The Curious Capitalist, Justin Fox, Economy, Markets, Business, TIME

Foreclosure Lite, Or Losing the Home You Bought With Nothing Down

If you've read anything about business in the last couple of months, and I'll work under the assumption that almost all the readers of this blog have to avoid repeating all the sordid details, you know about the subprime mess. The basic story line goes like this:

Irresponsible and unscrupulous bankers offered borrowers loans at high rates, or low rates (in the form of ARMs, or Adjustable Rate Mortgages) that would reset to high rates after a while. Now those borrowers, especially the ones whose ARMs have reset, can't pay. Many of them are in danger of losing their homes.

All of this is absolutely true. But I'm going to do something dumb here and step on the tracks in front of this fast moving train to pose a question about this story line. I want to ask what kind of responsibility the borrowers bear in all this. And I want to ask what exactly some of these unfortunate borrowers are losing. Some people are going to say that I'm an apologist for the worst brand of mortgage lenders. I don't think I am. But keep reading.

The thing that has struck me about every story about the subprime mess is that almost without exception the borrowers the stories cite put zero down on their homes. There are some people who might say that putting down no cash and getting a high interest loan to buy a home is irresponsible. I'm not one of them. In fact--oh, and it's embarrassing for a financial writer to admit I didn't know this, but it was a long time ago, and it wasn't nearly as common than--if I'd known that I could buy a house with zero down back in 1999 or 2000, I probably would have done that instead of waiting several more years until I had a down payment.

But a buyer who puts nothing down on a house and gets an adjustable rate mortgage is not really like a buyer who puts down, say, 20 percent with a fixed mortgage. There is a much bigger speculative side to what he is doing. If prices rise, he can gain a lot without having invested any of his own money. But if prices fall and he can't sell before the rate changes, he is taking a bigger risk. In a few cases--people who put nothing down and got interest only mortgages--the "buyers" are in some ways not really buyers at all, but more like renters who stand to gain a lot of money if the property appreciates.

I don't expect the average home buyer to understand all the ins and outs of this. One real estate lawyer I spoke with recently points out that many, if not most, buyers these days simply walk into a mortgage brokers' office and ask "How expensive a house can I get a mortgage for?" and then look for ... well, that house. It seems to me that in making a big financial commitment, even ordinary people have some responsibility to exercise the least bit of reasonable care. If you earn $5,000 a month after taxes, and your mortgage broker says that he can get you an ARM, but that when it resets your mortgage payments will be $4,000 a month, you don't need a degree in advanced math to ask, "Wait a second, can I really afford this?"

In many cases, the borrowers who took out high interest loans didn't do this. In others, it's quite clear that they couldn't afford even the initial payments.

But my interest here is not in beating folks who are in a financial jam over the head and telling them it's their own fault. The fact that buyers could have thought things through better doesn't mean we should have no sympathy for their plight. But I'd temper that with this observation: losing your home sucks no matter what, but it sucks a lot less if you didn't need to put any cash down to buy it.

If you put down nothing on a house, that doesn't mean you're willing to lose it. But it's just not the same as losing both your house and your life's savings with it. Lose a house on which you've put zero down and you're back where you've started. It's "foreclosure lite."

I know some people will say, "But your credit record is ruined." And indeed, for some years it is. But these days having a bad credit record means you're just in pretty much the same boat as people with good credit records were two decades ago: instead of being able to get a house with 5 percent down or zero percent, you need to actually have a down payment of 20 percent. To put it even more bluntly: the expansion of mortgage options, including even those devilish ARMs, has meant that people with lousy credit records can get a house on the terms as good as (and sometimes better) than those available only to those with good credit in the past.

Are ordinary buyers aware of all this? I think some of them are. Because not every borrower who took out a subprime loan or an ARM is now facing the poorhouse. You can even imagine that there are buyers who took out high interest or adjustable rate loans with zero or just five percent down in states where housing prices went through the roof and did very well. Actually, I don't need to imagine that: I know a couple of them.

Is that typical? Not necessarily. Maybe not. Without question, many more of these loans were made at the peak of the housing market than early on, as the market was just ramping up. But that doesn't change the fact that the biggest losers in the subprime mess are often not the borrowers, but the holders of the loans.

You'll notice I said "holders of the loans" rather than "lenders." Sometimes these are in fact the original lenders. In other cases, the lenders managed to "securitize" these loans and palm them off on investors like hedge funds. The bottom line is that it's those lenders and investors, not the borrowers, who are taking the biggest financial hit from these failed loans.

There are two caveats here I should include. One is that it is absolutely a problem when lenders--Countrywide comes immediately to mind--made preposterous loans knowing that other banks and investment funds would take them off their hands and face the consequences when buyers couldn't pay. If the originator of the loan doesn't carry the risk, they have little incentive to worry about whether the buyers will be able to pay it back.

Another caveat is that I'm also not talking about the bottom feeder lenders who found struggling, often elderly, people who had houses that they owned free and clear and persuaded them that they could solve their financial problems by taking out high interest mortgages on their fully paid for homes. Now some of those borrowers risk losing everything. The only appropriate policy in dealing with those lenders is one that ensures that they will burn in hell. But con artists who've found ways to snooker the elderly out of their homes are not a new thing. They existed before the subprime mess and unfortunately will continue to exist in the future.

I said earlier that my point was not to hammer the folks who are getting kicked out of their houses because they can't make the payments on their subprime loans. Nor, I'll add now, is it to garner sympathy for, say, the unfortunate investment funds that bought up these loans; I don't think anybody should be throwing coins into those cups.

But what I do want to do is ask whether those who would rush to protect future borrowers from subprime loans might not be advocating solutions that will have unintended and unpleasant effects. Remember this: A borrower with no money to make a down payment who takes out a loan at 12 percent and can't pay it winds up with no house. But the person who can't get a loan because he has no money for a down payment has no house to lose in the first place.

As I said, I expect that some of you will think my take on this is wrong, or even evil. If yours is different, then please do go ahead and send in your comments.

You Too Can Make 40% A Year

... as long as you don't mind losing everything every once in a while. The thought occurred to me as I read the profile of hedge fund manager Victor Niederhoffer in the New Yorker this week. As the profile was being written, Niederhoffer's flagship hedge fund blew up. And this wasn't the first time. Niederhoffer, a man who is probably not one of the great money managers of all time but might be one of the great self promoters, has had this happen before.

It may surprise you to know that there are well known investment strategies that in most years can create gains that will beat the stock market by miles. These strategies are not obscure. The problem is that when they fail, they leave you subject to catastrophic losses. You can find one such strategy described in this paper. The paper uses an example developed by one of its authors, economics professor Andrew W. Lo of MIT, of a fund called (I love this) Capital Decimation Partners.

For those interested in the details, Capital Decimation Partners' strategy relies on shorting certain stock options on the last day of the month, just before they're about to expire; you can find out more from the paper. This strategy yields returns of close to four percent a month. That sounds awesome, and indeed would be awesome, except for one little detail: every once in a while--and there's no way of predicting when, it can be after ten years or after one month--the strategy will go wrong, and results in a huge loss.

One natural assumption when you look at a hedge fund manager who loses a ton of money is to say, "Well, he blew up now, but he made a lot of money earlier." But that doesn't really work so well.

If you make 100 percent in a year and lose 50 percent you might think you've made an average of 25 percent. Actually, you've made zero percent. Not convinced? Start with one dollar. Add 100 percent. Now you've got two dollars. Now take away 50 percent. You're back to one dollar. Or, worse: take that 100 percent gain. Now imagine you lose 100 percent of your money. Now you get it. No matter how much money you've made before, after a 100 percent loss you're left with zero dollars.

Really sophisticated hedge fund investors understand that big losses are very hard to recover from (and if you've lost all your money, there's no percentage gain big enough to get you back from zero). This is why they look not just at how much a fund makes, but insist on seeing how much capital it has at risk. And they still often get things wrong.

Do I know if Niederhoffer was pursuing a strategy that, like Capital Decimation Partners', would impress investors only if they didn't understand the risks? I have absolutely no idea. He doesn't really tell the New Yorker's John Cassidy enough about his approach to know. I do know from the story that a guy who worked for Niederhoffer had some odd thoughts about how to evaluate Thailand's economic prospects:

Keeley believed that assessing a developing country’s economic prospects involved not only meeting with the C.E.O.s of leading companies but studying the lengths of discarded cigarettes—the theory being that the wealthier people are, the longer their butts—and the state of the brothels. After a couple of months in Asia, he reported to Niederhoffer that the brothels in Bangkok had recently become much cleaner and safer, and that Thailand was an excellent place to invest.

But that's neither here, nor there. It's also icky (that's not a term of art in economic analysis, it's just really the only word that comes to mind). I wish I knew more about how Niederhoffer's analysis of the markets worked. But hedge fund managers are notoriously secretive about this. Sometimes that's because their quantitative tools contain really valuable insights. But sometimes it's because letting folks see how they come up with big returns can also reveal the scary risks they're taking. Sometimes it's a mix of both.

Like I said, I've got no idea of the quantitative aspects of Niederhoffer's particular approach. But whatever it is, it's worth noting that the key to running a hedge fund is not just getting outsized returns. It's to do it without blowing up every few years.

Victor Niederhoffer Bonus Round: A friend, journalist Ilan Greenberg, points out that Niederhoffer seems to leave the implication that his child with his girlfriend (not to be confused with his wife) was unplanned. Says Niederhoffer:

We didn’t have in mind the ultimate outcome, but we created a fantastic legacy—the baby, the books, and the articles.

Niederhoffer's son is one and a half, and his girlfriend 53. I'm not really sure if by not having in mind the ultimate outcome Niederhoffer actually means that he hadn't expected the pregnancy. Greenberg asks if an unplanned pregnancy is even possible at that age. In a word, no. You don't even need to be a hedge fund wizard to do that bit of quantitative analysis.

Now we know: telecom kingpin Joe Nacchio believed more than anybody else in his company's future. Yeah, right.

Former Qwest CEO Joseph P. Nacchio, convicted of insider trading charges in April and sentenced to six years in prison, is appealing his conviction, the Journal reports.

Full disclosure here: I reported on Nacchio's shenangans at Qwest for Fortune in 2003, so I'm not unhappy to find the Joe Nacchio saga come to a conclusion with some kind of justice (read: see Nacchio go to jail). Still, the details of the Nacchio prosecution in some ways made me wary. The government's theory that a CEO is subject to insider trading charges for witholding or misrepresenting material information--the same principle applied to Ken Lay and Jeff Skilling at Enron is an aggressive one, and stretched irresponsibly can put a lot of CEOs in jeopardy for statements that are merely optimistic.

Nonetheless, any qualms I might have had evaporated when I read this startling bit of revisionism in Nacchio's appeal:

Many shareholders lost paper fortunes, employees lost jobs as the company downsized, and all demanded someone to blame. That person, it turned out, was the man who built Qwest into a telecommunications giant, and who, despite the vicissitudes of the stock market and the economy, believed more than anyone else in the company’s future.

Let's unpack this. First, "the man who built Qwest into a telecommunications giant." This is preposterous. Qwest still exists for one reason only: Nacchio was sufficiently savvy to use Qwest's vastly over-hyped and inflated stock to buy the Baby Bell US West, a real telecommunications giant. The business that Nacchio built--Qwest's original wholesale telecom business--was a mirage, kept going only through a series of deals in which Qwest signed contracts to buy services from companies that repaid the favor by buying from Qwest, creating the illusion of real revenues. Without the US West purchase, Qwest would have gone bankrupt just like the similar Global Crossing.

Second, there's that "believed more than anyone else in the company's future." Now you can't really quantify belief ... oh, sorry, you can. A good way to do it is to look at how much stock a CEO sells in the company he runs. Some CEOs sell a little stock. Some, and these are the CEOs who believe in their companies "more than anybody else," buy stock in their companies. Joe Nacchio wasn't one of them. Before Qwest's stock went through the floor, Nacchio managed to sell enough stock to put $260 million in the bank. He sure didn't believe in Qwest as much as the investors who were taking that stock off his hands.

Maybe those investors should have watched what he was doing instead of what he was saying. But the fact that in the telecom frenzy Nacchio managed to fool people into thinking that a CEO might "believe" in his company while frantically "diversifying" his portfolio out of its stock isn't a good reason to fall for the same tired line now.

(Thanks to the Journal for posting the full text of the appeal.)

400 Years of Corporate Scandal: An Anniversary

I wanted to do an item about the economics of exploration on Columbus Day, but now it's two days late, and I'll take advantage of another, related anniversary: 400 years since the founding of the Jamestown Colony in Virginia.

Yes, that was a long time ago. I wouldn't stop the presses for this either. If you just want to get the latest on the Chrysler strike or the stock market, you can press the "Back" button on your browser. Fair warning.

You might remember learning that the Jamestown colony was founded in 1607 by settlers who were funded by a group of investors, the Virginia Company of London, one of several mercantile groups (the British East India Company was another that hoped to make money in the exploration business). But you never get to hear much more about it and that might leave you wondering--okay, it maybe not, but it left me wondering--what ever happened to the Virginia Company? As in, "Why don't they still own Virginia?"

You might assume that in the natural course of things the crown would have realized that putting the new empire in private hands was a bad idea. But that's not really the answer. What actually happened was that the a disastrous battle with Indian tribes in 1622 that destroyed a part of Jamestown known as "Martin's Hundred" led to an outcry in Parliament and a royal investigation. The outcome of this was to show that not only had 347 colonists died in the Martin's Hundred massacre, only a fraction of the thousands of colonists shipped to Virginia were still alive.

A Library of Congress capsule history summarizes the investigation's conclusions:

Since 1606, approximately seventy-three hundred emigrants have sailed for the colony, and 6,040 have died either en route or after arrival. However, the Privy Council argues that that the colony has had a net increase of only 275 people since its founding. The colony suffers from chronic food shortages and seems unable to get a subsistence from its own efforts.

I've seen some other numbers on this, but they are in general agreement that a stunning majority of the colonists who tried to settle in Jamestown were dead within a few years. Among the reasons for this were the Virginia Company's desperate efforts to make the colony profitable by mandating the planting of tobacco instead of food. Director Terence Malik's 2005 film The New World gives you an appropriately harrowing picture of the conditions. (You'll notice that the quote above says 1606 while the colony was founded in 1607. That's because the first batch of settlers set sail in 1606 and landed in 1607.)

The outcome was that the Virginia Company's charter was revoked in 1624 and the colony was put under the administration of the crown. The investors lost their money. I wouldn't use this to make any big conclusions either about private versus government services or about the dangers of pouring money into the hot investment idea of the moment. But it is worth knowing that disastrous corporate meltdowns have a very, very long history.

Lazy Sexy Money, Or Why the TV Rich Don't Work

Writing about economics gives me plenty of chances to zig when everyone else zags. The rest of the blogosphere is going to be telling you about last night's Republican debate. So I'll talk about what's on TV tonight: Dirty Sexy Money, the new ABC show about the mega-rich.

Yes, I know. This probably means my Serious Journalism License will get taken away. Fine, I'll just keep practicing without a license.

For those of you haven't seen it, the show is about a lawyer who takes over his father's practice representing "the Darlings," the country's richest family. There's a possible murder, too, but let's not go there right now.

From the point of view of a column about the economy, one thing that's interesting about Dirty Sexy Money is that at least in the first two episodes you don't get to find out where all that money comes from. That might be because the creators noticed that, on a deep level, we'd rather not worry about it.

The Darlings' fortune is just there, like the Kennedys' money (Ever thought about where that's from? Probably not so much.) Usually when TV does the mega-rich, you know how the fortune was made--Dallas, oil; Falcon Crest, wine; CBS's new Cane, sugar--but you don't really see the characters visiting any oil wells or stomping grapes. So it's actually refreshing to have a show that dispense with the whole business of labelling the source of the cash and just says "Who cares?"


A promo for Dirty Sexy Money--and no, ABC didn't pay to put this here

But it's worth thinking about why TV's ultra-wealthy don't do much professionally but have affairs with each other, musical chairs style. You could speculate it's because how they make their money is not that interesting, but that's just not true. There's a lot that's absorbing in how fortunes are made, and you can see that play out in movies like Wall Street or even Trading Places--the latter, by the way, counts as one of my favorite business movies and slyly parodies the real story of how the Hunt brothers tried to corner the world silver market. You don't get to find out much about how Gatsby makes his money in The Great Gatsby, but you do want to know. In Leo Tolstoy's Anna Karenina, you get to know about every last ruble of Prince Oblonsky's fiscal ups and downs.

Nor is this really a fair depiction of the lives of the rich. Clearly many of them work hard--even if occasionally, as with Bill Ford, the more they work the more millions they manage to lose.

Now, it could just be a convention that the super-rich don't bother to work is just one of those TV things, like the convention, before Married With Children and Beavis and Butthead that no one on TV watched television.

I'll bet, however, there's more going on. I think the writers of Dirty Sexy Money and other shows about the rich have noticed that idleness is one of the great taboo fantasies of American life. It's a desire that dares not speak its name. It's more common, more illicit, and just as strong as the fantasy of power. Wanting to run things is a fantasy you're supposed to have. Wanting freedom from responsibility is a fantasy you're not.

As far as I know, no national survey has asked people "What would you do with a billion dollars?" but if one did, the response "Leverage it to take a controlling stake in a large corporation," wouldn't make the top five answers.

There are lots of surveys that have asked people how they feel about work, but that's a tricky question. There's a lot of social pressure to say, and maybe even to think, that your worklife is pretty good. In this poll by the Pew Research Center, 89 percent of Americans said that they were entirely or mostly satisfied with their jobs. That's a number so high that it may tell you more about how folks answer surveys than about what they really think. Or it might mean that the bar for counting a job as "satisfying" is low. I mean, 89 percent? That's higher than the percentage of people who love their mothers.

People say they like work, but they also (I rely on that same Pew survey, but you probably don't need a poll to tell you this) think that work is harder, less secure, and more stressful. I'll speculate here and say that, just between them and the TV, more people want a life of leisure than want to run a company. That might even include some of the folks who do run companies. In theory, we want the rich people on TV to have a job. But we don't really want to go to the office with them.

About The Curious Capitalist

Justin Fox

Justin Fox is TIME's business and economics columnist. This is his blog.  About the Authors


Mark Gimein

Mark Gimein is a business journalist whose work has appeared in Fortune, New York Magazine, BusinessWeek and the New York Times. He is guest blogging beginning 10/8/07  About the Authors


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