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my activities assigned capital i thought of myself as a value investor soon my attention was caught by this growing importance of the housing sector the amount and type of leverage the generations old acceptance and assumption that prices always went up and the very broad societal participation greater than 60 percent owning homes this all called out to me this was not just a case where a few early adopters made a lot of money or a few venture capitalists acted badly the entire economy depended on home price appreciation the slope home price appreciation consumer spending jobs securities markets all of it soon i would see financial armageddon with housing as trigger point now in predicting when and how the collapse would occur my focus was again on the actions of our government and the response of the private sector this was much in keeping with my studies a decade earlier in chicago let's consider that history the idea of an american dream being related to home ownership has been around for nearly a century nearly every modern president promoted in one way or another with a named program the government helped returning gis after world war ii buy homes and the government was the first to securitize mortgages in the early seventies private securitized mortgages followed shortly thereafter thanks to luanieri president reagan would sign the secondary secondary mortgage market enhancement act which among other things allowed in insurance companies and pensions to invest in these securitized mortgages and a short time later reagan signed a law that made these types of products much more tax efficient to be clear securitization of mortgages means there is actually virtually no limit on the amount of mortgages that can be originated by an institution they just get sold through to wall street to investors but all all this was considered harmless it was a good thing for the american dream to almost all concern for decades the desire to satisfy this dream though needed a tool something that would make home loans themselves much more affordable for those without the income credit or assets to afford one let's step back to 1982 again the depository institutions act legalized adjustable rate mortgages for the very first time these adjustable rate mortgages or teaser rate mortgages would in various forms be the primary mortgage product at the heart of the collapse of our economy two and a half decades later but adjustable mortgages did not take off immediately they really did not take off until additional more additional regulatory and legislative changes in the 1990s and early 2000s jump started the market for affordability products in the mortgage space specifically during the 90s the community reinvestment act of 1977 was reinterpreted several times by robert rubin the treasury secretary at the time and bill clinton the president at the time the general point was to increase pressure on banks to make more loans to less credit worthy customers and they did subprime issuance bloomed about five to six times during the nineteen nineties and there was a mini crisis thereafter bill clinton had a had a name for this drive as all prince presidents did his name was the national home ownership strategy then in 1999 the graham leach bliley act repealed the glass-steagall act of 1933 and officially removed the increasingly leaky separation between the activities of wall street banks and depository banks this freed banks to experiment and to expand into new lines of business none more fateful than the experiment with derivatives and subprime asset-backed securities the private market therefore gained the capability to mount a massive response to all the government's efforts to stimulate housing we all remember 1999 very well but in fact our global village underestimated many many risks throughout the 90s as is typical of a generally good economic time and we had to deal with stock market crash enron 911 and eventually war the federal reserve stepped in cutting the discount rate at charge lenders from 6 percent to roughly 1 percent in order to stay off recession other key short-term interest rates followed not all coincidence coincidentally from 2001 to 2003 we saw american home prices which had largely moved in line with household income over the decades suddenly accelerate up and away from the household income trend line home prices had good reason for such deviation from 2001 through 2003 rapidly declining short-term rates to lows not seen since the aftermath of the great depression induced a boom in adjustable rate mortgages a homeowner's dollar homeowner's dollar went farther during that teaser rate period and so home prices rose unnaturally risk would be low as long as home price appreciation was strong under this paradigm thanks to refinancing options it was a positive feedback loop with the full blessings of the us government in fact amidst early fears that the housing market was getting ahead of itself in 2003.
fed chairman alan greenspan assured everyone that national bubbles and real estate simply do not happen as i served and surveyed the national trends in housing at that time i wondered whether common sense ought rule against the application of precedent to the unprecedented mr greenspan went on to advise in 2004 that they were under utilizing the new types of adjustable rate mortgages in 2005 he allowed specifically the technologies used by subprime lenders to get subprime borrowers into homes tragically for all of us the federal reserve actually had authority to block any lending activity it deemed deserving of such treatment but it had absolutely no will to do so in any event by 2003 mortgage rates stabilized at 40-year lows and importantly plain vanilla adjustable rate mortgages had already come into widespread use this was a big problem for public lenders with a growth mandate they needed to stimulate more loan volume despite stable mortgage rates and inadequate income growth at this point if home prices were to rise significantly they would have to float almost entirely on the back of the type and quality of mortgage credit provided to the buyer critically interest rates alone would no longer determine affordability in my letter to investors at the time i termed this credit extension by instrument and it took our housing market into a new paradigm it was the private markets time to overreact the instrument chosen for subprime borrowers by lenders in 2003 was a relic of the 1920s the interest only adjustable rate mortgage lenders by implementing a mortgage product they had long avoided showed for all to see they were interested in growth more than they were interested in maintaining credit cred credit standards they were no longer interested in checking excess credit risk at the door by fall of 2004 i noted for my investors that the countrywide financial a very large national mortgage lender reported subprime mortgage originations up hundred and thirty fifty eight percent year over year despite a twenty four percent decline in overall loan originations evidence was therefore manifest banks were chasing bad credits inclusive of housing speculators the only question was how far could they go ominously fraud jumped the point at which the provision of credit was most lacks in my mind would mark the point of maximal price in the asset i imagine the top in the housing market would be marked by a mortgage in which home buyers of subprime quality were enticed to buy with teaser rate monthly payments near zero i was very aware lenders would take this to the nth degree thanks to securitization any loans the banks did not want to keep they could always sell through wall street to investors who were simply ravenous for yield importantly because subprime mortgages were being turned into securities there were mandatory regulatory filings and this is how i educated myself on the sector at times i felt i was the only one reading these things by summer of 2005 these documents revealed that interest-only mortgages had taken a substantial share in the subprime market just a year or so later after they were introduced to that market more than 40 percent of subprime originations that were passing through wall street on their way to investors this was up from 10 percent a year earlier simultaneous second lien mortgages ramped up significantly this was not disclosed in every document i read and stated income the stated income option available to borrowers inspired a new vernacular the liar alone in some mortgage pools 40 of subprime loans were for second or vacation homes condos in miami yet as late as 2005 moody's and s p so crucial to the securitization process moody's and s p being the ratings agencies everybody watched they were not reacting at all the top would be soon would soon be fast upon us as a subprime interest only adjustable rate mortgage started to touch maximum sales channel penetration we saw the introduction of yet another more extreme teaser rate mortgage called the pay option arm or cash flow arm in this new type of mortgage never before seen in a widely standardized format the borrower could basically pay next to nothing each month and the unpaid interest would simply negatively amortize into the growing mortgage balance rampant cash out refinancing had already made the home a magical atm for most americans and now housing had its credit card this was what i had been waiting for peak credit such a mortgage product would only exist as long as home price appreciation was a central assumption and home price appreciation was not long for this world precisely because this these mortgage products existed some of these sorts of mortgages started making their way into the subprime channels too i knew this because by 2005 as early as 2005 i could see these mortgages being packed into alt a securitizations i read those two those are between subprime and prime not all of these though were sold not as many as you would think were actually coming through this way though not most of them were not being sold through the street i noticed something else incredibly washington mutual and countrywide again two very national giants and home loans began to load their own balance sheets with these pay option adjustable rate mortgages facing yet another slowdown in loan volumes these companies saw the negative amortization feature as a way to show loan growth in a slowing market yet these companies in doing so also express confidence in home price stability in the event of a slowdown in loan origination of course this is what the ratings agencies the federal reserve congress the president and all the president's men believed as well i disagreed i saw absolutely no chance of home prices going sideways or stabilizing for any significant length of time once home price appreciation was no longer a given these new types of mortgages would simply disappear home prices starved of peak credit would fall and fall steeply as mortgage and refinancing options crumbled away the crisis in my view would start in 2007 by which time teaser rate periods on the vast majority of these new types of mortgages would expire or reset for a population of homeowners trapped in mortgages they could no longer afford and on the way down housing would take consumer spending jobs everything with it a positive feedback feedback loop of a very damaging variety was set up so seeing the economy on the verge of collapse i did the logical thing i sought to profit from it
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