Bailout Nation (18 page)

This last point is critical. If you want to know how home foreclosures in the United States led to massive economic disruptions worldwide, you need to understand the relationship between ultralow rates and the bond buyers. The Greenspan Fed's radical rate policies tossed the arcane world of bond fund management into turmoil, and the net result was all sorts of unexpected consequences that continue to be felt to the present day.

B
efore proceeding much further, here are a few brief words about how fund managers handle capital. There is an enormous amount of money run on behalf of large foundations, endowments, pension funds, and charitable trusts. The professionals who manage money for these institutions are constrained by some basic money management principles. Foremost among these is the payout requirement—the minimum distribution of money that these organizations must pay out each year. Each fiscal year, trusts and foundations must spend or give away 5 percent of the average market value of their assets. Failing to do so leads to heavy penalties (2 percent of assets), and the possible loss of their advantageous tax status.

This is why any professional money manager who is handling capital for these organizations wants to
safely
generate sufficient income to cover the 5 percent payout obligation. Foundations want to leave the trust corpus untouched, spending or giving away only their income. A well-managed trust should last a very long time, if not forever.

I will spare you the gory details, but it is accepted asset management theory—backed up by mathematical analysis—that over the long run, market returns eventually revert to their historic means. This basic assumption is built into models that fund managers use as the basis for their asset management plans. For stocks, expected returns are 8 to 10 percent per year. For fixed income, it's about half of that—between 4 and 5 percent returns from long-dated Treasuries. These are reasonable long-term goals, based on a century of inflation, interest rates, market returns, and other factors.

Hence, ultralow rates caused tremendous angst and consternation among fixed-income managers. They simply could not generate the needed returns when the Fed had driven rates so absurdly low.

Without some other higher-yielding, yet safe fixed-income option, the trust corpus was likely to be breached.

While market shocks occur from time to time, they tend to be within a certain measure of normal variance (mathematicians call them standard deviations). Major events that are a few standard deviations from the mean cause markets to briefly wobble, but they invariably return back to their prior trend. We saw this during such significant events as World War II, the Bay of Pigs invasion, the Kennedy assassination, the 1987 crash, the 1990 Iraq invasion of Kuwait, and the September 11, 2001, terror attacks. These were all very significant
human
events, but in terms of markets, they were actually rather minor.

Indeed, these earth-shattering events barely register as a squiggle on the long-term stock charts.

None of these events were as fundamental to the bond markets as what Greenspan did. When the Fed took rates down further and held them lower for longer than ever before, bond markets rallied and yields were decimated. (Bond yields move in the opposite direction of bond prices.)

Hence, Greenspan induced a mad scramble among the bond crowd. The housing boom played right into this dash for fixed-income returns.

W
hile fund managers were scrambling for yield, the ultralow rates simultaneously set off the biggest housing surge since World War II. In the 1980s, annual home sales averaged about three million units. That rose in the 1990s to between four and five million transactions, thanks to both population growth and declining interest rates. The 1990s bull market in stocks created plenty of paper wealth, and that too soon found its way into the real estate market. Housing prices had been in a bit of slump from the 1987 crash to the mid-1990s. Once rates fell after the 2000 tech-stock crash, however, the real estate market exploded: Prices nearly doubled from 10 years earlier, and total units sold went from under four million in 1995 to over seven million houses in 2005 (see
Figure 9.1
).

That meant lots and lots of mortgage financing.

The rate cuts that were fueling the real estate boom were wreaking havoc on pension fund managers' portfolios.

If they could not find additional rate of return (
and quick!
), their clients would have to tap the permanent fund corpus—meaning use some of the principal to make annual payments. To any trustee, that was unacceptable.

Figure 9.1
Housing Sales

SOURCE:
www.calculatedrisk.blog.com/

The answer to bond fund managers' prayers was found in an innovative structured product: securitized debt. Wall Street could take all manner of debt—credit cards, auto loans, mortgages, student loans—and repackage them into new bundles of new paper. Collateralized debt obligations (CDOs) paid out
significantly higher interest rates
than either U.S. Treasuries or blue-chip corporate bonds. And thanks to some Wall Street razzle-dazzle, they were
all triple-A rated
.

Most fixed-income products come with a grade from one of three major rating agencies, Moody's Investors Service, Standard & Poor's, and Fitch Ratings (more on them later). Investment-grade ratings include AAA, AA, A, and BBB. Non-investment-grade debt—also known as junk bonds—are ratings given to debt that is more economically sensitive, or whose finances are less stable, or that is highly speculative.

Triple-A is the most creditworthy rating; this grade is only given (in theory) to the highest-quality borrowers, such as the U.S. government and top companies like Johnson & Johnson, Northwestern Mutual, Berkshire Hathaway, and Exxon Mobil.

About now, you might want to ask yourself how this was possible: How could U.S. Treasuries be rated triple-A, and these CDOs also be triple-A rated? How could there be such a significant spread between the yields of the two assets? Doesn't the higher-yielding product involve more risk? If yes, why did CDOs have the same credit rating—essentially, a measure of a debt issuers' ability to pay its obligations—as bonds backed by the full faith and credit of the U.S. government (and 86th Airborne, if push really comes to shove)?

If not, isn't this a free lunch?

There really are only two possibilities: Either this was a brilliant heretofore unrealized insight or it was a massive fraud.