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The Housing Crash and Financial Crisis

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Gary Karz, CFA Follow GKarz on Twitter
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Founder, Proficient Investment Management, LLC

     Much has been written about the housing crash and global financial crisis. The list of suspects for causing or contributing to the crisis is very long. The Financial Crisis Inquiry Commission was created to determine the primary causes. The Final Report was released January 27, 2011 and it included a tremendous amount of information and background, but rather than a single conclusion, the report included one view representing the six majority Democratic appointed Commissioners and two dissenting views from the Republican appointed Commissioners. See FCIC Report Commentary for more background and articles about the report.

     While researching the topic I started making a list of all the books I could find that discuss the housing crash and financial crisis or some critical and related aspects (honestly not realizing what I was getting into and how many there have been). While some of the books on the list don't focus primarily on the crisis, I believe they may be useful for readers in researching the crisis. In some cases I asked the authors if they felt their book belongs on the list. The list is sorted by what I believe is the date of initial publication (some have multiple titles and editions that may or may not differ significantly). Of the more 300 books I've found (so far), I believe more than 30 (in bold on the list) qualify as "bestsellers" with The Big Short topping the NYTimes list for an extended period in 2010 and now having sold over 1 million copies.

     The books come from a diverse collection of sources including some that lost everything and others that made fortunes. In addition to many books from reporters and journalists, there are books by professionals in the mortgage, real estate, and investment industries, government officials, academics, individuals that were caught up in the crisis, as well as plenty of foreigners (discussing for instance the impact in Iceland and Greece). More books are in the pipeline. Given the divide that emerged among the FCIC commissioners, its easy to speculate that we may never get a consensus conclusion about what caused the crisis. I am attempting to clarify opinions by surveying the authors about the FCIC report, the primary causes of the crisis, and their prescriptions.

     I originally posted a single list, but I decided to split the list to separate 1) pre-crisis books (some arguably predicted a crash related to a housing or financial bubble) from 2) the books that have been written since the crisis began. Clearly, some that claimed to have predicted the crash were at a minimum "early." Separately, predicting the crisis didn't necessarily translate into profits or reduced losses. The beginning event and date of the crisis are debatable. HSBC's 2/7/2007 announcement that it anticipated increased losses from subprime mortgages is considered by some to be the start of the crisis, and it was followed by New Century's 4/2/2007 bankruptcy. Yet the stock market didn't peak until 10/9/2007 when the DJIA closed at 14164 and JP Morgan's purchase of Bear Stearns wasn't until 3/16/2008. The crisis intensified in September of 2008 with the government seizures of Fannie Mae and Freddie Mac, Lehman Brothers bankruptcy, BofA's purchase of Merrill Lynch, the government loaning AIG $85 billion, and Washington Mutual's bankruptcy and asset sale to JP Morgan. Yet the stock market did not bottom until 3/9/2009 when the DJIA closed at 6547. For now, I've decided to start the main list of crisis books with Subprime Mortgages: America's Latest Boom and Bust (6/28/2007) from the late Professor and former Fed Governor Edward Gramlich, which according to the product description "analyzes how the subprime market emerged, why it is in crisis."

     I created an additional supplemental list of books that I did not include on the main list, which includes some books that may also have discussions related to the crisis or aspects of it, but don't seem to be that specific to the crisis. For instance, I haven't included Decision Points by George W. Bush, nor have I Included Obamanomics by John Talbott on the main list. But former British Prime Minister Gordon Brown's book Beyond the Crash: Overcoming the First Crisis of Globalization focuses on the crisis and therefore is on the main list. There are many books discussing Goldman Sachs on the main list, but Charles Ellis's The Partnership: The Making of Goldman Sachs doesn't appear to discuss the crisis.

     There have been many discussions about the unpredictability of the crisis and the failure of many models to account for unexpected or outlier events. For instance, Nassim Nicholas Taleb published The Black Swan: The Impact of the Highly Improbable. Crisis Economics co-author Nouriel Roubini is credited with warning in 2006 of much of what later occurred (although Eric Tyson is less than impressed with Roubini's track record - see also Tyson's take on Taleb's Black Swans). I'm also not swayed by the "no one predicted this" argument since (1) some like Robert Shiller predicted the real estate bubble bursting (and I personally clipped this 7/5/2006 WSJ article in which Ken Heebner predicted a major price drop in hot real estate markets). There are probably more than 50 individuals that warned publicly about major problems to come prior to the start of the crisis (see Who Predicted The Crisis?). Additionally there are plenty of books (some classics) documenting the history of human created bubbles, manias, and crisis. And interestingly enough, the authors of All the Devils Are Here tell the story of Charles Kindleberger, author of Manias, Panics, and Crashes connecting with Joshua Rosner following his 2001 research report Housing In the New Millennium: A Home Without Equity Is Just a Rental With Debt (or see this article).

     I use the term "Global Financial Crisis" but other terms have been suggested included

Reviews

     In addition to the Financial Crisis Inquiry Commission Final Report, I've read the following sixteen books published since the crisis began - The Cost of Capitalism, Bad Money, The Myth of the Rational Market, The Greatest Trade Ever, The Big Short, The Trillion Dollar Meltdown, Animal Spirits, The End of Wall Street, The Weekend That Changed Wall Street (FAJ Review), Crisis Economics, Griftopia, Return to Prosperity, All the Devils Are Here, Reckless Endangerment, Debunking Economics (reviewed here), and The Occupy Handbook (reviewed here). I have also read The Coming Crash in the Housing Market (published in 2003) and Sell Now!: The End of the Housing Bubble (published in 2006) by John Talbott, Michael Panzer's Financial Armageddon (published in 2007), as well as John Rubino's 2003 book How to Profit from the Coming Real Estate Bust (see also Keen Survey, Talbott Survey, and Rubino Survey).

     The first book I read about the financial crisis was The Cost of Capitalism by Bob Barbera in 2008. We both worked for ITG at the time and I got a chance to hear Barbera present his book and opinions at a client conferences in early 2008. Barbera was one of the early writers to reference the late economist Hyman Minsky, who had argued that the more stable an economy, the greater the risk of an eventual crisis. Roger Lowenstein also cites Minsky for observing that "success breeds a disregard of the possibility of failure." Stabilizing an Unstable Economy was a book apparently published by Minsky in 1986. The Cost of Capitalism also includes some great quotes like the following.

     Those interested in learning more about Minsky's work can read his article "The Financial Instability Hypothesis" in this January 1991 document titled The Risk of Economic Crisis (see chapter 2). Many commentators have since referenced Minsky, but not everyone is sold. The debate played out thus far in the Financial Analysts Journal includes the following articles.

     The Greatest Trade Ever (now in paperback) was interesting to me partially because of the stories of the main players (mostly big winners). One item that I took a close look at in the books I've read was the acknowledgements (and reading between the lines who the authors interviewed). John Paulson spend over 50 hours with Zuckerman and "Many of the other protagonists in the story were just as generous with their time." One fascinating story describes a critical meeting of Bear Stearns staff with a group of Hedge Funds, in which Paulson confronts Bear management regarding their exposure, which the other Hedge Fund managers then follow-up on. The resulting exodus of hedge fund money likely sealed Bear's fate, which came roughly a month later.

     Among the players that predicted and profited from the meltdown were (1) John Paulson and his former employee (2) Paulo Pelligrini (he resigned to form his own firm end of 2008, but returned his clients money). Arguably the creator of the greatest trade was (3) Michael Burry and his story is especially fascinating. Burry had all the signs of an extraordinarily skilled and successful stock picker before turning his attention (or obsession) to the housing market and his belief in its inevitable bubble burst. Burry's own investors attempted to withdraw from his fund before it turned dramatically in their favor and Burry resorted to using a side-pocket maneuver to prevent his investors from pulling their money out.

     Other stories in Greatest Trade include those of (4) Greg Lippmann, who made Deutsche Bank $1 billion each in 2007 and 2008 and his clients reportedly made over $25 billion (Lippmann apparently moved on in 2010). Another fascinating story was (5) Real Estate Investor Jeffrey Greene who learned about the trade from Paulson, but put on the trade himself (understandably ticking off Paulson in the process). (6) Andrew Lahde struggled to get started and raise enough money to put on the trade, but eventually made over $100 million for his clients before closing shop and making news with his farewell letter.

     The Greatest Trade Ever also has a particularly interesting section that lists some famous investors that actually lost big on attempts to predict crashes (including several that led to suicides) - "History is littered with legendary investors who gave in to temptation and rode financial waves to their ruin, or attempted gutsy maneuvers to profit from what they viewed as inevitable crashes, only to suffer humiliating losses that sometimes haunted them for years."

     Best selling author Michael Lewis's equally fascinating book The Big Short was released about 4 months after Greatest Trade. Lewis' background and connections from his early career at Salomon Brothers (chronicled in Liar's poker) and his outstanding story telling make him a perfect author for the story. The Big Short also features Paulson, Burry, and Lippmann, but adds additional background and players. An excerpt from the book focusing on Michael Burry was included in Vanity Fair's April 2010 issue.

     Continuing the list of big winners, Lewis introduces us to (7) Banking Analyst Meredith Whitney (see also Doomsday?), (8) Steve Eisman (who only gets a slight mention in Greatest Trade), and (9 & 10) Jamie Mai and Charley Ledley. Like Burry, Mai and Ledley appear to have been very skilled having started with a $110,000 Schwab account which they multiplied numerous times by identifying incorrectly priced options and derivatives that could pay off huge. Their first big hit was turning $26K in Capital One options into 526K, then 500K in UPC options turned into $5 million, and another 200K bet multiplied to $3 million. Within two years they had parlayed the $110K into $12 million before ever starting the big short.

     Classics in the book include comments about Chinese Walls, Merrill Lynch (you can get the gist from Larry Swedroe's Review) and some great quotes like "The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all." The Big Short also tops this list, but it's for it's frequent use of profanity.

     Andrew Redleaf (11) of Whitebox Advisors was another investor that predicted the crisis and made his clients significant profits. His book Panic: The Betrayal of Capitalism by Wall Street and Washington was released on 3/16/2010, a day after The Big Short.

     The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash was originally published on 3/4/2008 a few weeks before Bear Stearn's government sponsored purchase by JP Morgan (and obviously written many months before). The revised paperback was released on 2/9/2009 and renamed The Two Trillion Dollar Meltdown. I read the hard copy original after having already read most of other books discussed here. Meltdown is a relatively short book at 169 pages, is very readable, and is thought provoking regarding many aspects of the economic and political conditions leading up to the crisis. Morris at one point summarizes "In short, we are in a box with no good way out." Comparing the crisis with the 1998 LTCM crisis, he wrote "In 2008, there is no one to call a meeting, there is no conference room big enough to hold the parties, and no one knows who should be on the invitation list."

     Morris summarizes many positive and negatives about the US, and discusses some interesting topics like Sovereign Wealth Funds and the fact that American workers work longer hours than other advanced economies, but also have the highest output (aside from Norway). For the most part his points are on target although some discussions could have used some fine tuning. For instance Morris writes "The national average income of stockbrokers, for example, was $250,000 in 2005. (This despite the fact that their economic contribution may be negative, based on the mean performance of managed equity funds compared to unmanaged index funds.)" Stockbrokers are an easy target that I've commented on as well, but it's important to differentiate between the functions that stockbrokers provide that do add value (like providing best execution services, and investment advice to those that wouldn't otherwise have access to them) from those that don't add value (like speculative trading).

     Animal Spirits: How Psychology Drives the Economy, and Why It Matters for Capitalism by George Akerlof and Robert Shiller was published in January of 2009. The book disusses animal spirits and the role they play in economics. According to the authors, the term derives from the latin form spiritus animalis, with the word animal meaning "of the mind" or "animating." It refers to a basic mental energy and life force. But in modern economics animal spirits has acquired a somewhat different meaning; it is now an economic term, referring to a restless and inconsistent element of the economy. They discuss how manias and panics occur and argue that "The proper role of government, like the proper role of the advice-book parent, is to set the stage. The stage should give full rein to the creativity of capitalism. But it should also countervail the excesses that occur because of our animal spirits.

     In explaining the crisis they cite George W. Bush's comment that "Wall Street got drunk." Other interesting discussion include numerous observations from behavioral finance. Some excerpts include the following.

     Roger Lowenstein's book The End of Wall Street came out in 2010 about three weeks after The Big Short and Panic. One of Lowenstein's prior books When Genius Failed summarized the rise and fall of Long-Term Capital Management. That failure and rescue, in hindsight, foreshadowed the global financial crisis in numerous ways. Lowenstein does a particularly good job of highlighting some of the systematic problems that led to the housing crash including problems in the appraisal and ratings processes (see Lowenstein's article Triple-A Failure in NYTimes Magazine for more on that topic). But Lowenstein also points out that "Real Estate was the country's bedrock. But for many families the home had become something else: a casino."

     Lowenstein presents another perspective from (12) mutual fund manager Robert Rodriguez, who also predicted problems in advance and his investors did relatively well as a result (see Rodriguez Survey). Lowenstein's has an interesting footnote about the tendency of crisis to occur in 7 years cycles, attributed to Jamie Dimon and JP Morgan's 2007 annual report (the severe recession of 1982, the 1987 stock market crash, the S&L and commercial real estate bust of 1990-1991, the LTCM collapse (1998), the Internet bubble burst (2001) and, now the mortgage crisis). That point resurfaced recently in this Bloomberg article that looks ahead to 2015. Lowenstein brings the crisis moments back to life in detail in describing the stressful conditions and makes some observations like "During 2009, Secretary Geithner conferred with the head of either JP Morgan, Goldman, or Citi an average of once every two days."

     Another great discussion includes the following. "A generation invested a higher proportion in stocks, fed on the nostrum that risk was, essentially outmoded. Just as the fall of the Iron Curtain supposedly ended history, Wall Street's smooth rise through most of the 90's and the 00's was to have ended market history. (No more earthquakes-just steady gains.) The crash of 2008 spelled the end of that end. The prejudices of a generation, the conviction, repeated so often it had become gospel, that stocks were ever and always a sound long-term investment, smoldered into ash. In the aftermath of the crash, not only was the return on stocks negative over ten years, it trailed the return on government bonds for the previous twenty years. Indeed, stocks were barely ahead over a thirty-year time frame. The ramifications were profound. Portfolio allocations by individuals as well as by endowments, pension funds, and other institutions were rewritten. Society altered it's view of an acceptable level of risk."

     Many of the books also include stories about the big losers. Lewis notes that the international monetary fund put losses on U.S. originated subprime related assets at a trillion dollars. In addition to Lehman Brothers, AIG, Fannie Mae, and Freddie Mac, JP Morgan Chase took over Bear Stearns and then Washington Mutual, Bank of America absorbed Countrywide and then Merrill Lynch, and finally Wells Fargo and Citigroup fought over who would take over Wachovia.

     Several of the books discuss the conflict that some of the winners grappled with between making money while betting against the mortgage market and the implications for the country and individuals harmed by it. Effects of the Financial Crisis and Great Recession on American Households from Michael Hurd and Susann Rohwedder is a recent paper on that topic. Lewis discusses the difference between the profit motive and the logic of making the big short trades for hedging purposes, as in the banks and investors with exposure to real estate prices and mortgage assets.

     One of the reasons the crisis remains in the news is obviously because we are still trying to figure out what governments should be doing now to solve the remaining problems. That is the subject of plenty of other books on the list. I found Crisis Economics interesting because the authors make suggestions in addition to summarizing their interpretation of the causes of the crisis. They were apparently influenced by among others George Soros, Eisman, and bloggers Paul Krugman and Greg Mankiw (also linked from the home page). They also include some great quotes like the following.

     Crisis Economics and End Of Wall Street both point out the growth of the financial industry (similar to discussions on the Investment Costs page) in addition to the government role in contributing to the crisis (see articles and links for more on that topic). While Eisman offers his theory on Merrill Lynch's history of involvement in past crisis (in Big Short), Crisis Economics fingers Goldman Sachs and its decision to go public as a turning point and also skewers Citigroup.

     The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall St. by Justin Fox includes an in depth review of the history of the efficient market hypothesis largely from an academic perspective. Fox includes terrific information about the work of among others Irving Fisher, Harry Markowitz, Paul Samuelson, Gene Fama, Jack Bogle, Fisher Black, Richard Thaler, Ed Thorp, and Andrei Shleifer. While clearly not focused on the crisis, Myth is included on the main list because market efficiency (or lack thereof) remains a suspect in contributing to the financial crisis, plus it includes a terrific Epilogue titled "The Anatomy of a Financial Crisis" culminating with a Robert Shiller meeting in September 2008 prior to Lehman Brothers bankruptcy.

     There have been many that claimed to have predicted the housing crash in advance. Some of those claims appear to have some supporting evidence, but some of them also started predicted the crash long before the peak of the bubble, and thus saw prices rise significantly before turning down. John Talbott's book The Coming Crash in the Housing Market was published in 2003 and I recently picked up a copy. Talbott has a solid background including a fairly long career at Goldman Sachs and the book is very readable. It's interesting to scan the Amazon reviews chronologically given that this book was several years premature in predicting a housing crash. In 2003 the book helped to ignite the debate on valuations, with many agreeing that prices seemed high. But over the next few years, prices rose sharply leading many reviewers to conclude his primary prediction was off base. Yet following the crisis, others later claimed he got it right. I think Talbott did a good job of discussing many issues related to housing prices including interest rates, consumer debt levels, price to rental ratios, prices relative to income levels, as well as life priorities like family and material possessions. Talbott also took aim at Fannie Mae and Freddie Mac from several angles, making an argument that proved to be on target. Some have suggested that calling for a crash in 2003 bordered on sensationalism, but Talbott was not the first and cites many prior articles with similar predictions.

     By 2006 residential real estate prices had risen significantly in most parts of the country despite prior predictions from Talbott and others. At the start of that year Talbott's follow-up Sell Now!: The End of the Housing Bubble was published. In it Talbott admits to being angry and discusses why eight theories about prices at the time failed to explain the boom. He starts with an interesting comparison to Japan's prior experiences and documented that the wealthiest communities experienced the greatest price increases. Talbott also persuasively argued that the impact of the bubble bursting would be dramatic. A few excerpts from the book include the following.

     With How to Profit from the Coming Real Estate Bust I believe John Rubino qualifies for having predicted the crisis, although (like Talbott) he was "early" (the book was published in 2003 and calling for a recession in 2004). Rubino wrote for instance, home owners were treating their homes like piggy banks, borrowing against home equity to maintain lifestyles, which "boosts the economy but causes us to incur debts that will soon force us to stop spending. The result will be a deep recession." He discussed many of the same issues highlighted by some other individuals that predicted the crisis including the rise in home ownership rates, the growing debt, and Hyman Minsky's research.

     For investors a critical question is whether the fundamentals have changed to suggest that the historical data no longer applies. Given that we've had a relatively anomalous period of low stock market returns, it's a legitimate question. Yet there are also plenty of studies that show returns following crisis tend to be strong which is consistent with the idea that you should buy when their is blood in the street. In Investing during crisis, Eric Tyson referenced John Templeton who stated "Bargain hunters embrace the timeless lesson from history that crisis equals opportunity."

     On the other hand, in The 11-Year Itch: Still Stuck at Dow 10000, Jason Zweig points out that "investors need to remember that stock markets can go nowhere for ages, as they did in the U.S. from 1929 to the end of World War II, in Germany from 1900 through 1957, and in Japan since 1989."

     Laurence Siegel notes in Black Swan or Black Turkey? (in the July/August 2010 issue of The Financial Analysts Journal) that "From 1 January 1969 through 28 February 2009, the S&P 500, including reinvested dividends, had a slightly lower total return than the Ibbotson index of long-term U.S. Treasury bonds (on the basis of data from Ibbotson Associates [now Morningstar]). Forty years and two months is a long time to wait for the equity risk premium to be realized, only to be disappointed with a realization marginally below zero. (Because of the subsequent fast recovery in the stock market, this condition did not last long; but stocks are still underperforming the long bond over historical time horizons lasting decades.)"

     There are plenty of bears out there, but I'll end with this. Professor Jeremy Siegel remains a bull and Laurence Siegel concludes his article with the following - "I am pretty sure that global growth will continue to surprise on the upside, but not with low volatility and not because of macroeconomic policies but despite them. Growth will happen because people, left to their own devices, will do almost anything they can to make better lives for themselves and their children." (See also Siegel Survey.)

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