Conundrums Lead to Investment Opportunity

November 1, 2007

In Alan Greenspan’s most famous market commentary, he merely hinted at the possibility of irrational investor exuberance. The ensuing far more irrationally exuberant behavior in the stock market was surprisingly ignored by Greenspan, at least publically. 

His second most famous market commentary centered on the 2005 bond market. Greenspan testified before Congress that the flat yield curve with low long-term interest rates around the globe was a "conundrum". Normally, ten-year interest rates are higher than two-year rates - sort of a reward to the lender for locking in a fixed rate for so long. Greenspan explains:

“…But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum….”

Now here's the Greenspan to English translation:

“What kind of moron would lock up his money at 3 ½% for ten years?”

Maybe Greenspan would have referred to bond market investors as being irrationally exuberant, but his choice of phrasing garnered too much attention and now has decidedly negative connotations. 

Irrational exuberance means "giddy to the point of stupidity". Investors should have been concerned about 100 P/E ratios on tech stocks, but they were too busy being exuberant over double-digit revenue growth and triple-digit stock price growth.

A "conundrum" is something that simply doesn’t behave quite as it should – a riddle with no correct answer, just an abundance of opinions. Perhaps a conundrum is merely irrational exuberance-lite. At exactly what point does a bond buyer become irrationally exuberant? There was a brief spell in 2003 when a ten-year U.S. government bond yielded only 3.10%. After taxes and inflation, this was likely a no-return investment – and not just for a few months or years, but for ten years. 

Maybe the world merely created more wealth than investment opportunities. Or perhaps bond investors were irrationally exuberant. Certainly, the low rates on ultra-safe bonds increased the desire to make not-so-safe mortgage loans at 5%-6% - the rate of safe government bonds just a few years before the irrationally exuberant bond era.

Only requiring a low interest rate on a somewhat high-risk loan is the irrational exuberance equivalent of buying a growth stock with a 100 P/E ratio. With the 100 P/E ratio stock, you're ignoring the substantial risk that the company won't grow quickly in the future, which could lead to a 90% plus stock price drop, in order to focus almost exclusively on what will happen if everything works out swimmingly. 

Lending someone money at 5% to buy a home that has doubled in price in recent years says you're not that focused on the possible risks, mainly 1) the home securing the loan could lose value until it's worth even less than the loan itself, thereby turning your asset-backed loan into a semi-asset-backed loan, 2) the buyer can’t make the payments, and resolving the issue take months or years and leads to losses for the lender.

Another risk that's fallen off the radar in recent years is the concern that a mild panic might make the loan completely impossible to sell at a price anywhere near its value – for example, a $10,000 adjustable rate loan paying 6% might be worth only $5,000 today. 

For  all the talk today about the great housing crash, payments are still being made on many loans backed by homes. The trouble is the securities that are pooled mortgages are just near untradeable – they are priced as if about half the portfolio will be in default in a year or two, and that very little in the way of assets will be recoverable when the payments stop.

How investors – mostly big institutional investors who supposedly think rationally and are trained in all things Finance - believed mortgage loans could lose 20%-50% of their value in just a few weeks is the real conundrum when the risk in housing lending has been inching up for years. It also gets us thinking about some possible out-of-favor investing we could do in coming months based on how irrationally paranoid these investors become.

Nobody has been down on housing more than us. But if a loan falls in price 50% - even a crummy subprime loan – at some point, you have to consider it a worthy risk. It wasn’t that long ago that investors wanted nothing to do with the Nasdaq, (it did plunge from 5,000+ to just over 1,000 in 2002) and yet today we’re back to minting dot com billionaires. It's considered completely normal for a company to buy a stake in an Internet content company that's just a few years old with a valuation of $15 billion on the startup, as Microsoft just did with Facebook.

If a pool of subprime home loans falls 50% in price and payments are still being made on the loans, then the effective interest rate you earn goes from perhaps 6-7% to 12%-14%, certainly a yield worth taking a little risk for. It gets better. Let’s say the home behind the loan falls 50% in price. If the homeowner stops making payments, you’ll still recover your investment at a rate of 50 cents on the dollar.

The only way such a pool of loans could really hurt you is if the post-real estate crash equity fell to under 50 cents on the dollar and everyone stopped making payments on the loans. As doom and gloom as we’ve been on this issue, this scenario seems a bit unlikely. All is not gravy, because second lien (home equity) loans might have no equity at all if the home's value falls even 10% (assuming the 1st lien loan is for 100% of the home value post-drop). But even then, a full half of the borrowers would have to stop making payments before your yield drops to what you could earn in more reasonable risk bonds.

Anyway, we’re sniffing around the mortgage wreckage. We might be a bit early. It could get worse (and will get worse for home prices). But anytime we hear that nobody wants to own something, we really have no choice. That’s how we roll – rationally exuberant. Stay tuned.