion to the sacred law and a rejection of Western influence where faith turned into ideology. The present jihad against the West had its genesis more than six and half centuries ago when Gallipoli fell in 1354 when Europe's chief preoccupation was keeping Islam at bay. It is once more a preoccupation in the West in the face of the revitalizing Islamic Revolution. Since the early 1990s radical Islam had continued to grow every month and every year, gathering more adherents to its cause and Abdul al-Jabbaar had become one of its most vocal disciples. Abdul spent two years at the mosque engrossed in spiritual studies. He became more radical in his beliefs as his spiritual awareness increased. His friends and fellow brothers became impressed with Abdul's understanding of Western economics and how the economies and markets functioned.
Muhammed al-Amin was well connected with Al Qaeda and spent a lot of time traveling back and forth between London and Pakistan, spending time with Bin Laden as well as other mullahs within the Al Qaeda hierarchy. On one of his trips he mentioned Abdul's qualities and knowledge of Western economics, which he thought might prove useful to the leadership at Al Qaeda. It was suggested that Abdul get military training in Afghanistan. Abdul agreed to the offer and spent 1998-2000 in a military training camp outside Kandahar.
Abdul returned to London at the end of 2000 more fervent in his beliefs. That was when he began hatching a plan to cripple the U.S. economically. The key was the American consumer. Conspicuous consumption was an abomination to Abdul's belief system. As Islam continued to spread in the U.S., gathering adherents in the downtrodden classes, it was widely believed that steps would eventually be taken to impose many of the propositions of Islamic law. Militant Islam's goal was to capture control of governments and it was openly hostile towards those who stood in its way'no matter what their religious persuasions were. Abdul began to recruit fellow disciples from various mosques within the city. By the end of 2002 Abdul was mentoring 10 disciples who came from Africa and the Middle East. There were 2 Moroccans, 5 Algerians, and 3 Saudis. They became the nucleus of his cell.
Like millions around the world, Abdul watched the attacks on 9/11. In the aftermath, he marveled at how quickly the American economy recovered from the attacks. Within nine short months the recession seemed to have ended and another boom had begun in the real estate and financial markets. That boom continued nonstop throughout the second Gulf War. By the end of 2004 and the beginning of 2005, America was experiencing another asset bubble in the mortgage, bond, and real estate markets. The inflated wealth from real estate was in turn feeding a consumption binge by American consumers.
Abdul's plan was to deal a mortal blow to the American economy by bringing that consumption binge to a halt. The plan was to utilize an army of suicide bombers to attack on the busiest shopping day of the year'the day after Thanksgiving. The Christmas season accounted for almost 40% of all retail sales. If his squad of bombers could attack crowded shopping malls and movie theaters over the holiday weekend, fear would grip the American consumer.
Abdul shared his plan with Muhammed, who then revealed it to the upper command within Al Qaeda. Eventually that command established direct links with Abdul. Muhammed began to courier plans on an encrypted computer disc between Abdul in London and the high command in the mountain ranges of Pakistan. Muhammed considered himself a person of importance because of his connections to the high command. However, the high command didn't trust him because of his loose tongue and his propensity to embellish his own importance.
The high command agreed to Abdul's plan and communication was given to prepare for its execution. In January of 2004 Abdul left London for Mexico City. Money would be provided through an unnamed drug trade contact to provide the funds for training and operations. Abdul's cell group would follow him from London by summer 2004 to begin language training. The plan would be to move them across the porous southern U.S. borders toward their final destination targets in the U.S. by the fall of 2005. A year spent in intense language training and acquiring the social customs of Mexico would help the bombers pass off as immigrant Mexican workers in the U.S. Al Qaeda had contacts with the MS 13 drug gang. The gang had been paid generously to insert the cell group across the border. They agreed on rendezvous points where the underground highway system would deliver the suicide bombers to their final destination points.
Everything worked liked clockwork, thanks to Abdul's rigorous planning. By September 2005 his cell group of 10 committed believers had reached their final destinations. They were assured by Abdul that their families would be well taken care of. Proof had come from small unmarked payments delivered to each would-be martyr's family. The terrorists were now in place in Orange County and Los Angeles, Ft. Lauderdale, Minneapolis-St Paul, Houston, New York City, Chicago, and Phoenix. The strike day for the attack was set for November 25th.
Rogue Wave Forming: The Financial Markets
The source of any trouble can seem insignificant when it begins. But small beginnings can amount to big consequences. That is the way history is written. A source of irritation'dismissed by leaders or market participants'often ends up becoming the turning point, the fulcrum upon which the balance of power changes or market trends reverse. An archduke is shot, a harbor is bombed, the stock market crashes, and a chain of events is ignited. Suddenly a tinderbox is lit. The focus of observation changes, crises erupt and the world becomes a different place. Without warning, there comes that day when an event catches the experts off guard. This is when the unexpected emerges out of nowhere, through an event or events that nobody anticipated and the experts didn't foresee. The experts call them "standard deviations," which appear at the tail of the bell-shaped curve. Although often dismissed as unlikely, far too many incidents at the extremes fill market history. As it turns out, the tails are more swollen than is commonly believed.
The fall of 2005 was one of these times. Oil prices remained stubbornly high throughout most of the summer. The Gulf of Mexico had been continuously buffeted by a series of hurricanes that wreaked havoc throughout the region. Natural gas prices remained high despite the steady buildup in inventories. The same held true for oil. Instead of falling, as so many experts had been predicting, oil prices remained high, confounding the experts. Predictions of oil had given way to oil. Yet the oil never arrived. Instead, the oil markets remained locked in a narrow trading range bouncing back and forth between - a barrel. By October oil prices were back over a barrel and natural gas had risen to . The futures market was pricing in another quarter-point rate hike at the Fed's November 1st meeting.
The combination of rising energy prices and Fed rate hikes were now turning out to be lethal. Consumers were complaining of having to pay more than a gallon for gasoline. The impact of higher energy prices was being felt throughout the entire economy.
SUV and truck sales at Ford and GM had fallen off a cliff. Both automakers were hemorrhaging from losses. GM had lost .1 billion in the first quarter, nearly 0 million in the second, and it was expected that the trend would continue well into 2006. The company was facing big challenges in replacing employee pricing with lower-priced models that offered fewer discounts. Things were no better at Ford. The market was hopeful that profits would improve for the beleaguered automaker. Yet the company announced more layoffs and made plans to close more U.S. plants in order to improve its ability to meet its debt payments.
The manufacturing sector within the U.S. continued to show signs of contraction with more layoffs and firings announced each month. It had become common for companies to accompany their earnings announcements with announcements of layoffs or plant closings. GM had slashed payrolls by 25,000; Winn Dixie: 22,000; Hewlett-Packard: 14,500; Eastman Kodak: 10,000; Bank of America: 6,000; Kimberly'Clark: 6,000; and Cingular: 4,000. Each month Challenger, Christmas and Gray announced layoffs that were now consistently averaging over 100,000 a month.
Corporate profits had clearly peaked at the end of 2004 with the exception of the energy and homebuilding sectors. It was clear from quarterly pre-announcements that the slowdown in corporate profits was accelerating. While the ISM Index and Industrial Production bounced back in June and July'helped by employee-discount auto sales'by August and September they had turned down again. By October the ISM number was sliding back toward 50.
The second quarter GDP numbers had been strong thanks to auto sales and a downward adjustment in the inflation rate. The statisticians at the Bureau of Labor Statistics (BLS) were masking an underlying weakness in the economy that was beginning to emerge by the beginning of summer. By fall it was apparent that economic activity was in a marked slowdown. Fed officials maintained the economy would remain strong, but there were renewed worries over inflation. Unit labor costs had turned up, productivity had slowed, and according to recent business surveys, more companies were raising selling prices. The consumer wallet was being stretched to the limit.
More banks and financial companies were putting out warnings as loan margins shrank. The financial press was full of stories about banks relaxing credit scores and ignoring debt/income loads. Competition had become fierce in the lending world. With everybody trying to steal customers, most firms fought back with aggressive counter bids. The result was that lending standards continued to deteriorate despite concerns and warnings from regulators. The subprime lending market accounted for a 28% share of new mortgage lending in the past six months. Loan-to-Value loans (LTVs) of 95% or more had risen to almost 20% of all homeowners. More than 40% of all first-time homebuyers in 2005 made no down payment. Piggyback loans made up approximately 40% of all home purchases in 2004, making it necessary for would-be homeowners to stretch the monthly budget to new limits. Many borrowers such as the Wheelers and Bensons were unprepared for higher payments due to rising interest rates. A stretched borrower affected the other side of the lending equation, which was the lender. Neither side to the transaction was ready for an abrupt change in interest rates.
In California well over 60% of all mortgage originations in 2004 were ARMs or interest-only mortgages. The influx of marginal buyers purchasing with cheap and easy credit was rapidly making housing unaffordable. This was the exact opposite of the last real estate downturn in 1991 when interest rates had put housing out of reach for most Americans. Now that interest rates were climbing, creative mortgage loans were starting to explode. Even worse there were growing signs of stress starting to show up in the subprime mortgage market with defaults and bankruptcies on the rise. Retail sales were starting to feel the impact of a stretched consumer budget as households dealt with rising energy and food costs. Long-term interest rates were now starting to rise consistently. After reaching a low in June, rates had made a double bottom. Rates since then had begun their inexorable rise.
In Washington the political climate had turned ugly with battles erupting over the Supreme Court nominee and other nominations to district and regional courts. Trade disputes were front-and-center stage with the battle over Unocal and the irritation over slow progress on China's revaluation of the yuan. Political tensions were heating up overseas as well. Suicide bombers were now starting to show up in other European capitals'there seemed to be an endless army of bombers.
To say the markets were on edge was to put it mildly. The S&P 500 had peaked in August before beginning its inevitable descent following the August FOMC meeting. The markets had been looking for signs that the Fed was approaching the ninth inning. Instead, it got more of the same. The Fed would continue to raise rates at a measured pace with all things equally balanced. In the August statement, there was one sentence about inflation that caught the market's attention. By September there were a plethora of pre-announcement warnings coming from many sectors of the economy. Analysts immediately rushed to lower their estimates for the third quarter. Investors were in the mood to sell. A falling stock market was riding in tandem with a falling bond market. By October the markets were starting to turn ugly.
Commodity prices continued to rise, foreshadowing an up-tick in consumer inflation, against the experts' predictions of a cycle peak in prices. Historically, commodity price peaks have seldom occurred before new supply and reflation efforts by the Fed have devolved into stagflation. The had not yet arrived at that point.
Source: Barry B. Bannister, CFA, Legg Mason Wood Walker, Inc. July 14, 2005
With labor and raw material prices continuing to climb, profit margins were being squeezed and it was reflected in the rise in pre-announcement warnings and earnings misses. Something the markets seem to forget is that after every bear market'such as the one in commodities from 1980 to 1998--farmers, miners, and energy companies need to replace fixed assets, find new sources of supply, and replace depleted reserves, all of which are only made possible by pricing power.
At the moment, the Fed was willing to risk recession in order to forestall a return of pricing power and higher inflation rates. The market wasn't prepared for another quarter-of-a-point rise in the fed funds rate at the November 1st FOMC meeting. That rate hike was the straw that broke the camel's back. Headlines had already proclaimed it, 'A quarter point too far.' The October unemployment numbers reported after the November 1st FOMC meeting showed that the economy was now starting to shed jobs. The numbers were small and didn't jibe with the Challenger, Christmas & Gray report which showed over 150,000 announced job layoffs in the month of October alone.
News of an economic slowdown began to accelerate and weigh on the dollar.
The dollar index had headed back down to 80 in October. By November the index was in danger of breaching 80 and was struggling to hold on. Not even the Fed's rate hike seemed to help. Foreigners were exiting the markets and were looking for suitable replacements. They found that replacement in gold. The debt-based recovery was coming to a close. As interest rates and inflation rose in the U.S., foreign capital began to withdraw. Foreigners now began to fear the depth and the gravity of the emerging down cycle. The rapidity of what was unfolding was now starting to alarm the experts. The price of gold began to advance against a broad swath of currencies. By October gold had surpassed 0 an ounce as sophisticated investors turned toward the only currency that couldn't be debased. It was looking more and more like the metal would burst through the 0 barrier, a price the markets hadn't seen since the dollar crisis of 1987. By early November, the XAU had surpassed its previous peak of 112.88 reached back in January of 2004.
Rumors circulated when the markets opened on Monday, November 7th that Greenspan had been taken to Bethesda Hospital for chest pains and an irregular heartbeat. A spokesman for the Fed said the visit was only a routine physical. Routine physicals weren't given over the weekend. The markets were beginning to believe there was some truth to the rumors. Rumors were also starting to surface that several large hedge funds were in deep trouble. Talk on the Street was that Grecko's WedgeBook Partners was having difficulty unwinding its derivative book. The subprime mortgage market was beginning to experience difficulties as each firm's models began to reprice inventory. But what was the correct price? In falling markets, prices changed daily. Traders didn't know what the correct price was because prices were in a state of constant flux.
Meanwhile the financial networks did their best to assuage investor fears. Talk of another 'soft patch' became the common sound bite in the financial press. The financial networks did their best to parade an army of experts from Wall Street who gave the Alfred E. Newman defense, 'What, me worry?' Each expert gave the standard mantra that they remained overwhelmingly bullish and that now was the time to buy stocks to take advantage of the upcoming yearend rally. Experts believed that the Fed was now on hold and that if the economy continued to weaken, investors shouldn't worry. The Fed would come to the economy's defense.
On Main Street and on Wall Street individuals began to look out for themselves. The economy was slowing down rapidly, job layoffs were accelerating again, profits were falling and prices were rising in the form of higher energy and food prices. Food production had an Achilles' heel: the price of energy. It showed up in direct costs like fertilizer and diesel fuel, and in indirect costs such as processing, packaging and transportation. Households were beginning to feel the pinch at the pump and at the grocery store. The average Joe wasn't buying the Fed and the government's moderate inflation story. It was now becoming far too noticeable to disguise.
The experts were puzzled as to what would be the best course of action. The rise in consumer debt and the falling efficiency of that debt had the government experts in a quandary. What would be the best policy response? There was simply too much debt in the economy. One response would be to inflate it away by printing money and by subsidizing interest rates to keep them artificially low. This response had been used successfully during the 1991 recession and S&L and banking crisis of that era. The defaulted loans and real estate had been liquidated and low interest rates had proved to be effective in reliquifying the banking system. However, debt was far higher today and interest rates much lower. Different policy responses would be necessary. This was where "helicopter money" and new innovative responses from the Fed would come to the fore. Having the Fed monetize assets of different classes had already been discussed as possible policy responses in Fed research papers going back to the late 1990s. Some of the ideas had been employed after the Nasdaq crash, the 2001 recession, and the terrorist attacks of 9/11.
In the worst case if foreigners continued to bail out of the currency, driving the dollar down and interest rates higher, the government could always impose currency and price controls. However, the government found itself in a difficult situation. Unlike the 1930s when there was too little GDP versus debt, today's environment was much different. The problem today was too much debt versus low GDP. The U.S.'like during the Johnson and Nixon administration'had been conducting a 'guns & butter' policy. The result was record trade deficits and budget deficits that had only temporarily receded as a result of asset inflation (higher tax revenues) and a partially recovering economy. Something had to give and it looked more like the post 1971 Bretton Woods informal agreement was in the process of unwinding. The great unraveling had now begun.
On Wall Street and on Main Street, the lives of John and Terry Wheeler, Jack and Shelly Benson, Erica Barry, J. Gordon Grecko, and families like the Welds would change dramatically. A great wealth transfer was about to take place. Fortunes would fall and a few fortunes would rise. History was in the process of being written'history that was never the same, but close enough to rhyme.
To be continued.
Coming Next "Helicopter Commander"
