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There would come a day that would be unlike any other day. There would be an event unlike any other event. It would precipitate a crisis unlike any other crisis before it. It would emerge out of nowhere at a time no one would expect. It would be an event that no one anticipated—a crisis the experts didn’t foresee. It would be an exogenous event—a rogue wave. When the crisis arrived it caught market participants by surprise. Its arrival was swift and unexpected. Losses hit every sector. The devastation was encyclopedic in its breadth and utterly cataclysmic in its destruction. A financial nuclear chain reaction had been set in motion that rippled across every market and reached into every corner of the globe. It shook the very foundations of the global financial system leaving fear and destruction in its wake. At the epicenter of this storm was the titanic hedge fund, WedgeBook Partners, and its captain J. Gordon Grecko. WedgeBook had $20 billion in equity, of which two-fifths belonged to Grecko and his partners. At the core of the storm was the firm’s $150 billion in debt and its asset book of $1.5 trillion. In Wall Street terms $20 billion in equity was big money, yet it was absolutely insignificant when sized against the firm’s debt of $150 billion and leveraged assets of $1.5 trillion. It took less than six weeks to lose it all. In the final stages of its demise WedgeBook was losing a billion dollars a day. WedgeBook’s leverage of 75:1 was too dangerously high. In good times and in stable markets that leverage had magnified the fund’s legendary returns. In unstable and declining markets that leverage proved to be fatal. In times of extreme duress markets can seize up, liquidity can dry up, and panic can overwhelm the whole financial system. When crises erupt, investors eject out of every market with alarming speed. They abandon exotic and emerging markets and run from risk wherever it lurks. Like fire in a movie theater, everyone runs for the exits simultaneously. When everyone is selling at the same time, sellers can overwhelm markets. When a firm has to sell in a market that has been seized by panic, there are no buyers. When there are more sellers than buyers, market prices plunge to extreme lows—far below what investors ever anticipated. This is what happened to WedgeBook Partners. In the final days of WedgeBook’s demise, leverage and lack of liquidity unleashed hell on the world’s markets. What transpired in the end was beyond anyone’s comprehension. There was a flaw in the system that all the models had missed. The probability of systemic risk, ever present, lying invisible in the background, was considered a once-in-a-lifetime occurrence and a statistical impossibility. These were the "fat tails" that lingered at the end of the bell-shaped curve, waiting patiently to explode. Although statistically possible, they were considered improbable and therefore they were kept out of sight and out of mind. The problem was that they reappeared more often than was acknowledged. The notion that relying on any formulaic model posed inescapable systemic risk eluded the financial elite. This was true of J. Gordon Grecko whose belief in himself and the predictability of his models bordered on conceit. The fact that one day, without warning, trades would leap off the charts was considered by the best minds to be an unlikely statistical freak. The hubris of men like Grecko and others like him who worked on the Street and the financial capitals around the globe was rooted in their belief in the infallibility of their models. They assumed each roll of the dice or every trade would be governed by the same statistical model and the gods of chance would continue to smile upon them. There are reasons why financial markets can run to extremes. Markets are more random than certain. It is this arbitrariness that catches the markets by surprise. Each day’s closing price is not a complete sample from which long-term trends can be projected into infinity, as if each trade or coin toss will come out the same. The only problem with this assumption is that more often than not, the patterns change. When they do, they became disruptive events. They turn into a one-hundred-year or perfect financial storm. This was one of those times. The events as they unfolded had a beginning as they would have an end. The clues warning of the coming storm were there for all to see. They were simply ignored. However, before the storm, there was a beginning and it is to that beginning that we must now return. It is here that we find the clues that foretold this series of most unfortunate of events.
Life was going well for John and Terry Wheeler. John was kept busy working weekdays and weekends at The Ranch. Most of the builders had sold out of their projects. They were now anxious to have them built before mortgage rates rose even further. Escalating interest rates would make it more difficult for buyers to close escrow. Many subcontractors were offering incentives to their workers to work weekends with time-and-a-half and higher pay for piece work. The builders were also anxious to close these projects as buyers had locked in their prices, but raw material prices and labor rates were rising, eating into profit margins. John's overtime and Terry’s high tips gave the Wheelers some financial breathing room. The refinance package that Jack Benson put together last Spring had cut their monthly payments by $650 a month. That savings, combined with the monthly rent they received from Terry’s sister, Angela, had made all of the difference in the world. Besides, from the look of things, John's company had plenty of work. In addition to Big Sky Ranch, a bigger and more exclusive development was going up further west from The Ranch. Unlike previous building cycles, it looked like this one would last a long time. John and Terry felt blessed. They had managed to consolidate all of their debt and at the same time increase their income. Their home continued to appreciate as well as their new investment in a condo. Terry was ecstatic when she read Sunday's home section of the paper. The median price home in San Diego was now $554,000. San Diego homes had appreciated by over 138% in the last five years. The Union Tribune was calling for another 6% appreciation next year due to strong buyer demand. It was hard to believe their 2,800 square foot home was now worth almost $850,000! Their new condo investment was also working out just as Jack Benson had predicted. The first three phases at St. Tropez were completely sold out. Because of the demand for the units, Prestige Builders had been raising prices by $5,000 in each phase. Their $2,500 investment had already appreciated by $15,000. There were only three phases left to sell and the sales office real estate agent expected that the builder would continue to raise prices in each phase. By the time it came to close escrow, their investment should be up by $30,000. They were getting rich and Terry loved every minute of it. The key was to invest. Their struggles were finally paying off. In the beginning they had difficulty making ends meet, especially in furnishing their home. But now their investments were working for them. By owning part of the American dream, their home had turned into a cash flow machine. At first they had struggled to make their mortgage, furniture, and credit card payments. Furnishing a new house wasn’t cheap. Thanks to Jack Benson’s help, debt management, and the appreciation of their home, their financial problems had been solved. The Subtle Things Finances had improved enough to allow Terry to go back to her old habits. She and Shelly Benson now spent Saturdays at the malls with lunch and shopping. Everything was paid for with credit cards, but unlike the past, Terry usually had the money in her checkbook to pay off the credit cards when the bills came due at the end of the month. However, deep down she knew their good fortune was a precarious one. It depended on everything going well—John’s overtime, Terry’s tips, Angela’s monthly rent, and real estate continuing to appreciate. What would happen if her world changed? What if the restaurant business declined, John’s overtime ended, Angela moved out or if real estate prices went down? These were ugly thoughts and Terry quickly dismissed them.
It wouldn’t be so bad, if it was just a few things. However, prices seemed to be rising on just about everything they needed or they liked to do. Their cost of "living"—going to the movies, a dinner out, an occasional Padre or Charger game, or their favorite bottle of wine—was all going up. Since the beginning of the year Terry noticed her weekly grocery bill had risen by $15. She also noticed that either the prices had increased or the packages seemed to be getting smaller. Their favorite restaurant had raised the average dinner price by 10%. Dinner and a movie now cost them $100. When she and John first starting dating five years ago dinner and a movie was less than $50. It now cost her $45 to get her hair cut and styled and if she wanted to splurge on highlights, her salon bill jumped to $125 and that was before the tip! Even her favorite shampoo and conditioner had gone up by $5. Individually, these price increases didn’t add up to much, but when added together, they became significant. Since Summer both John and Terry had noticed that the monthly surplus was shrinking. They had both resolved to turn down the thermostat this winter to reduce their monthly heating bills. The trips to the malls on weekends with Shelly Benson were starting to eat into their monthly budget. With Christmas coming up, there was no money in savings, so that meant the Christmas bills wouldn’t get paid off. The Wheelers didn’t need to cut back, but it was getting close. This holiday season would definitely put them back in the hole again. Then there were those stubborn price increases. They both couldn’t help but notice that prices were rising everywhere. John always remarked that he didn’t understand what the financial people meant by the 'core rate’ of inflation. “Didn’t the government people have to buy gas and food or heat and cool their homes? What kind of 'core rate' were they talking about?" As far as the Wheelers were concerned, the cost of living was rising in the suburbs. Maybe the “core rate” only applied to city people and not suburbia. Even with these doubts, Terry was looking forward to Christmas. Shelly Benson had called and the girls were planning a marathon shopping weekend the day after Thanksgiving. She planned on buying a few new sweaters and a terrycloth bathrobe to keep her warm this winter. She also wanted to look at furniture. She had thought of buying John a La-Z-Boy chair for the upstairs bedroom. Since her sister Angela moved in, nightly TV was dominated by reality shows and chic flicks. John still wanted to watch football and sports, which left only the upstairs bedroom. There had been several arguments over the big screen TV. Angela seemed to think paying monthly rent gave her exclusive rights to the big screen. It irritated John on more than one occasion. A new recliner chair for their upstairs bedroom just might keep the peace between John and her sister. The La-Z-Boy chair would fit in the corner of the bedroom opposite the plasma TV. The girls could watch Fear Factor and John could watch sports in their bedroom. The La-Z-Boy chair would make watching Charger football more comfortable. That chair could be a peacemaker and the perfect Christmas gift. She was also thinking about an entertainment cabinet for the big screen TV, audio equipment, and family albums downstairs. With the kind of money she and John were making on their real estate investments, they could afford it. If the Benson’s could buy nice things, why couldn’t the Wheelers?
By the end of September nearly two-thirds of Big Sky Ranch had been sold. Homes were selling faster than they could be built. This worried several of the builders because selling prices had been locked in while building costs were open-ended. Everything was going up. Construction material costs were up over 11% over the last year ending in September. Gypsum prices had risen 21%, lumber 12%, steel and copper construction products 62%, asphalt 12%, PVC up almost 100%, not to mention diesel fuel, which was up over 50%. There was a rush to get things built while buyers could still qualify. The problem for both buyers and sellers was construction costs were escalating along with interest rates. If rates went up too far, buyers wouldn’t be able to meet higher mortgage payments. Several developers had experienced drop-offs prior to closing simply because of rising interest rates. The gap between variable rate loans and fixed rate mortgages had narrowed considerably. Lenders were now recommending interest-only ARMs to enable buyers to qualify.
Pine Brothers was anxious to close out their Big Sky project. The Paradise Village condominium project was half sold and completely under construction. The entire 180 units were being built at once. Erica Barry had come up with a marketing blitz to move the rest of the project. Meeting with project managers she developed a list of the most popular options: stainless steel kitchen appliances, washer and dryer, granite counters, crown molding in the living room and master bedroom, Hunter-Douglas silhouette blinds for the windows, and tile floors in the entry way, and master bath. The whole package didn’t add more than $10,000 to the cost of a unit. The upgrades were priced wholesale, since the greatest mark-up was already built into each unit. She called the new program “What you see is what you get!” The option was available on three of the least expensive units. It was designed for newlyweds and young families, who were first-time homebuyers. The options package gave these first-time homebuyers everything they needed to move in and occupy their new home without all the hassle. It was a smashing success. By November Erica had sold 120 out of the 180 units. Heavy advertising in the Sunday paper brought buyers out of the woodworks. In addition to the option package Erica had put together a special financing package with the help of Danny Garcia at CityWide Mortgage. The financing package included three attractive financing options: a 5-year, 7-year, and 10-year interest-only ARM. At today’s rising home prices, buyers didn’t have the luxury of paying off principal. Adjustable rate mortgages, negative amortization and interest-only loans were the only way to buy a piece of the American dream in southern California. By keeping payments to a minimum with creative financing, the real estate bubble was kept inflated. Historically low mortgage rates, which had been falling for decades, was the fuel behind the boom.
The financing package not only made the purchase of the units affordable, but the option package made it easy to buy. There were no decisions to be made. There were no upgrades needed as the builder had already provided them. There were no extra appliances to buy when the package already included the kitchen appliances and now even the washer and dryer were included. The windows came with coverings. The buyer only had to choose from a limited variety of color choices for their flooring or counter tiles. It was kept simple. All you had to do was qualify. Once that hurdle was met, you simply bought and moved in. For first-time homebuyers, it was the right program and the right price with few headaches. Erica had sold two-thirds of Paradise Village before the models had been completed. This did not go unnoticed by her superiors. Pine Brothers was partnering with a major developer and insurance company on a new planned community that was going to be even more exclusive than Big Sky Ranch. The new development would contain more than 5,600 acres of land, over 3,000 homes, a public golf course, a five-star resort hotel, a 5-acre regional park, a neighborhood pool for every 140 homes, a strip mall with exclusive shops and restaurants, and 18 miles of hiking, biking, and rough terrain trails for exercising as well as observing wildlife. It would be the company’s most ambitious project to date. The whole community was being designed and targeted toward the new urban elite, the professionals—attorneys, doctors, dentists, professors, stock brokers and financial planners, software engineers and entrepreneurs. This would be a development aimed at six-figure incomes. You would need it in order to qualify. Inherited money was also welcomed. Pine Brothers would have four projects within the new development, Hacienda Del Sol. There would be two different starter home projects, one luxury duplex as well as a gated community of two-story and single story luxury homes. Starter homes would begin at $750,000 before options. The luxury duplex would start at the upper 700’s and low 800’s. The gated community would be priced at $1 million and keep rising. The largest home would begin at $1.25 million. The company was excited about the project and the top brass knew exactly who they needed to market their project—the sales and marketing genius of Erica Barry. Not only was Erica good at marketing and selling, but her beauty and charm fit perfectly with this new upscale community. Bernie Taubman, Erica’s boss, phoned Erica and told her that next Monday’s sales meeting would be rather long. He asked her to get one of the other agents to fill in for her.
She had good news for her boss on Monday morning. She had sold five units over the weekend. That would certainly perk up the sales meeting. The meeting was mainly filled with construction difficulties. The company had an enviable problem—the homes were sold faster than they could be built. However, construction costs kept rising, while sales prices were locked in. To complete the project, the company wanted to limit price increases at a time interest rates were rising. Her boss invited her out to lunch at the local bistro. It was at lunch that Bernie shared the good news. Erica was being promoted. Pine Brothers was making her Sales Director for all four developments at Hacienda Del Sol and she would work exclusively with corporate marketing. Erica would direct advertising budgets, work with the design team on floor plans, elevations, and options as well as direct the sales force. Her office would eventually be located at the design center at the new development. For now she was being pulled off Paradise Village and would work at the company’s downtown headquarters. Erica's office would be next to Bernie's on the 10th floor with a view of San Diego Bay. That new office came with a substantial salary increase. She was now a six-figure professional with big bonus potential.
John Millman was employed as a financial analyst at CityWide’s Newport Beach headquarters. He worked with finance and accounting on developing budgets, analyzing profitability, and tracking cash flow. What he was beginning to see in the monthly financial statements started to worry him. Non-performing assets as a percent of total assets had been steadily increasing since the beginning of the year from 0.13% to 0.20% of total assets. In addition to the increase in non-performing loans, the bank's profit margins were starting to narrow. The bank's weighted average costs of funds had risen from less than 2.50% at the beginning of the year to 3.17% as of its most recent Form 8-K filing. That wasn’t what concerned him. What worried Millman wasn’t the bank's profits. Profits were at record levels. It was the composition of profits that was starting to give him the butterflies. Over 25% of the bank’s profits were accrued interest from negative amortization loans. Even more alarming, this trend was increasing. Because of rising real estate prices, loan officers and builders were clamoring for lower mortgage payments. The bank was only too happy to oblige. Most of the bank's portfolio was comprised of variable rate mortgages, interest-only and negative amortization loans. Fixed-rate mortgages were less than 15% of the bank's total book. To accommodate builders’ demands for lower payments, the bank had concentrated its business model on variable-rate and interest-only loans. Interest-only mortgages now represented almost a third of the bank's business. Of these loans nine out of every ten carried adjustable rates. When they adjust to higher payments, it increased the probability of default. John Millman felt this trend was what was behind the increase in non-performing loans since the beginning of the year. This could turn into an alarming trend, if the Fed continued to raise interest rates. Over 80 percent of the bank's lending business was adjustable. This meant that over the next two years nearly all of the bank's loans would be bumped higher. This was good news for the bank, but bad news for the bank's customers. Since most mortgages required little money down, the bank didn’t have a strong enough equity cushion. Low down payments, interest-only, and negative amortization loans meant buyers weren’t building any equity. This also meant that the bank didn’t have much collateral backing its loan portfolio. If interest rates continued to rise, home prices would eventually begin to decline and that would mean less equity for the homeowner and less collateral for the bank. This could turn into the perfect storm for the bank and the bank's customers. Rising interest rates could create payment shock for homeowners. Many of them would not be able to cope with the increase in monthly payments, which meant non-performing assets would continue to increase. CityWide had become a major player in the hottest real estate markets in the country—California, Nevada, Florida, Arizona and the Internet. In the process of marketing loans to eager buyers CityWide may have stretched itself too thin by lending money to customers, who would have never qualified a few years ago. These were marginal buyers—who like the bank—had stretched their monthly budgets too far. They had very little equity in their homes and with negative amortization or interest-only loans, the only way to build equity was through price appreciation. What happens when home prices stop going up in value or begin to decline? To John Millman this was a trend that warranted close monitoring.
Traders by their very nature are high-strung people. The constant stress and anxiety of buying and selling was taxing on the human body. If the stress of trading didn’t wear you out, the eye strain would. Most traders spent their day eyeballing computer screens with their fingers on the trigger ready to buy or bail depending on the tiniest nuance in the charts. As far as trading was concerned, Tony Shapiro was one of the best traders on the Street. His ability to identify turning points in the markets is what made him number two at WedgeBook. Tony was simply good at what he did. The other traders referred to him as "The Knife.” He could cut through all of the noise and clatter in the markets and pick out trends before they became obvious to everyone else. Tony’s ability to read markets had bailed out WedgeBook on more than one occasion. Grecko’s big picture calls were what made WedgeBook’s returns legendary. However, there were times when Grecko’s macro moves lagged the markets. That is when Tony really earned his pay. During these brief lapses in Grecko's performance, Tony’s trading skills were what delivered the returns. This was one of those times. Grecko’s macro calls weren’t kicking in, which meant the fund was losing money. They got bagged on the paired GM trades early in the year and repeated that mistake with Delphi bonds. Both trades (and similar ones like them) had knocked off half of the fund's performance for the year. Grecko had also been wrong on gold. With the dollar index up 14% this year, the price of gold should have been tanking. Instead it was setting new records. Currently WedgeBook was barely in positive territory. Tony was the relief pitcher and it was now time for him to deliver and win this year's game. Grecko’s macro calls would take further time to play out.
Tony returned to the GM and Ford trade. This time it was one-sided. Kerkorian had thrown the markets through a loop. However, Tony felt the trade had merit. Oil prices kept climbing, which meant higher gasoline prices. Gasoline prices skyrocketed during the summer, which would eventually harm the big automaker's most profitable SUV sales. By mid-July Shapiro began going short on GM and Ford as well as other industrial stocks. By the time the hurricanes hit, gasoline prices were soaring and SUV sales were tumbling. It was a gutsy move, but by early August WedgeBook was short 5 million shares of GM between $35-32 a share. Tony also doubled the fund's short position in Ford, which had been bought in early January around $14. The summer shorts were added between $11 and $10 a share. WedgeBook was also short the big industrial stocks, DuPont, Alcoa, and Caterpillar. As the price of oil jumped after Katrina, Shapiro had also piled on shorts on the large cap integrated oils.
While most of the fund's equity positions were on the short side, the fund was also long the financial stocks. This was Grecko’s call. Grecko held that the Fed would eventually relent after the economy headed into a recession. A drop in interest rates would be a big plus for financial stocks. Tony had nailed it taking on big long positions in Citigroup, JPMorgan, and the major brokerage firms such as Goldman, Morgan Stanley and Merrill. The men who ran these firms were Grecko’s golfing buddies. Most of them had a stake in WedgeBook either as a counterparty to one of the fund's derivative bets or directly as a lender. Grecko loved dropping subtle hints at cocktail parties that the fund was long their stocks. It was good PR and would come in handy when he needed to call in a chit. Right now everyone was focused on year-end bonuses. The fact that WedgeBook was taking big positions in financials stocks only served to curry favor with his lenders. Shapiro had also been trading the technology sector. WedgeBook had been rotating back and forth between long and short positions in technology. Currently the fund had taken a big stake in Microsoft, Wal-Mart, Costco, and Amazon.com. Tony sensed Christmas wouldn’t be as bad as the consensus believed. Little by little Shapiro was pulling the fund out of the hole. The only drag on the fund's returns was their gold short position. By Thanksgiving WedgeBook was back in the black and more importantly—ahead of the markets. Beating the markets is what generated the fund's 20% bonus fees. If everything stayed on track, WedgeBook should have another good year. Returns wouldn’t be stellar, but they'd be good enough to beat the market and generate the bonus fees.
The Set Up The trip to the Caymans was just what the doctored ordered. Shapiro always felt calmed by Grecko’s presence. There was a confidence in his boss that reassured Tony that things were going to be okay. Their relationship was one of master and student. Tony may have been agile as a trader, but it was Grecko’s macro calls that really made the big money. The ability to call a trend, discover an arbitrage opportunity and then to leverage that opportunity was what had made the fund's returns legendary. Grecko wanted Tony to decompress. He needed him in top form to close out the year. The warm and balmy temperatures were refreshing after the snow storms and chilly weather in New York. The long weekend was spent relaxing, fishing and scuba diving.
The fund had plenty of cash thanks to liquidations of its convertible bonds and real estate holdings. The fund's mortgage-backed bonds were in the red, but Grecko expected that to reverse once the Fed went on hold. The fund's derivative holdings in IOs (Interest Only) and POs (Principal Only) derivatives would be increased based on his call. Right now they were in the black, but not by much. Grecko was also looking at emerging market debt and junk bonds where the yields were much higher. When the Fed went on hold, Grecko expected credit spreads to narrow again. Even though Gordon had underestimated the Fed’s resolve, he still felt things would play out as planned. The key was holding on and waiting for spreads to converge again. The Fed had raised rates more than he anticipated, but he felt that was due to unusual circumstances with Katrina and the spillover effects of rising energy prices. The hurricane season was now over and he expected energy prices to eventually subside. Once they did, inflation rates would come back down and the threat of inflation would disappear. In fact, as the economy began to soften as a result of rising rates, he expected talks of deflation to resurface by late Spring when the winter inflationary chill had time to thaw out. Tony’s batteries were recharged. He slept in late and returned to New York late Monday evening. His job was to keep the fund in positive territory until the end of the year. He would cut losses by tightening stops and double-up on winning positions. There were only four weeks left to payday. He was determined to deliver by keeping the fund firmly in the black. The next four weeks would be a whirlwind of trading.
In early October Abdul al-Jabbaar was called back to London. No questions. No details—just the command, "Be there." Perhaps there was a change of targets within the US or the timetable was accelerating. Abdul was curious. All of his preparations had been made for a strike as originally planned. In London Abdul met with Al Qaeda’s regional commander, Ben Yuusuf. Abdul’s plan was postponed. Word had come down from Tehran that the attack was to be put on hold. There was a schism within the conservative establishment in Iran. A rift had broken out between Iran’s top politician, Akbar Hashemi Rafsanjani and Iran’s new, hard-line President, Mahmoud Ahmadinejad. Rafsanjani represented the pragmatic conservatives, while Ahmadinejad was backed by the hard-line clerics. The hardliners wanted to strike a blow against the US. The pragmatists thought it best to wait until Iran was capable of defending itself. Iran was close to developing its own nuclear weapons. The pragmatists didn’t want to give the U.S. or the Israelis an excuse for an attack on its nuclear facilities. An attack now, if traced back to Iran, would be condemned by the international community and would provide justification for a military air strike by either the U.S. or the Israelis. Ahmadinejad’s extreme views were influenced by his spiritual mentor, the Ayatollah Mohammad-Taqi Mesbah-Yazdi. Mesbah-Yazdi favored isolating Iran from the West. It was thought that Mesbah-Yazdi was behind Ahmadinejad’s inflammatory declaration that “Israel should be wiped off the map.” Mesbah-Yazdi was intent on derailing peace negotiations in the Middle East. The hardliners represented by Ahmadinejad were in favor of accelerating terrorist attacks and keeping the region at war. The pragmatists were in favor of making accommodation with the West and lifting Iran from its pariah status through back-channel deals on Iraq and its nuclear program. The pragmatists were pushing for inclusion, while the hardliners were in favor of exclusion from the West. While the pragmatists pushed forward with reforms, the radical hardliners, worried over the future of their radical ideology, pushed for conflict. At the moment the pragmatists were winning. Working through back-channels, word had been sent to call off the attacks in the US. For the present, Abdul’s group would become a sleeper cell instead of a strike force.
Erica loved her new position and quickly got into the thick of things. The Hacienda Del Sol infrastructure was expected to be completed by year-end. Utilities, sewer, and water pipes were in. Streets and building pads were being cut and the first group of models was now under construction with the grand opening expected by early Spring. Hacienda Del Sol was definitely going to be an upper-end development. The average starter home in the new development would begin in the low $700s before options. Mid-sized homes would be priced between the mid $800s and lower $900s. The big homes in the gated community would all be priced well over a million. Land was a big premium. Most of the lots would be less than 5,000 square feet. The starter home lots would be less than 3,000 feet. Like the Big Sky Ranch project, Pine Brother architects were incorporating popular options such as gourmet kitchens, elegant master bedrooms and master baths with roman tubs and large walk-in closets. Buyers could add optional studies, tech-centers and lofts. Other optional upgrades would include stainless steel appliances, upgraded countertops, bath lights and plumbing fixtures. There was also a plethora of high-tech upgrades from security systems, LAN locations and Ethernet hub, to home theater surround systems. Hacienda Del Sol would be one of San Diego’s most elegantly planned master communities. If you were an aspiring urban professional, this was going to be the place to live—but at a price. You had to have money. It took a six-figure income to live there. It also required equity. You had to have money to plunk down up front in order to buy in. At these prices, lenders wanted to see collateral backing their loans. Everyone would be pre-qualified before being put on a waiting list. Pine Brothers would have four projects from starter homes to larger-sized estates within a gated community. The kick off was planned for Thanksgiving weekend with a special option bonus and attractive financing package. Erica would be overseeing sales the opening weekend. The goal was to sell out the first phase in all three of the smaller developments. If sales went well, the second phase would be released for sale in early December. Pricing and financing had been put together in an attractive package. Pine Brothers was eagerly awaiting the public’s reaction to what they considered to be the best planned master community in the entire city. The first three projects were ready to sell. Erica had been working with Danny Garcia at CityWide who suggested interest-only ARMs. Because of the price range, buyers were required to put down 20% in order to qualify for the lower interest rates.
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PACKAGE
With 20% down, interest rates were still attractive with rates below 6%. The interest-only ARM kept payments low. With 20% equity, lenders had enough cushion in case of a default. This reflected the growing sense of caution within the lending community. At this late stage in the cycle, lenders were now requiring larger down payments on homes priced at these levels. The banks were looking for qualified buyers—not the marginal homebuyer. Monthly payments of $4,200-$4,400 were a comfortable payment for couples or individuals with a six-figure income. The Grand Opening weekend went beyond Pine Brothers' expectations. Erica and her sales agents sold out the first phase of the larger homes and six out of ten of the smaller homes. Even more promising was the response to the company’s gated community. The gated community would feature 60 two-story and single story homes from 3,960 to 4,450 square feet. The gated homes were going to be priced from $1,050,000 for the smallest model to $1,250,000 for the largest model. With options and lot premiums, these homes could sell for $1,500,000. There would only be 60 homes. Erica already had over 200 names on her waiting list. More than half on the list were registered and pre-qualified. Pine Brothers believed the response to their Grand Opening was a harbinger of good things to come. Their marketing research and focus groups pointed to a strong demand for a luxury planned community. Hacienda Del Sol offered urban professionals everything they would want from extensive biking and exercise trails, gourmet shops and restaurants and a community golf course, to neighborhood pools, an outdoor amphitheater, clubhouses and public parks. There were also plenty of amenities for the soccer moms and their young families with public baseball and soccer fields, lighted sidewalks and parks, tot lots, and even an animal park for the family canine. As a result of selling out of phase one, Erica was pushing the company to release phase two by early December. She also wanted to accelerate plans for the gated community. Her waiting list for million-dollar homes was growing by the day. Erica also thought about her own upgrading. Her condo wouldn’t be ready to close until late Spring. She had already made $40,000 in price appreciation. With selling bonuses, a pay raise, and this price appreciation, Erica was thinking of flipping her condo and buying into the smaller starter homes at Casita. The company had a 10% discount program for execs. If she added the company discount to her profits on the condo, she would have enough to qualify and trade her condo for a starter home. Her new salary gave her the means to trade up. A quick phone call to Danny Garcia confirmed she would qualify. Erica decided to put her condo on the market. There was a waiting list at Paradise Village with anxious buyers willing to accelerate their move-in dates. It took only two days to sell. With her condo sold to a qualified buyer, Erica put in a reservation on a plan two, mid-sized model at Casita. Because of her executive discount, she would be in the home for not much more than $620,000. With option upgrades, maybe $650,000. Not bad for hard work. She was trading a 1,600 square foot condo for 1,930 square foot single-family home. On top of that, her executive discount meant options at cost as well. Her bonus of $25,000 would buy her a well-appointed home.
It was good to finally have a day off. John and Terry would have time alone. Angela was invited to dinner at her boyfriend's parents. They planned on a late Thanksgiving dinner since John wanted to watch the football games. John also planned on taking Terry out to Big Sky Ranch to walk through the condos while the turkey was roasting. The development was really taking shape. The community pool and cabana was just about complete. Landscaping around the stone entrance and the front entries to each complex had been put in to give the community a lived-in look. They awoke early and headed out to Big Sky, since John wanted to make it back in time for the games.
John joked, “Hey, Terry, my plasma screen would fit perfectly here.” Terry was lost in thought as she imagined what her furniture would look like in the condo. Was there enough space? What would it be like to live here alone with just John and no Angela? Was this big enough of a home to start a family? Where were these thoughts leading her? What was she thinking? John noticed Terry’s silence. She seemed to be day-dreaming. He too was lost in his own thoughts. What would it be like to live here with just the two of them? How much cheaper would it be? Would he have to put in as much overtime? Payments on a place like this had to be a lot lower than what they were now paying. He thought about how much money they had made on their home. What if they sold? How much money would they walk away with—$200,000, $250,000, maybe $300,000? John tabled the thought of selling, but perked up when Terry asked to see the other units. She wondered when would these units be available. “Why do you ask?” John responded. “I don’t know. Just thinking.” Terry replied. Both of them looked at each other. “Are you thinking what I am thinking?”, asked John. "Maybe. It sure would be nice to be out of debt or at least not have big mortgage payments. How could we ever start a family with the amount of money we owe?" Their minds were spinning as they headed back home. They arrived just in time for John to catch his game. He was so tired that he fell asleep halfway through the game. Terry fixed dinner with all of the trappings. It was so nice to have peace and quiet in the home and a little time with John. She thought about the morning's visit to Big Sky Ranch. The end unit was definitely affordable and it had enough room to accommodate all of their furniture. What would it be like to be out of debt or at least have a debt load that was manageable? She hated having to scrimp. It had only been recently with the refinancing and Angela moving in that had they had room to breathe. She was well aware that their debt load increased every month because of negative amortization. She saw the monthly bills and the loan balance each month and it frightened her. Terry enjoyed weekends at the mall with Shelly Benson, but how long could that continue? It sure would be nice to get off the debt treadmill. At dinner John looked pensively at Terry. Then he posed the question, “Are you happy living here?” “If you mean do I want to go back to apartment living, the answer is no. But would I consider a change or an alternative like what I saw this morning, the answer is yes.” Those were the words John wanted to hear. He had been thinking of this alternative from the moment he first started wiring the project. He clearly understood working seven days a week and having Angela as a renter wouldn’t last forever. They were fortunate in that their home had appreciated enormously—enough to bail them out of their debts. Even so, their payments were still high and it took overtime and renting a room to Angela to make ends meet. Why not cash out now while they had the chance? Sure, it would be downsizing, but the condo was still a lot more room than their old apartment. The end unit had a living room, a media niche and three bedrooms plus a loft. That was more than enough to suit them both and maybe start a family. They were both in agreement. They would do some homework and keep mum about it. John wanted to keep this private for the moment especially from the Bensons. John thought he would check with the real estate agent at Prestige Builders. Maybe they could transfer their deposit to a larger, end unit. Terry would call their real estate agent, Tom Bennett, to get an appraisal of their home and find out how long he thought it would take to sell it. The Christmas season was around the corner, but from what John said, sales activity around the Ranch was still brisk. Maybe they would have some luck. Shelly Benson called for Terry at 6AM the day after Thanksgiving. She and the girls wanted to get an early start before the crowds flocked to the malls. All were excited about the holiday season. It was as if they needed a distraction or a reprieve. They started at Nordy’s, where Shelly found several Faconnable brushed flannel plaid shirts for Jack at $115 a pop. A matching Nordstrom’s cashmere sweater cost $185. Shelly was on a roll. She fell in love with a Tommy Bahama Havana watch, which set her back $350. By the time they got to lunch, Shelly had already blown a grand. The only thing Terry kept thinking was how does she do it? Jack and Shelly couldn’t be making more then she and John. For once Terry was more circumspect. The La-Z-Boy chair was going to cost $500, maybe less, if she could find it on e-Bay. Terry limited her purchases to a few Tommy Bahama sport shirts and men’s cologne. She found a Karen Neuberger shawl-collar robe for $50 and two pair of DKNY flannel pajamas for $60 each. Terry was proud of herself. By the end of the day she had spent less than $500 and had gotten most of the things that she wanted. Terry had already nixed the entertainment center plan. She didn’t have any idea what John would spend. But so far, Terry's purchases were manageable and could be paid off within two months. There would be no more long Christmas hangovers this year. Shelly was another story. She spent as much on herself as she did on Jack. It must be nice. “How do you do it?" she asked Shelly at lunch. That was when Shelly told her Jack had taken out a home equity loan for the holiday season—enough to pay for Christmas and a holiday Caribbean cruise. The way Jack figured it, between their home and two condo investments, they had made over $100,000 on their real estate investments this year. No sense in saving it all. They were simply taking out a small portion—just $10,000—for a spin. “I keep telling you, Terry, Jack and I don’t want to wait 'til we’re old and gray to enjoy life. We want to enjoy a little now." Besides, with the way their real estate investments were going, Jack figured they could do more. Wow, Terry thought. She knew Jack was smart when it came to financial matters. She only wished John had a little of the same financial savvy. In some ways she was envious of Jack and Shelly, but in another way, she was tired of the debt treadmill they had been on the last three years. At least they now had a plan of their own. As it turned out, Prestige had an end unit that had recently fallen out of escrow. She and John could buy the unit at phase one prices. The unit, with a few options, was priced at $520,000. The only bad news was that they couldn’t transfer their profit to the new purchase. Since they were getting an end unit at phase one prices, it really came out to a wash. Tom Bennett also had good news. He felt their home should sell for $850,000 and should sell within six to eight weeks, depending on interest rate changes. There was only one other home on the market in their neighborhood right now, so selling wouldn’t be a problem. He felt confident their home would sell due to all of the upgrades they had put into the home. The pool and spa were beautiful. John and Terry felt putting their home on the market during the holidays was out of the question. They agreed to list their home right after New Years.
Meet Billionaire, Sam Beckman Samuel T. Beckman was a media and real estate mogul. He had made his initial fortune buying small local radio and television stations in smaller cities throughout the U.S. in the late '70s and '80s. He sold out to Capital Cities in 1990 and redeployed his capital, buying properties throughout the U.S. after the 1991 recession and S&L crisis. Beckman had made a small fortune in the media business, but his biggest fortune would be made in real estate. Flush with cash after selling his media business, Sam was at the right place at the right time to take advantage of a bursting real estate bubble. He began buying a portfolio of bad loans from a failed thrift that the government had taken over for 50 cents on the dollar. Within a few years he sold those loans for 70 and 80 cents on the dollar, making $500 million in the process. His profits from selling his media empire and the profits earned from flipping under-priced mortgages gave Beckman the capital to form his own vulture fund. In the early-'90s, the government's newly-formed Resolution Trust Corp (RTC) was sitting on $350 billion in non-performing loans, backed mostly by real estate. It was the buying opportunity of a lifetime. Beckman bought one loan package after another from the RTC. Often he sold back the same loans to the original borrower for 70-80 cents on the dollar. Many owners were anxious to hold on to their properties, so they paid Beckman handsomely to buy back their own paper. If Beckman wasn’t flipping mortgages, he was buying distressed properties either from the government or Japanese investors, who were bailing out of their inflated trophy properties in the U.S. By the end of the '90s Beckman had become a billionaire. As tech investors lost fortunes in the new century from the technology crash, Beckman’s fortune would double again. He financed and built large housing and condominium projects in San Diego, Phoenix, Las Vegas and Miami. Sensing money was going to be cheap after the 2001 recession and terrorist attacks of 9/11, Beckman expanded everywhere there was a hot market. He built large home tracks in Phoenix and Las Vegas and condos in Los Angeles, San Diego and Miami. If there was a hot market, Beckman was there first. Sam Beckman had a nose for real estate sizzle whether it was Malibu, Phoenix, or Miami. By the end of 2004 the sum total of all of his properties was worth over $2.5 billion. But by the beginning of 2005, Beckman didn’t like what he was starting to see. There was too much money chasing real estate. Money was coming out of the woodworks from hedge funds, pension funds, and private-equity groups, to rich investors. They were all bidding up the same properties. The way he saw it, there was too much money and debt, chasing very few good deals. Investors weren’t paying attention to value or what they were paying for property. This was buying without thinking. To Sam Beckman, that meant it was time to start cashing out while the ducks were still quacking. By the middle of the summer Beckman began to unload most of his U.S. properties. He was getting top dollar for his housing and condominium projects. As property prices continued to soar, his net worth skyrocketed. Still, Sam kept on selling. Beckman wanted to unload most of what he owned in the U.S. while property markets remained hot. Eventually rising construction costs combined with rising interest rates would bring about another real estate bust. Lending institutions were overextended. Loan portfolios had low collateral to back them as many lenders had lent to buyers who were putting very little down on their properties.
Even worse, many institutions were making loans to marginal buyers through negative amortization loans. The soaring profits in the banking industry were a mirage. The financial industry was a house of cards waiting to fold. When it did, it was going to require another government bailout similar to 1991. This time the bubble was more inflated and would require a far bigger bailout. That meant another buying opportunity of a lifetime was directly ahead. Beckman was getting liquid, while speculators were leveraging up. As the holidays approached, it was time for Beckman to relax. He had liquidated most of his holdings and had received top dollar for all of his properties. He was looking forward to getting together with family, friends, and close associates—men Beckman had partnered with over the years in his spectacular rise to the top. Every year the Beckmans threw a Christmas party at their Santa Barbara ranch. The ranch was nestled back in the Santa Barbara hills in what was some of the most exclusive real estate in California. Beckman had money, but he was also surrounded by it. Most of the invitations went to billionaires or centa-millionaires, the kind of people you would find on the Forbes 400 list. If you weren’t a billionaire, you at least had the money to live like one. Neighbors included the famous as well as the rich. Morgan and Hank Weld had both received invitations. A
Holiday Gathering The Beckman dinner parties were always well attended. A conclave of fellow peers was a welcome event. The combined net worth of attendants that evening was equal to the GDP of a small country. Everyone was in a good mood that evening, which implied to Beckman that his guests were making money. He was surprised, however, by the tenor of many of his associates as they retired to the veranda for brandy and cigars. Some, like himself, had been making fortunes in real estate, but they too had been selling or thinking of cashing out. Others like Weld were heavily invested in oil, a family tradition, or in gold, which was a novel idea for Beckman and a few of his guests. While everyone had been making money either in real estate or their own businesses, very few—other than Morgan—had been making money in stocks. Everyone seemed worried about something. Too much debt in the economy, the real estate bubble, the dollar or Fed rate hikes were topics raised on the veranda. Everybody believed that eventually Fed rate hikes were going to lead to a crisis somewhere. The question was, where it would erupt? Who would be the first causality? How bad would it get and how long would it last? Beckman proffered his assessment of real estate. “There is too much money, too much debt, and too few brains chasing few good properties. The amateur entrepreneurs and the public were now coming into the market. They have no clue about real property value. At current prices, very few deals pencil out. I believe this is the top.” Morgan
Describes the Coming Crisis A few asked what Morgan was doing. "Well, I’m in oil, a market I know well and I’m buying gold and silver, lots of it." Everyone was aware that gold prices had been setting multi-decade records.
Morgan had everyone’s attention, especially since he was one of the few men in the room making money in the markets. Morgan went on to explain the trade deficits and the Fed rate hikes. Foreign money was pouring into the U.S. because it was felt that our economy was stronger and our interest rates were much higher than Europe and Japan. That picture was changing. The ECB had recently started raising interest rates and the Bank of Japan was preparing the ground to shift away from its zero-interest rate policy.
Several of the guests cornered Morgan privately to ask him for advice. Morgan told them to watch the energy markets, inflation, gold, and the dollar. Morgan felt that next year was going to be brutal for the markets. Rising energy prices, especially heating oil and natural gas this winter, was going to drive inflation rates higher in the months ahead. Higher inflation rates would keep the Fed on offense, forcing the Fed to raise interest rates more than it wanted. At some point the Fed would raise interest rates too far, leading to the unwinding of the asset markets. When the crisis arrived, Morgan believed it would be quick and lethal to the financial system. The party went on later than expected. Morgan Weld was literally holding court out on the veranda. Everyone seemed to want private time with Weld to get his advice. The Beckmans finally let their guests know that the evening was coming to a close. They all wished each other well and agreed to get together again. The golf and charity benefits in the Spring would be the ideal occasion.
John and Terry Wheeler thoroughly enjoyed the holidays and were excited about their future plans. They kept their plans secret and would not divulge them until the "for sale" sign appeared on the front lawn. Tips during the holiday season had been average, but enough to help pay for Christmas. There would be no holiday hangover this year. John loved his La-Z-Boy chair and surprised Terry with a matching pearl necklace and earrings. They spent the time off during the holidays making clandestine visits to their new home and on more than one occasion talked about starting a family. They had a lot to look forward to in the New Year. Getting out from underneath their debt burden had been a catharsis for both of them. The Bensons were another story. Judging by what the Wheelers saw on Christmas Day, the Bensons gave the impression they were rolling in the money. While making coffee Christmas morning, Terry couldn’t help but notice the huge, red bow on a brand new Lexus RX 400h in the Benson driveway. The Bensons were now a two-Lexus family. Jack owned an LX 300. The RX 400h was Jack’s Christmas present to Shelly. Terry had always been impressed with Jack’s financial prowess. She was even more amazed when they went to the Bensons to watch the games on New Year’s Day. They had the thrill of watching football in high definition on their new Sony 60“ Grand WEGA LCD projection TV. Terry had worn her new pearls, but they paled in comparison to Shelly’s new diamond horseshoe pendant. "How do you do it?" Terry asked Jack during a commercial break. Jack explained that he was simply monetizing some of the gains on their real estate holdings by rearranging some of their debt. Between their home and two condo investments Jack bragged that they had made over $100,000 in appreciation in 2005. He was simply taking advantage of the gains and low interest rates to enjoy a few of the nicer things in life. Speaking expansively, he went on to tell John and Terry that he was thinking of taking additional equity out of their home to buy another condo in a new development that was opening up in the Ranch. The new condo development would have smaller models and come complete with everything from appliances to window coverings. The only upgrades were in flooring. He was looking at buying the most popular model, a 2-bedroom, 2.5 bath residence with approximately 1,400 square feet. Jack told them they ought to do the same thing. "You need to start pyramiding your wealth like Shelly and I have done. Just look at the money you’ve made on your home and your new condo investment." He and Shelly were going out to the Ranch next weekend to look into buying one of the new units. Jack asked if they wanted to go along. The Wheelers declined. Some people were meant to be investment tycoons. John and Terry knew they weren’t. They wished the Bensons well, but said they were more than happy with what they had. As they went home after the game, they both remarked what a shock the "for sale" sign would be that following Monday. They were not looking forward to the next encounter with the Bensons. Terry was sure Jack would say what they were doing was foolish. She didn’t care. All she wanted now was to get off the debt treadmill and start a family. If that meant downsizing, then so be it. Perhaps if they had got into a home much earlier like the Bensons, they would find themselves in different circumstances. All she knew was these were the cards they were dealt and she and John were determined to make the best of it. WedgeBook had made the year thanks to Tony’s trading skills. The fund had earned a nine percent return, which was better than the markets. The major indexes had finished out the year in the low single-digits. WedgeBook’s returns were respectable and high enough to earn incentive fees. That meant big bonuses for Grecko and his partners. It would be their last respectable year. In less than six months the fund would be bankrupt, creating the biggest financial crisis since the demise of Grecko’s mentor John Meriwether and LTCM. Erica Barry had gotten her wish with Pine Brothers. The second and third phases at Hacienda Del Sol had been released by the second week of December. However, unlike the first phase, sales were going slowly. Erica attributed that to the holiday season. People had other things on their minds at the moment. She was encouraged by the weekend traffic, but no one was buying. They were just looking. She expected that to change after the holiday season was over and the New Year began. Meanwhile she was caught up with the holiday cheer and the prospects of moving into her new home. She had a lot to look forward to next year. Overall, 2005 had been a good year for Erica. She had received a big bonus and promotion, a substantial salary increase, and had traded up to her first home. She could only dream what the next year would bring.
Retail
Sales Rising
Energy Prices
The stage was set for the downturn to begin as the New Year began. Regulators were starting to bear down on bank lending practices, which were showing signs of breaking down. Bank lending standards had deteriorated considerably. Credit risk was on the rise. It had jumped in several places on the regulators' radar screens, most notably in commercial and residential real estate. The OCC’s 2005 Underwriting Survey reported net easing of retail underwriting standards for the first time in 11 years. In the commercial real estate sector lenders were routinely adjusting loan covenants, lengthening maturities and reducing collateral requirements. On the residential side the breadth and extent to which banks had relaxed lending standards was starting to worry regulators. Lenders had been scrambling to find ways to make inflating real estate prices more affordable. The result was not only the relaxation of lending standards, but also the proliferation of high-risk loans. Interest-only products made up approximately 50 percent of all mortgage originations in 2004. By the first half of 2005, interest-only options were replaced by payment-option ARMs, comprising nearly half of all new mortgage loans. Every other mortgage was a “piggyback” or reduced documentation loan. The trend in residential lending was toward the “layering” of multiple risks. Regulators were finding that the tendency toward higher-risk loans was taking place across both ends of the FICO spectrum, with the riskier borrower at the forefront. Nearly 50 percent of these sub-prime holders of option-ARMs had current balances above their original loans. All of the ARMs, interest-only, and option-payment ARMs were due to be reset. The 3:1 and 5:1 ARMs, which dominated the residential lending market since 2003, were going to reset over the next few years. The resetting was already taking place and would accelerate next year. In the case of option ARMs, payments would go up each year for the first five years, resulting in negative amortization or a larger loan balance at the end of the first five years. Beginning in the sixth year, the loan would be repriced at a new interest rate. In the case of the Wheelers, the Option ARM used to purchase a condo was set initially at 5.487 percent. The first year payment was $1,179. It would rise to $1,575.47 in the fifth year. In the sixth year when full amortization begins, the payments would jump to nearly $2,500. The higher payment was the result of a bigger loan balance and full amortization. It could get worse, if interest rates moved higher at the time the loan was reset. If interest rates should increase 1 to 2 percent to 6.5 and 7.5 percent, payments could double from where they originally started to $3,000. Consumer
Slowdown Apparent
Corporate
Profits Peak Easy
Money Takes Its Toll The problem with central bankers and economists is that they think they know how to handle financial crises. The standard prescription is to throw money at the problem. When the crisis is over, you come in and mop up the money. This was done repeatedly under the Greenspan Fed. In the October 1987 stock market crash, the Peso crisis in 1994, Asia in 1997, Russia and LTCM in 1998, Y2K in 1999, and 9/11 in 2001, the response was always the same. Throw enough money at the problem until it eventually goes away. However, each new crisis would be followed quickly by another. Each rescue operation would require larger amounts of money and longer periods of recovery before mop-up operations could begin. The problem with mop-up operations is that they usually led to the next crisis. This next crisis was about to begin.
There was a pall that settled over the economy and the markets as the New Year began. Christmas sales had been weaker than expected with the exception of on-line sales. Retailers weren’t meeting their numbers and they were anxious to get rid of inventories through aggressive markdowns. There was a plethora of sales in January, but the harsh winter weather kept most shoppers at home. A flurry of blizzards and snowstorms blanketed the Mid-West and East Coast. Weather and energy were back on the front pages again as were layoffs. In the first week of the new year, Ford had announced restructuring plans designed to reduce debt and overhead in an effort to put the company back into the black. The first step was trimming back the white collar workforce by 5,000. Other layoffs including factory closures were in the works. The Ford layoffs had followed the 30,000 GM layoffs last November. Both companies were hemorrhaging from billion-dollar quarterly losses. The big gas-guzzling SUVs and trucks weren’t selling to an energy-conscious consumer and dealer inventories were piling up. Both companies tried rebates and special financing in an effort to lure buyers. Unfortunately, buyers weren’t taking the bait. Oil prices were back over $60 a barrel, gasoline prices were rising, and natural gas prices were headed back to their record highs of $15 by mid-January.
In addition to layoffs, a number of companies were issuing warnings ahead of the fourth-quarter reporting season. Companies were anxious to air their dirty laundry early, hoping investors would forget about it by the time the actual numbers were reported. In addition to earnings misses, the economic numbers were no better. Housing sales and starts had begun to decline and home prices nationwide were starting to soften. Delinquencies were rising again as were bankruptcies. Higher interest rates and rising energy prices were acting like a vice, squeezing the consumer from both sides. On the international front, the U.S. dollar continued to gain incremental ground thanks to rising interest rates, but the buck was starting to receive competition as central banks in Asia and Europe raised their interest rates. The dollar was holding on, but it was beginning to show signs of weakening. The trade deficits remained persistently high as the U.S. imported more oil and natural gas at much higher prices. As the US economy showed signs of slowing, as more companies reported profit shortfalls, and as delinquencies rose, credit spreads began to widen again to over 400 basis points. Nervous investors began to price in greater risk. The S&P, which reached a multi-year high in December, was beginning to break down as it fell below its 200-day moving average in early January. On Main Street... Wheelers
Stick With the Plan
Pine
Brothers Are Discouraged CityWide
Scrambles as They Prepare for the OCC Audit | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Prelude
The
only distressing thing in her life right now was that prices, along with
real estate continued to
go up. Terry and John spent more than $120 a week to fill the tanks in
both their cars. That was thirty dollars more than last year. Their monthly
bills had been creeping up and the local utility informed them
that natural gas prices were going up this winter. Last month’s utility
bill was over $300! The monthly cable bill had risen by $8 and the cost of
a movie ticket was now $10. You could add another $10 for a small coke and
popcorn. Even John had noticed the price increase for Charger tickets.
John and Terry paid $160 for two tickets to see the San Diego Chargers
play the Oakland Raiders on December 4th. It was expensive, but
it was John’s birthday weekend.
Erica
had no idea what her boss was up to, but felt they had to be pleased with
the progress she was making at Paradise Village. She knew the company had
another project in the works. She had participated in some of the
preliminary design meetings. Perhaps they needed more of her input on
options? She was excited about the possibilities. Erica really enjoyed
what she did for a living and it showed in her enthusiasm. Lucky for Pine
Brothers, that enthusiasm was electric with buyers.
The
intensity of trading was starting to wear on Tony’s nerves. Between two
pots of coffee and Krispy Kreme donuts, Tony’s body ran on caffeine,
sugar and adrenaline. Shapiro was popping as many pills as the number of
cups of coffee he drank. Tony took Zantac to control the heartburn and
acid, Nexium to repair the damage of the heartburn, alpha and beta
blockers to control blood pressure, and Ambien to get to sleep. At the
rate he was popping pills, he thought of buying drug stocks. Tony was
earning his pay the hard way, but he had been called in as a relief
pitcher. He rose to the challenge. Grecko sensed the wear and tear on his
head trader and knew it was time to intervene. Gordon invited Shapiro to
join him aboard his 130-foot yacht, Achilles, in the Grand Cayman for a
long Thanksgiving holiday. The G4 was on its way to La Guardia.
Grecko’s
cook prepared Tony’s favorite dinner, Beef Wellington, for Sunday night. Jasper served up the appropriate wine—one of Gordon’s
favorites, Opus One. At dinner on Sunday Grecko laid out his macro bet. It
hadn’t changed. It was his belief that what would unfold would play out
in text-book fashion. As the Fed continued to raise interest rates, the
economy would weaken, the yield curve would invert, energy prices would
peak and inflation would subside. By next year the economy would be close
to recession if not in one. Bernanke would have no choice but to lower
rates. Grecko was convinced that Bernanke would be as friendly to Wall
Street as his predecessor. By next summer the Fed would be lowering
interest rates. Grecko pointed out that M3 had increased by almost $300
billion since the beginning of August. The Fed may be talking tough, but it was keeping the financial system liquid with plenty of
money.
Terry
noticed how attractive the development looked with the landscaping in
place. She remarked to John, “You know, this really wouldn’t be a bad
place to live.” She loved the private walkways and walled courtyards,
which enhanced the Spanish and Tuscan elevations of each town home
complex. Even though these were town homes, the walled-in courtyards and grass-lined sidewalks really gave you the look and feel of a home. Terry
especially liked the end unit, which had a front as well as a side covered porch.
The unit had 1,630 square feet with a very livable floor plan. The
downstairs had a spacious kitchen and a nice-sized living room with
fireplace and media niche. The upstairs was equally as spacious with a
loft, two bedrooms and a large master bedroom with a walk-in closet and
media niche across from where the bed would go.
Morgan
and Hank stayed in town for a few days to go over family business, discuss
the portfolio, and visit with Abigail and a few of her Hollywood friends.
Morgan had been buying deep in-the-money calls on natural gas and oil stocks, and
selling deep out-of-the-money puts to gain extra leverage. He was
convinced of another energy spike led by natural gas and heating oil as
the cold winter set in. The weather experts were forecasting a colder-than-normal winter. With oil and natural gas production still down in the Gulf
of Mexico he believed prices would head higher. He continued to follow the
futures market. Morgan couldn’t help but notice that commercials continued
to increase their net long positions, while large speculators and small
traders were heavily short. Morgan was betting on the side of the
commercials. He also added to the family’s gold and silver positions
with each pullback in the precious metals. The family portfolio was now
heavily-weighted towards energy and precious metals and a sizable position
in cash. When circumstances were right, Morgan intended to switch out of
T-bills and into foreign currencies at the first sign of Fed easing. Right
now he was enjoying the climbing yields on short-term treasuries.
The
end of the year closed on a fragile note. The markets represented by the
major indexes ended up in positive territory, but just barely. The FOMC had
increased interest rates for the thirteenth time on December 13th,
taking the federal funds rate up to 4.25%. The minutes accompanying the
meeting were like a Xerox copy of previous meetings. There was no hint of any
let up in future rate hikes. This put a damper on the markets for the
remainder of the year. There were a few brief rallies into the year-end as
a result of robust on-line shopping. Retail sales weren’t bad, but they
weren’t the kind of numbers that markets could celebrate over. There was
a definite slowdown taking place with consumers and it was beginning to
show up in consumer sentiment and play out on the retail front. The only
way retailers were making sales was through steep discounting. Unless
something was marked down or put on sale, it was hard to find buyers. There
were a few bright spots such as the sale of iPods, Microsoft’s X-Box 360,
and big screen TVs as more households thought of getting their
entertainment at home.
Cold
temperatures and severe winter storms meant the demand for energy soared
as did prices. The consumer was being hit on all fronts from soaring
energy bills and rising food prices, to rising interest rates on home equity
loans and credit cards as a result of the new bankruptcy bill. Rising
heating bills were hitting consumers at the same time that their financing
costs were going up.
Rate
Risk in
All
of the variables for a consumer slowdown in spending were now in place.
The
deterioration in credit quality had not been reflected
in credit spreads. With liquidity pouring into the markets, money
searched for the highest returns. The yields on high-risk debt had come
down. In the U.S., corporate credit spreads had narrowed to less than 200
basis points, while in emerging markets, they had dropped to below 400. In
Europe they were less than 50 basis points. The level of interest rates in
the high-yield market was not priced for risk. If anything, credit spreads
were reflecting permanent good times. Investors weren’t being
compensated for the risks that they were taking. Just as mortgage payments
were due to reset, the whole risk continuum in the bond market would also
be reset. It would take a financial crisis to bring this event about.
The
near-record highs in energy were spilling over into the inflation indexes.
The PPI, CPI, and import prices continued to rise, putting pressure on
interest rates and the Fed. It was becoming clear to the markets that the
Fed would raise interest rates for the fourteenth time at the end of the
month. The Fed would take the federal funds rate up to 4.5 percent. The
key would be the language accompanying the FOMC meeting. What would
Bernanke do as he took over the reins of the Fed? The markets were
beginning to price in higher rates.
The
Wheeler home was listed at $850,000. Their agent, Tom Bennett, had planned
on holding open houses on weekends in an effort to market the property.
John and Terry were hopeful they could get full price for their property,
which would give them more money to put down on their condo. They got a
little discouraged when a "for sale" sign went up at the
Goodmans the following week. The Goodman home was priced at $840,000, but
didn’t have a covered spa or patio like the Wheeler home. Tom Bennett
was still hopeful they could get close to full price on their home.
However, by the end of January, there had been no bites. Even worse, the
Goodmans had dropped their price down to $829,900 at the end of the month.
Dick Goodman had lost his job at a local media company. Local media
companies were tightening their belts and cutting jobs, attributing their
plight to the slowing economy and a weak advertising market.