The Daily Reckoning PRESENTS:
As the subprime industry continues its steady decline into the bowels of bankruptcy, we can’t help but wonder what these lenders were thinking. Bill Bonner explores this industry’s business model, and finds out that sometimes, thinking isn’t necessary - just showing up to work is enough. Read on...

Probably the greatest disappointment to a modern man over the age of 50 comes when he looks in the mirror.

We say that not as a man who has just had his vacation in a bathing suit, but as one who has spent the last couple of days reading the financial press. The two are alike in that every time you look, the picture seems to get worse. 

A brief summary of the subprime industry’s business model: There is a market, lenders noticed, of people who cannot afford houses and do not qualify for the credit necessary to buy them. On the surface of it, lending money to these people does not seem like a business you would want to take up. But ‘subprime’ borrowers could be decent fish, the sharks reasoned, as long as they could make the mortgage payments. The quants did the math. The strategists looked ahead. Even if the occasional client couldn’t pay up, they had the rising housing market to lift the value of their collateral. And so, a new ‘go-go’ financial industry got going...and pretty soon, its hustlers and entrepreneurs - like the whiz kids of the dotcoms who preceded them - were driving Ferraris and drinking Chateau Petrus.

The Orange County (California) Register:

“For Kal Elsayed, a former executive at New Century Financial, a large lender based in Irvine, driving a red convertible Ferrari to work at a company that provided home loans to people with low incomes and weak credit might have appeared ostentatious, he now acknowledges. But, he says, that was nothing compared with the private jets that executives at other companies had.

“‘You just lost touch with reality after a while because that’s just how people were living,’ said Mr. Elsayed, 42, who spent nine years at New Century before leaving to start his own mortgage firm in 2005. ‘We made so much money you couldn’t believe it. And you didn’t have to do anything. You just had to show up.’”

It was this last line that caught our attention and triggered our disappointment. It reminded us how each generation of geniuses are later unmasked as frauds and fools. It reminded us too of what weak-minded simpletons we humans are; we are always falling for our own line of guff. 

Modern Homo Sapiens Economicus believes in capitalism. He believes in it as he once believed in the Holy Trinity or the Virgin birth - as dogma. And so, he takes up its tenets and excesses without question or arriere pensees. And, he makes as big a mess of it as his ancestors did of the Crusades.

This is as true of the lumpen as it is of the masters of the universe.

Recall Henry Paulson’s soothing words:

“Credit issues are there, but they are contained,” the U.S. Treasury Secretary said to reporters in Tokyo during a four-day tour of Asia. The U.S. financial sector is healthy and most institutions won’t feel “a big impact.”

But a big impact is just what institutions feel - after they have flapped their wings and taken to the air. Typically, they come down with a thud.

The geniuses packaged, bought and sold subprime debt right until they heard the crashing noises. They believed the credits were good as long as homeowners could make their payments. And they saw no reason why homeowners wouldn’t be able to make their payments as long as they had jobs. That was their line of guff; and they believed it. In a world of full employment, there was no reason for the mortgages to go bad - in theory. But theories arise as needed when there is a sale to be made. 

The theory was that low interest rates were giving a whole new group of borrowers access to credit. The reality was that, what made credit available to un-creditworthy borrowers, was the kind of corruption that wishful thinking hides, but that mirrors...and history...reveal.

“What drove the housing-led cycle was not as much the cost of credit,” notes Merrill Lynch’s David Rosenberg, “but rather the widespread availability of credit - irrespective of your FICO score [a measure of your ability to repay]...only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”

Now, despite 4.6% unemployment and 4.7% yield on 10-year Treasury notes...the subprime lending business is crashing and burning. From Orange County comes news that the aforementioned New Century Financial is trading below $5 a share...a precipitous fall from its high of $66 in December of 2004. At today’s price, in theory, the Golden State lender must be the bargain of a century, with a dividend yield of 167%. But, again, the reality is different: The news report also tells us that the company may be forced into bankruptcy. 

While the subprime lenders are being pulled from the wreckage, the superprime borrowers are still flying high. In theory, hedge funds charge extraordinary fees for extraordinary performance - 2% of capital and 20% of performance. For what? To return to the Greek alphabet, for helping investors get ‘alpha’ - a rate of return above and beyond ‘beta,’ which is what the general market produces.

Warren Buffett, probably the greatest investor who ever lived, says the whole idea is “grotesque.” In last week’s letter to shareholders, he explains that you could invest in his “hedge fund,” otherwise known as Berkshire Hathaway, and pay no management fees at all.

 The compounded average annual gain of Berkshire Hathaway from 1965 to 2006 is 21.4%. What does the average hedge fund get? In 2006, hedge funds produced a 14% return, almost doubling the 7.6% of 2005 and better than the 10% they did in 2004. Over the longer run, hedge funds show an annual return of about 7%.

Mark Gilbert, summing up for Bloomberg News, concludes that hedge funds, “levy outsized fees on the pretense of generating tons of clever alpha, when they are really just seizing the beta available to anyone.”

In other words, in practice, the hedge fund managers, like the dotcom entrepreneurs and the subprime lenders, are not really geniuses at all. They make their money just by showing up...just like everyone else. And they get the same rate of return. Or worse.

Many funds and hedge funds jumped into Japan after that market went up 40% in 2005. The following year, 2006, was disappointing. The Nikkei Dow rose barely 4%. How did the hedge funds do? As Merryn Somerset Webb reported last week, “far from proving their ability to make absolute returns in any market conditions, [hedge funds] did particularly badly; they all fell between 5% and 20% over the year.”

Subprime lenders did not hedge the risk inherent in lending to weak borrowers. Instead, they sought it out and leveraged it up. Hedge funds seem to have done the same thing - reaching out a little too far in order to grab a few extra points of yield. Now, we wonder who owns the $23 billion of New Century Financial debt...and who owns the rest of the debt in the subprime area? We wonder too, who owned the $2.5 trillion worth of equity value that disappeared last week? Surely, there’s some more ‘big impact’ lurking out there...still waiting to hit someone.

We look in the mirror and hope it isn’t us.

Regards,

Bill Bonner
The Daily Reckoning

© 2006 Bill Bonner
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Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is - an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt - now available in paperback - just click on the link below:

The Most Feared Book in Washington! http://www.dailyreckoning.com/empireofdebt.html