Succeeding Through Market Bubbles for the Philosophical Investor

China Export

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Chinese Lending Practices

I am reading with some fascination the incredible excesses that have been taking place in China with regard to terrible lending practices and widespread fraud. The unregulated banking system is clearly running amuck in China. Here is a very interesting link from Mish’s Global Economic Trends highlighting the massive problems unfolding with regard to loan guarantees not to being honored. Interestingly, one of the major problems in our housing market collapse was the inability of mortgage insurance companies to make good on their guarantees to cover some of the losses of lenders who made larger loans than they otherwise would and led to more people being able to buy and prices inflating market bubbles. This created huge problems for the financial system when they defaulted on their obligations. Given this terrible experience, the regulator for Fannie Mae and Freddie Mac just announced that mortgage insurers who want to be accepted by Fannie and Freddie must have significantly higher capital. This necessitates the need to raise more money, lowers the returns available to investors unless the cost of the insurance is raised quite significantly. This is another structural headwind for housing and should favor renting. Here is the link to the Bloomberg article.

“Radian said it would need about $850 million to meet the standard now and expects to be able to comply within a two-year transition period allowed under the rules. Milwaukee-based MGIC didn’t provide a figure and said it faced a “material shortfall.” Genworth Financial Inc. said yesterday that it may need as much as $550 million at its mortgage insurer by June 30, 2015, to meet the standards.”

The point of switching gears to the U.S. experience is to show that when companies making loan guarantees turn out to have underestimated the risks they were ensuring quite significantly, then they will most likely fail at some point with deflationary consequences to the asset class or classes it was insuring.

Back to China. Another example of financial excess is the huge fraud that took place in which loans were taken out based on collateral that was pledged for multiple loans as this article describes. Here is a brief synopsis:

Large banks and trading firms are frantically trying to determine whether they have fallen victim to a suspected commodities fraud emanating from the giant Qingdao Port in northeast China.

Citigroup and several other big Western banks are concerned that their loans may lack the appropriate collateral of big stockpiles of copper and aluminum at the port. The banks have inspectors on the ground who are trying to assess whether enough of the metals are there. The worry stems from suspicions that a Chinese company pledged the same collateral for multiple loans. Chinese authorities are investigating the matter.

It was announced on July 10 that Standard Bank has $170 million of exposure to the fraud.

Ultimately, I think this situation unfolding in China and which I’m sure will get much worse will continue to positively benefit U.S. real estate as more and more people seek to get capital out of China into a much more secure political, legal, and financial environment like the United States. There are some compelling economic reasons regarding succeeding through market bubbles, which I will revisit at the end.

Historical Economic Conditions in the United States – Late 1920’s and again in the 2000s

Before returning to China, however, I thought it would be interesting to go back in time when the United States was experiencing a very similar phenomenon of runaway greed, fraud, and exploitation of very unsophisticated investors….The 1920s….and then again in the 2000s with the subprime debacle.

Frederick Lewis Allen is one of my favorite financial historians. I absolutely love the three books I have read of his: Only Yesterday: An Informal History of the 1920s, Since Yesterday: The 1930s in America, and the one I just finished, The Lords of Creation. The book was written in 1935 and chronicles the rise of the financial class and how wealth became extraordinarily concentrated in the hands of top bankers, financiers, industrialists, and insiders who looted compliant and poorly organized shareholders. Sound familiar? Ultimately everything blows up with the crash of 1929 and the ensuing Great Depression. What is particularly fascinating to me is that so much of the carnage was still in place and being uncovered so the reader gets a pretty good feel of the enormous consequences when the captains of industry and finance focus completely on their own enrichment regardless of the collateral damage it causes in the everyday lives of the citizenry. The financial structures via holding companies and investment trusts were built on such a shaky edifice of incredible leverage that if the wind blew even one mile more than its current below average speed, then the house of cards would fall. And fall it did. I highly recommend the book and everything else Lewis has written. Every serious investor should read the three I have mentioned above.

Charles Mitchell rose to prominence as one of the most aggressive bankers during the roaring twenties. His bank lent large amounts of money to speculators to buy on margin and National City’s investment bank was all in during the market top, resulting in huge losses when it all came crashing down. Lewis spends some time in the book describing the meteoric rise to the top of Mitchell and what made him so successful. He was a remarkably talented individual. Lewis summed up his talents as follows:

“What had brought him so far in such a brief span of years? Inexhaustible energy, a restless imagination, a powerful faculty for concentration; that talent for organizing and stimulating the efforts of other people which we call executive ability; that specialized and commercialized variety of the talent for persuasion which we call salesmanship.”

Although he used his remarkable skills of persuasion and organization to capitalize on, foment, and exploit the frenzy that was developing for marketable securities in the late 1920s, the seeds were planted years earlier as the following excerpt shows:

“ONE day in 1915 or 1916 Charles Edwin Mitchell and Bruce Barton were standing together by a window in the Bankers’ Club in New York, looking down upon the city. Said Mitchell:

“Every once in a while one of our bondmen comes into my office and tells me he can’t find any bond buyers. When that happens I don’t argue with him. I say, ‘Get your hat and come out to lunch.’ Then I bring him up here and stand him in front of one of these windows. ‘Look down there,’ I say. ‘There are six million people with incomes that aggregate thousands of millions of dollars. They are just waiting for someone to come and tell them what to do with their savings. Take a good look , eat a good lunch, and then go down and tell them.””

This type of salesmanship and optimism is classic and reminds me of some of the practices depicted in The Wolf of Wall Street which preyed on people’s susceptibility to the allure of easy money and discarding discernment when easy dollars appear in sight. The combination of Mitchell’s tremendous talents and skills combined with the seemingly insatiable appetite for marketable securities in the late 1920s was a ferociously powerful and dangerous combination. The following description has striking parallels to the subprime mortgage bubble and the dot com days 80+ years later.

“Buyers were so easily persuaded and the sale of securities was so lucrative that soon there was a furious competition among investment bankers and the investment affiliates of the big banks to find concerns which were willing to put out bonds or stocks for expansion. The manufacturer did not have to go hat in hand to the bankers to ask their assistance; the bankers came to him, eager to issue securities for him and feed them out to banks and private buyers…The fruits of financial activity were so inviting that bankers began to operate with more and more regard for these fruits and with less and less regard for the effect of such activity upon the businesses involved. The feet of the gentlemen of Wall Street began to leave the hard ground upon which stood factories and shops; these gentlemen began to float higher and higher in a stratospheric region of sheer financial enterprise —a region of reorganizations and mergers and stock split- ups and trading syndicates and super-super-holding companies and investment trusts.”

We used to say at the height of the mortgage market bubble that Wall Street needed to start to manufacture borrowers in order to keep satisfying the global demand for its securities backed by pools of mortgages. More and more mortgages needed to be created to feed the beast. Of course, there were not enough qualified borrowers to take on those mortgages applying traditional underwriting standards in terms of down payments and credit history. Something had to give and of course, it was the standards as the gravy train was going full speed. They were loosened dramatically and the credit spigot was opened up at very high pressure. We all know the consequences.

Tremendous carnage was left in the wake of the excesses and abuses carried out during the late 1920s bull market. In fact, Wikipedia lays some serious culpability on Mitchell. This is how Wikipedia describes Mitchell:

“Charles Edwin Mitchell (October 6, 1877 – December 14, 1955) was an American banker whose incautious securities policies facilitated the speculation which led to the Crash of 1929. National City Bank’s (now Citibank) abuses under his leadership brought an end to ownership of investment affiliates by commercial banks.”

Glass-Steagall was a major component of the Banking Act of 1933 which prohibited commercial banks from owning investment banking and securities affiliates. This was done to prevent some of the egregious abuses like those spearheaded by Mitchell. The goal was to protect depositors from bank managements that could personally benefit by using the low cost, and ultimately federally insured, deposits of the bank to fund much riskier ventures in the securities industry while not sharing the same level of risk as other shareholders. Ironically, it was Sandy Weil who spearheaded the dismantling of Glass-Steagall, along with Alan Greenspan, Robert Rubin, and the Clinton administration. It’s ironic because Weil ran Citigroup, which owned Citibank, which was the offspring of National City Bank that was run by Mitchell and helped bring the U.S. economy to its knees in the 1930s.

Some shrewd students of history and human nature predicted that dismantling or watering down Glass-Steagall would ultimately lead to another financial disaster because the same abuses would occur. Although it was the shadow banking system that was not regulated by the Federal Reserve that caused much of the problems between 2005 and 2009, many of the large, regulated banks were caught up in the madness that was unfolding in the subprime world, much of which was fueled by their investment banking affiliates. Chuck Prince, who ran Citigroup during the heyday of the subprime bubble said the following in July 2007 in an interview with the Financial Times, “As long as the music is playing, you’ve got to get up and dance,” he said. “We’re still dancing.” Prince was saying that the bank was compelled to keep lending on very aggressive terms because global liquidity was so strong that any individual decision by a bank to tighten up lending standards would lead to a loss of business. There was enormous pressure to keep dancing. Prince was ousted in November 2007.

Wealthy Chinese Protecting Their Wealth by Investing Overseas – Succeeding Through Market Bubbles

As I mentioned earlier, much of what was cataloged above is happening in China. In the U.S. they try to put some of the fraudsters in jail. In China, they’re not afraid to execute them. This will not end pretty. This means there will be a sense of urgency among wealthy Chinese, and even less wealthy ones, to protect their wealth (and maybe their lives) by investing in assets overseas. The U.S. is a perfect place.  A Bloomberg article about Chinese buyers of U.S. properties shows how this is happening quite significantly now, particularly for residential properties in California. What really caught my attention and tells me that China’s values are based on pure speculation and it makes a lot of sense for the Chinese to move money here is the following:

“Even as prices climb, U.S. real estate remains a relative bargain for Chinese investors, according to William Yu, an economist at the University of California at Los Angeles’s Anderson School of Management.

Two-bedroom condominiums in Shanghai’s Pudong district cost about $1 million, almost twice as much per square foot as condos in West Los Angeles, according a report by Yu last month. The Pudong units command $1,400 a month in rent compared with $3,300 in Los Angeles.”

We observed similar head-scratching economics as we saw the cost of buying condos and homes in Southern California, Miami, Las Vegas, Phoenix, etc. versus how an investor would value them based on rental yields. It was clear that one had to bank on continued appreciation to justify such valuations. Eventually, the math won out and housing prices collapsed and owning rental properties became much more lucrative. The economics described above between Shanghai and Los Angeles are too far out of whack and my guess is the gap will close with Shanghai coming down far more than Los Angeles coming up, or the combination of the two. I can see Los Angeles showing continued, steady, modest appreciation while Shanghai comes down significantly.

This post attempted to draw some parallels between what is going on in China today and what we experienced in the United States in the 1920s and mid-2000s. The interesting question is why do such financial excesses come about. There has been a lot written about how multiple, powerful psychological forces come together in what Charlie Munger calls the “Lalapalooza Effect” to generate misjudgment on a massive scale with very negative consequences. What hasn’t been explored, however, until very recently is whether there are neurological responses that can make people become more susceptible to getting caught in speculative bubbles? If you missed last weeks blog please go back and read it because it addresses the speculative market bubbles.

One comment on “Succeeding Through Market Bubbles for the Philosophical Investor
  1. Pete Jantz says:

    Great blog as usual. Please remember to change my email address to:

    [email protected]

    so I’ll get your next blog.

    Cheers! Pete

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