Peter Schiff 3: A Financial House of Cards is Constructed

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Part 3 in our series condensed from a speech Peter Schiff’s gave on March 13, 2009 to the Austrian Scholars Conference.

The Real Estate Bubble morphs into a Financial House of Cards

When the Bush Administration came to power, they tried to combat the recession and the after affects of the 2001 terrorist attacks with deficit spending. They cut taxes, increased government spending and Federal Reserve Chairman Alan Greenspan slashed interest rates down to 1%.

So we had a flood of money and fiscal stimulus.

And what was the result? Americans borrowed massively to fund the biggest spending spree in history and our trade deficit just skyrocketed. More importantly it acted as a leverage for huge amounts of real estate and consumer purchases.

It was all borrowed money.

Very few people used their own money. In fact many of the people who were buying real estate were buying it with nothing down. Is it any surprise that people gambled when they had nothing to lose? Especially when they had so much to gain? Real Estate prices were rising and everyone believed it was a never-ending gravy train.

At one point in California, I believe it was 2005, they took a survey and the average homeowner believed his property was going to appreciate by 20% each and every year for the next 10 years.

That is what was expected.

At the time the average California home was selling for about $500,000, which was about 10 times what the average household actually earned. But these guys actually believed if they bought that house they would make $3 million dollars over the next 10 years.

That’s what they sincerely believed!

Now is it any wonder they lied on their mortgage in order to get that appreciating asset? Is it any wonder that they signed up for a teaser rate mortgage? Do you think they cared what happened to the loan two or three or five years from now? They didn’t care what the reset was, they were gonna be rich. All they had to do was buy the house and they were going to be rich. It didn’t matter what the mortgage payment was going to be because the house would take care of it.

In fact if you calculate what the average Californian expected to earn from house appreciation, it exceeded what he expected to earn from his job. It used to be you worked hard to earn money and be able to buy a house. Now it was if you buy a house, you don’t need a job.

And for a few years, it worked. The people who bought houses were getting rich. And the banks made it very easy to monetize that gain. You didn’t even have to sell your house, all you had to do to realize that gain was remortgage and you could borrow the money out of all the appreciation. Instant equity and money in your pocket. Plus you could still live there.

It was like the goose that laid the golden eggs. No one would sell their house, because it would just keep going up. In fact people went out and got second houses with nothing down to keep it going and then borrowed the appreciating equity to fund more consumer purchases.

Part of the problem here was that realtors redefined the American Dream. The American Dream was always you save your money, you work hard and anybody can succeed. You don’t have to be born to a royal family, you don’t have to be an aristocrat… anybody of modest means can grow up to be a captain of industry or be President of the United States… that was the American Dream.

Somehow the realtors turned it into home ownership and buying a home and just getting rich. That was the American Dream they were selling: that you didn’t have to work.

Well that dream is now dying.

So we had this gigantic bubble. And the bigger problem here was the lenders. I knew that when the real estate bubble finally burst, it was going to spell huge trouble for the financial industry – and thus the stock market – because I knew that the banks and the financial institutions had, as the bedrock of their assets, all these IOU’s, all these mortgages.

It’s simple. If the mortgage holders don’t pay, then the assets aren’t worth what everyone thinks they are. Which means the banks are undercapitalized.

And I knew just by looking at it that Fannie and Freddie were going to have to go bankrupt. They had guaranteed 50% of the mortgages and those mortgages weren’t worth anywhere near what Fannie and Freddie thought they were. People were borrowing to buy these houses so I knew that when people couldn’t pay those companies, they were going to have to go under.

Compounding this looming potential disaster was the securitization process.

At the time I was helping a client set up a hedge fund in 2005 that was shorting sub-prime mortgages and I learned about the whole securitization process.

First it started with Freddie and Fannie. If it wasn’t for Freddie Mac and Fannie Mae, Americans couldn’t have borrowed all this money to buy houses. The only reason they could do it was because the American government was co-signing their mortgages. And they knew if you lent someone money to buy their house and they can’t pay you back, then the government will pay you back.

So people were able to borrow more money than the free market would allow because the government was there to co-sign the mortgage. But there were some mortgages the government wouldn’t co-sign. These were the ones known as the sub-prime mortgages.

But Wall Street figured out that they could ‘securitize’ these mortgages. The government won’t guarantee them, but we will buy them all up, put them into these structured products and by structuring them like this we will be reducing their risk.

And it was crazy. After they sliced and diced them,better than two/thirds of these sub-prime mortgages were rated 'Triple A'. And these were mortgages where people have put nothing down, have lousy FICO scores, were in jail or don’t have jobs, whatever it was, two/thirds of them were rated ‘Triple A ‘

‘Triple A’!

I mean, how could that be? How can you take all these lousy mortgages, bundle them up, and they're rated Triple A?

But a lot of people owned structured products, which was one of the main reasons that there was a market for them, and a lot of people were looking for high yield products, so no one quesitoned it. Buyers just ate it up confident that these were high quality investment products.

And because Wall Street had ‘securitized’ all these new mortgage bonds, and gave them Triple A ratings, they were able to sell them to the Japanese, sell them to the Chinese and sell them to the hedge funds…there was demand.

And why was there so much demand for high yielding assets? Because the Fed had interest rates too low. Everyone needed yield and they were willing to take risks to get it.

And where did all these foreign Central Banks get all this money that they recycled back into these bonds? Because of our trade deficits. Because interest rates were too low and we were buying too much stuff on credit.

And as the market was flooded with more and more money from these Triple A products, it became even easier for people to borrow more money and buy more houses.

It was because of securitization.

So you had the government perpetuating this crisis and you had the attitude that real estate prices couldn’t fall.

How bad was this attitude? In 2005 I had a booth in Phoenix, Arizona at an investment conference. And the person next to me had a real estate company that specialized in hooking up people with bad credit, who couldn’t buy homes, with people with good credit. And the people with good credit co-signed the loans of the people with bad credit. Now this guy with bad credit can get a house and the other guy would get some extra payments or something.

Now there was one flaw in his argument. I said, “what if the guy, this deadbeat person who can’t get a loan, what if he can’t pay? What happens to your client who co-signed?” And the reply was, “well… then we will just sell the house”. I said, “Okay, but what if the value of the house goes down?” And he looked at me like I was from Mars. He said, “this is Phoenix. Real Estate prices don’t go down in Phoenix.”

Everyone had this idea that housing prices would never go down. So nobody questioned these faulty Triple A ratings. And it didn’t matter anyways because if someone defaulted on a mortgage within the package - which, of course, was always supposed to be apreciating, so you had the house to sell.

But I knew that housing prices were going to fall. And when I went on television they told me, “that’s not going to happen, it hasn’t happened since the Great Depression, that’s impossible.”

But it was possible. All you had to do was look at the way the system was constructed.

And if housing prices started to fall in any one area, the resets on the subprime mortgages would trigger a massive unravelling of the system because of the way everything had been 'securitized'.

So guess what happened?

Tomorrow: The Dominos Start to Fall

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