Fed Policy Is Working -- Moral Hazard Is Back

By: John Rubino | Wed, Oct 3, 2012
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A near-death experience isn't something one gets over right away. So it's no surprise that the US leveraged speculating community was a tad more cautious than usual for a while. Real estate investors, for instance, still bought houses, but only on very favorable terms where rental income would clearly exceed expenses. And investment banks still repackaged loans into asset backed securities, but on a very small scale, since there weren't that many willing/able buyers for exotica that was "toxic" so recently.

This was completely unacceptable to Washington, of course, since the only way an over-indebted economy can "grow" is if speculators can be induced to take unwise risks. So this year we entered the whatever-it-takes phase of the process, where borrowed money became nearly free and permanent, open-ended quantitative easing was promised.

It was a Hail Mary pass, but it seems to have worked, at least in the narrow, Twilight Zone terms in which today's system operates. That is, moral hazard -- the sense that you can do pretty much anything you want because the government will bail you out -- is back as a driver of deal making. See this on the return of a practice last seen during the housing bubble:

House flipping makes a comeback

Forget the carnage of the last few years. The allure of the quick buck endures as home flipping makes gains in hot real-estate markets.

Remember home flippers? How could anyone forget those villains of the housing market crash?

A Santa Rose Press Democrat blogger (tongue slightly in cheek) recalls them as "predatory fish prowling the turbulent waters of the real-estate market, feeding off of distressed properties and swimming away with quick profits."

Well, flipping is back. Investors and even some amateurs are venturing in, snatching up ruined, cheap foreclosures in the hope of making profits on rehabbing and selling or renting distressed homes.

RealtyTrac, in an instructional webinar on flipping (more on that in a minute), defines flipping as "buying a home ... usually at (a) discounted price, rehabbing it to sell at full market value, and reselling that property -- all within 90 days and ideally for a profit."

Flipping rises again

"When we see mold in the basement, we just say cha-ching," a New Jersey investor tells CNNMoney in this video. She shows off renovations to a home she purchased for $180,000, saying she plans to list it for $450,000.

CNNMoney says:

One in four homes that sold are actually bought by investors. Part of the reason is because of the millions of foreclosures on the market. With so many empty homes out there it's easier to find a good deal.

RealtyTrac publishes a database of bank-owned and foreclosure properties. It says that about 1,300 people - 47% of them classified themselves as "new investors" and 13% claimed to be "experienced investors" -- recently signed up for its Foreclosure Flipping 101 webinar.

In a slide show from the webinar, RealtyTrac shares a few nuggets about flipping: In the first six months of 2012, there were 99,567 property flips, an increase of 25% from 2011, and an increase of 27% from 2010.

Hogging the market

Aggressive flippers are dominating housing markets in many cities. That puts first-time homebuyers at a competitive disadvantage. USA Today says that "instead of having their pick of homes to buy in some markets, they're losing houses to cash buyers and bidders with bigger down payments, or they're facing bidding wars spurred by shrinking numbers of homes for sale." (Post continues below video.)

And this on the growing appetite for exotic structured debt instruments:

They're back! Yield hunt pushes funds into CLOs, CDOs

NEW YORK (Reuters) - Fund managers are increasingly eyeing riskier exotic assets, some of which haven't been in fashion since the financial crisis, as yields on traditional investments get close to rock bottom.

Returns from investments in "junk" bonds, government guaranteed mortgage securities and even some battered euro-zone debt are plunging in the wake of global central bank policies intended to suppress borrowing costs.

In particular, the Federal Reserve's latest move to juice the U.S. economy by purchasing $40 billion of agency mortgage-backed securities every month is forcing some money managers who had previously been feasting on those securities to get more creative. The only problem is they may be getting out of their comfort zones and taking on too much risk.

"I would not be surprised if some managers are reaching outside of their expertise for a few extra basis points," said Bonnie Baha, a portfolio manager for DoubleLine's Global Developed Credit strategy.

To keep performance high, credit-focused managers are moving back into some of the risky assets that got tarnished during the financial crisis like collateralized loan obligations, or CLOs, securities cobbled together from pools of corporate loans.


Mark Okada, the co-founder and Chief Investment Officer of the $19 billion Highland Capital Management, said bank debt, CLOs, and some mortgage securities will provide the best returns in credit as the Fed continues to depress yields in the United States until the job market springs back to life.

"The government is in their market," Okada said of MBS, which has been so profitable for hedge funds this year. "The government isn't in my market buying loans and bonds."

That translates into big opportunities for Highland and other managers who have the expertise - and stomach - for such exotic securities. Of the $19 billion in assets Highland manages, $14 billion is invested in CLOs.

The firm's investments in $1.2 billion of secondary CLO assets are returning 27 percent this year, a person familiar with the firm said. Returns for the bulk of their CLO holdings could not be determined.

The issuance of new CLOs fell off a cliff in 2008 during the financial crisis, after reaching a peak of roughly $100 billion in 2007. CLO activity has slowly been ticking back up, and JP Morgan research analysts forecast $35 billion in new CLO supply this year, almost triple the $12.6 billion issued in 2011.

Some thoughts

The policy hope is that energized speculators will kick-start a virtuous feedback loop in which regular people once again borrow and spend, creating an economy that grows unaided by extraordinary monetary stimulus. This is more Keynesian fever dream than reasonable possibility, since if American citizens and local governments are too indebted to borrow more today (which they are, as credit card debt is replaced by student loans and unfunded pension liabilities explode) then it will take a lot more than slightly higher home prices to turn them back into rampant consumers.

What will it take? A widespread realization that the dollar is falling and will continue to fall for years, which means debts taken on today will become easier to manage in the future as they're repaid in ever-cheaper currency. Borrowing then becomes shorting the dollar, a financial speculation, with consumption a mere byproduct. What you acquire with the borrowed money is almost beside the point.

In this scenario, individuals and municipalities become financial intermediaries, funneling newly-borrowed dollars from banks to road builders, car makers, home builders, and, crucially, to precious metals dealers. Gold and silver are tiny markets compared to cars and houses, and will go parabolic if they get even a modest slice of this pie.



John Rubino

Author: John Rubino

John Rubino

John Rubino

John Rubino edits DollarCollapse.com and has authored or co-authored five books, including The Money Bubble: What To Do Before It Pops, Clean Money: Picking Winners in the Green Tech Boom, The Collapse of the Dollar and How to Profit From It, and How to Profit from the Coming Real Estate Bust. After earning a Finance MBA from New York University, he spent the 1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and a frequent contributor to Individual Investor, Online Investor, and Consumers Digest, among many other publications. He now writes for CFA Magazine.

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