Liars' Loans

Bill Bonner
The Daily Reckoning
Sep 18, 2006

The Daily Reckoning PRESENTS: What will happen when the Hindenburg of derivatives meets a spark from the housing bubble blow-up? We don't know. But we had a ringing sound in our ears earlier this week. We thought we heard bells. Bill Bonner explains...

On Tuesday came news that the house of Goldman continues to prosper. The company announced record profits. It also announced that its 25,647 employees would make more than half a million dollars a piece this year - a 19% increase over last year.

On that very same day, a headline proclaimed the latest milestone in another, possibly related, trend: the U.S. trade balance hit another record, at $68 billion for the month of July.

How these two bits of synchronicitous news are related would be a good subject for an issue of The Daily Reckoning, we thought. But that is not our theme today; instead, we will turn our focus to Goldman and Greenspan, along with a supporting team of millions of witting, unwitting, and completely witless accomplices have wrought.

The housing bubble in America is losing air; the papers are all over the story. While the evidence is mixed, cocktail conversation has turned from how much money people have made by selling their houses to how much money they might have made if they had sold a little earlier.

But while lips tell the stories, the message still hasn't arrived at the part of the brain that can add two and two. Homeowners are still borrowing and spending; they have not yet cut back in anticipation of harder times ahead. And financiers are paying big money for derivatives and the companies that produce them. While the credits creak and wobble, the creditors haven't seen so much M&A activity in 10 years. Merrill Lynch, for example, just paid $1.3 billion to acquire National City Corporation's mortgage origination business. And, judging by profits (Goldman's are up 16% over last year), bonuses, and prices - the masters of the financial paper shuffling business are in high cotton.

What is Goldman? Among people who package and sell debt in large volumes and at large prices it is the leading brand. Debt comes in many varieties and many forms - especially after Goldman gets finished with it. But the variety called "mortgage backed securities" is worth looking at more closely...if not for illumination, at least for amusement.

A mortgage-backed security is backed by a mortgage. But what backs up the mortgage?

We put the question to an Irishman. "These houses are so expensive...how can people afford to buy them?"

"Ah...you might wonder what the real source of this Irish Renaissance is. It is debt, pure and simple. We had interest rates of 10% or more - until we joined the European Union and got the euro. Then, all of a sudden, you could borrow money for only 3%. You can imagine what that did - the whole place went on a spending spree - mostly concentrated on property, because the Irish love owning their own houses. I think it is something left over from the British rule, when we weren't allowed to own property. Now, we can own it... and now, with these interest rates, we can afford it. At least, as long as the lenders will keep lending on favorable terms. Right now, they practically stop you on the street to try to give you money.

"That's the real secret. The Germans had worked and saved for decades...and developed attitudes about money and institutions...all these things that allowed them to have interest rates around 3% without going crazy on credit.

"Then, when that low borrowing rate was introduced to Ireland, it was as if the pubs were giving away free pints 24 hours a day. The party has been going on ever since.

"So you see, we have everything you have in America: a property bubble even bigger than yours...with interest only housing loans... new cars everywhere...new buildings...everything."

The one thing the Irish do not have - a property bust - we predict they will get soon. Good and hard.

So far, the property bubble has added $30 trillion to the "wealth" of the developed countries alone. Borrowers may have been inclined to stop spending years ago, many would have gone broke, but the lenders wouldn't let them. New ways of letting out money were developed...each one more exotic, and more tempting, than the last. Not only could the mark pay less-than-market rate interest on his loan, and make payments when and if he chose to do so, he was also allowed to borrow with no proof of income; in these "liars' loans" whatever he stated as his income was taken down for fact.

While, down low on the economic food chain, men in cheap suits sold ARMs to people with hardly a financial leg to stand on, up higher, better dressed pitchmen derived from these dubious credits highly leveraged "securities" which they offloaded onto supposedly sophisticated financial institutions.

It is one for the financial history books. Conditions for credit expansion had never been better than they were in the last quarter of the last century of the 2nd millennium and the first few years of the next. In 1971, the world's money lost all contact with reality. The dollar, completely freed from gold, could be stretched almost infinitely. And then, Paul Volcker crushed excessive inflationary expectations in the early '80s, while increasing globalization helped hold down consumer prices. And then began the great bull market in bonds...in stocks...in houses...in credit generally, and credit derivatives in particular. And now the whole world floats in the biggest bubbles ever - expanded, among other things, by $236 trillion worth of [notional value] derivatives.

"We have no idea what will happen in the next 12 months," we told our audience in Dublin. "No one seems to think these bubbles will blow up. And since they're not worried about it, insurance against a blow-up is fairly cheap. Put options, for example, are a bargain. Gold at less than $600 is a bargain too.

"Not that we expect gold to soar. Gold may go up. It may go down. But it won't go away. When the credit expansion turns into a credit deflation a lot of other credits will disappear."

That is when the liars default on their loans. And Goldman's bonus checks get smaller.

Bill Bonner
email: DR@dailyreckoning.com
website: The Daily Reckoning

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