The US housing market remains on federal life-support as recognition of the government’s housing liability will wreck its balance sheet
If there was ever any doubt that the US housing market was being artificially supported by the federal government, new statistics dispel this. A recent Bloomberg article, here, highlights how dependent the US housing market has become on federal assistance.
Fanny Mae and Freddie Mac, already financial wards of the state, may ultimately require $1 trillion dollars in federal bailout funds. This sobering statistic belies the very notion that the US housing market operates as an efficient, free-market enterprise, and that housing values are based on arms-length transactions.
The fact is, the housing market is currently anything but arms-length or free-market. Gross price valuation distortions have occurred within many asset classes in the last 10 years, including commercial and residential real estate. These distortions occurred for many reasons, but were primarily due to the near freefall of credit standards that now threaten our banking system. Easy money distorted prices, and now threatens the survival of hundreds, if not thousands, of banks.
Fannie and Freddie own or guarantee 53 percent of the nation’s $10.7 trillion in residential mortgages, and have sold $1.4 trillion in mortgage-backed securities to the Federal Reserve and the Treasury Department since the crisis began. The liabilities assumed by the housing giants remain off the federal balance sheet, an accounting fiction that grossly underestimates the government’s long-term debt exposure.
The fact remains that unless housing prices quickly rebound, a proposition that is highly unlikely, private investment in the securitized mortgage markets will remain anemic, at best. With home prices continuing their decline, mortgage default rates accelerating, and housing inventory increasing, the housing market will continue in virtual freefall.
Fueling this pessimism are recent reports, here, (WSJ) that home starts fell by 17 percent in May, and that the rental market has strengthened as the homeowner-renter calculus has shifted favorably to rentals. This subtle change in psychology will seriously challenge, for at least the next decade, the notion that homeownership is always preferable to renting. The US’s near-neurotic obsession with home-ownership is largely to blame for this mess, and lawmakers consider this issue the third-rail of politics. Fanny and Freddie were only able to increase the percentage of people who own their homes by significantly lowering credit standards, a fact conveniently ignored by housing market pundits and legislators.
The reality is that for many people, renting a home is the far preferable choice. This notion, though, would turn the “American dream” on its head, and become an admission of social and cultural failure. Americans have wailed over this home-ownership ideal for decades, and held it out as the gold-standard and benchmark to other Western societies. This ideal, though, has been revealed for the failure it is. The Wall Street Journal’s David Wessel recently examined the US’s housing mortgage-finance system, here, and concluded that the US has overemphasized the virtues of home ownership. He notes that Americans are addicted to a “unique and costly strain of mortgage, a 30 year fixed rate loan that can be paid off at any time without penalty.”
The coming months and years will see ever increasing delinquencies, defaults and foreclosures. Fanny and Freddie will continue to draw on ever-increasing resources for their survival. Lawmakers, facing re-election pressures this year, will continue to emphasize the broken ideal of homeownership for all. The Federal Reserve and Treasury will continue to print money and subsidize the vast homeownership machine. The market, though, may finally realize that there is no end in sight to federal support, and recognize that the housing giants’ liabilities have actually become liabilities of the federal government. This end to the accounting fiction will be painful, as recognition of this liability may ultimately downgrade the financial viability of the dollar and of the US government. Practically, there is no end to this quagmire. We’re stuck.

Michael Burry, who accurately predicted the housing calamity long before anyone else, offers insight into the behavior of crowds, and those that move against them.
Michael Lewis’ article in Vanity Fair, here, is a short tease for his new book, The Big Short, which exposes how Michael Burry, a hedge fund manager, accurately predicted the housing debacle far in advance of the actual crisis. The Vanity Fair article reveals how Burry single-handedly outmaneuvered Wall Street’s elite, and how this success has not ingratiated him to those he took to task.
Burry, a Stanford educated physician, is undoubtedly very smart, but this is not why Burry was able to see what others could not. It is Burry’s questioning, contrarian nature that led him to perform substantial due-diligence into as assumption that others had taken for granted: that housing was on an epic, sustained run that would never cease.
Burry’s story is a tale of two unique, if interrelated, phases. The first phase involved Burry’s tenacious slog through a thicket of documents, prospectuses and textbooks, looking for clues to the impending disaster and performing bank credit analysis on the home loans that he was analyzing, the same analysis that should have been performed by the issuing banks, but wasn’t. The second phase, convincing Wall Street to create financial products so that he could short the market, was pure genius.
Michael Burry’s analysis of the housing market and his conclusions are due primarily to his dogged due-diligence, pure and simple. This effort was nothing short of herculean in scope but otherwise unremarkable and tedious, and was the product of Burry’s tireless review of thousands of documents. Once completed, though, this due-diligence provided Burry the platform for the unshakeable faith in his ability to detect patterns and draw conclusions from within the housing bubble, and ignore the conventional and usually mistaken wisdom of crowds.
What did Michael Burry see in the housing crisis and what patterns and conclusions did he reach?

Burry began learning about the bond market early in his career, learning all he could about credit and how America borrowed money.
He then began learning about subprime-mortgages and reading mortgage bond prospectuses. He learned that the mortgage bonds were backed by subprime mortgage loans for which underwriting standards had virtually collapsed. Subprime loans had been issued in a nearly infinite pastel of variations, most having as their common theme placing people into homes that they likely could not afford.
Burry then concluded that lending standards were virtually nonexistent, and that the subprime loans backing the bonds would eventually begin defaulting in massive quantities. Loan volume was inversely correlated with loan standards: as lending standards went down, loan volume substantially increased.
Degradation of lending standards occurred primarily because the banks no longer kept the loans on their balance sheet, but sold them off to be packaged into the bonds.

For all his genius, Burry’s conclusions regarding the housing market were unspectacular, largely predictable, and the product of study and due-diligence. Surely, anyone with even a modicum of common sense and intelligence could have replicated this analysis. But no one did.
Burry’s true genius, though, was in fashioning a methodology, an instrument really, through which he could short these housing bonds directly, without having to short the peripheral stocks involved in the housing industry, such as homebuilding companies or materials suppliers. Initially, he began buying credit-default swaps, a form of insurance that would pay in the event of default, on companies he thought might falter in a protracted real-estate downturn. This, though, was dangerous, as there was no guarantee that the companies would actually default or go bankrupt.
The most direct way of shorting housing and the bonds that affected them was to purchase credit default swaps on the subprime bonds themselves. Credit default swaps on subprime bonds, though, did not exist in 2004. Eventually, Burry persuaded Deutsche Bank and Goldman Sachs to sell him the credit default swaps he so badly wanted. The rest of the story played out exactly as he had anticipated: the housing market collapsed and so did the subprime bonds associated with it. This is how Michael Burry turned due-diligence into hedge fund success.
None of this, though, would have happened without Burry’s insatiable appetite to digest, read and synthesize information, his ability to analyze and relate seemingly mundane bits of information into a weave. What personality characteristics did Burry possess that might influence or otherwise enhance these abilities?

An obsession with fairness.
An obsession with topics that interested him.
The ability to work, focus and concentrate.
A drive to be productive.
The ability to recognize and make sense of complex patterns.
An innate sense of the correctness of his convictions, while completely opposed to prevailing wisdom.

The first five of these personality characteristics are shared by tens of thousands of smart, capable individuals throughout the world. The last one, though, is tenaciously difficult to acquire or possess: the ability to stand against others and dare to be right.
Why did Burry possess this ability and why did he alone stand and fight against overwhelming conventional wisdom? Because Burry alone had done the due-diligence required to prevail, and he alone understood the coming debacle. Where others guessed, he knew, where others vacillated or wavered, he stood firm. All because of the grinding, dirty slog through a seemingly impenetrable forest of documents.
The lesson drawn is not Burry’s genius in creating a unique financial product with which to short Wall Street. This is hedge fund politics at its best. The lesson for the rest of us lies in understanding the degree to which simple, predictable, and thorough due diligence under-pinned his entire effort, which in turn provided Burry the unshakeable belief in his early convictions that the entire housing market would soon collapse. This in the face of the greatest asset-price inflation ever witnessed, which made housing contrarians like Burry extremely unpopular and subjects of ridicule.
Michael Burry did not guess or speculate with disproportionate amounts of his hedge fund’s investment. No, Michael Burry understood his subject-matter so well that he was sure that he bet correctly. Not even his own investors believed he was right, and many sought to withdraw from the hedge fund.
Of course, Burry was right, as he asserted in this recent New York Times editorial, here, but no one really acknowledged this, not now, not then. Burry became this debacle’s Cassandra, cursed by the knowledge of imminent collapse but reviled for being right. Still, I would rather be right.

A recent study by three University of North Carolina researchers indicates that market short sellers profit from their enhanced ability to discern publicly available information, not from market manipulation or insider knowledge.
Common wisdom is that short sellers, those market participants attempting to capitalize on the misfortunes of individual stocks, manipulate or shape negative information to their benefit. The study, reviewed here in the New York Times, and published here, reveals that short sellers are merely very astute and perform a very high level of due diligence. These “informed traders” do not merely time the markets and information, and therefore, obtain unfair advantages over other market participants. Rather, short sellers perform effective due diligence and often prognosticate future failure or scams.
The researchers looked for evidence that short sellers’ informational advantages were due only to timing and “inside information”, and looked for evidence of abnormal short selling ahead of news events in the U.S. over the 2005-2007 period. They found no such patterns, and noted that the “ratio of short sales to total volume is nearly constant around news events.” The researchers actually found that “there is a significant increase in short selling AFTER the news event” which indicates that the short sellers are trading on publicly available information.
Prior research studies indicate that short sellers, for instance, do not tend to trade before earnings announcements. Other studies found no evidence that short sale transactions concentrate prior to bad news events. These results tend to indicate that short sellers may have an “informational advantage” and are informed. The studies also “highlight the importance of looking at more than one news category in assessing short sellers’ behavior, and shows that the information content of news leaves room for traders with different abilities to process the information to arrive at different conclusions about the value relevance of the news.” The recent study contributes to the research by highlighting how short sellers come to enjoy this advantage.
The results indicate that “the public release of information presents trading opportunities for skilled processors of information, that is, when news is released, traders with superior information processing skills can convert this news into variable information upon which to trade…Those traders who show exceptional skill in converting such data into value-relevant information are rewarded with superior returns on event-driven trades.” Specifically, the study found that “short sellers tend to trade at the same time as other traders, and when they do not, they trade after other traders. These results suggest that short sellers do not anticipate news.”
The study’s authors conclude by noting that news stories containing earnings projections, analysts comments and ratings, earnings, joint ventures and product distribution reports were deemed newsworthy by short sellers, but that short sellers possesses an uncanny ability to process the information provided to them.
In our current environment, market regulators and the investing public excoriate short sellers for something they do better than anyone else: perform effective due diligence and reveal market manipulations or scams (think Allied Capital and David Einhorn as just the most recent example). Instead of punishing short sellers for their uncanny wisdom, the SEC and other regulators should be studying their investing styles and the due diligence they perform, as they are often more predictive of future failures and frauds than regulators or other market participants. The SEC, laughably, has become a parody of an effective regulator, especially after the Madoff, Sanford, and Allied Capital scandals.
Market participants should celebrate short selling as an exercise in self-regulation rather than manipulation. Anyone or anything that enhances transparency in a market opaquely unaware of its shortcomings should be promoted rather than punished. Our economy has lived through perhaps the greatest act of self-delusion since the Dutch Tulip crisis, yet many still disdain any attempts to enhance its transparency. Short sellers are but one, isolated bridge to a fair and self-regulated market.