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The Other Side: Can a Black Swan have an ARM?


This particular Black Swan multiplied and rests too comfortably in the backyards of many market handicappers.

Note From Prof. Krueger: I wanted to share what may be on the other side of both a headline and a stock that you have no doubt read and heard of.

Before anyone disagrees with either crazy notion, let me be the first to join you.

This will be the origin of each "Other Side" column. I am simply sharing the result of work that began by attacking my own ideas (posing as the other side of each of my trades and structural positions and building a case against myself), especially if I can find a mis-priced trade resulting from over-bet assumptions including, at times, my own. Our biggest mistakes can be found in the mirror, not on the screen.

As the U.S. consumer misses another scheduled funeral this summer and the stock market rallies directly into the mountain of debt that should have derailed it long ago, I share this installment of the Other Side with an untold riddle about what happens when a bird goes to a bar and leaves a big tip.

I have buzzed here in Minyanville about the amount wagered against sub-prime borrowers possibly dwarfing the amount borrowed that may actually be at risk. The Black Swan that was feared to be sitting on somebody's books somewhere became the chalk, not the impossible underdog offering long odds because there's no way it could happen. It happened. There is a tremendous problem. There is no doubt about the risk. But this particular Black Swan multiplied and rests too comfortably in the backyards of many market handicappers. It is no longer the unthinkable. It is thought. Is it overbought?

I think the real concern will be the adjustable rate mortgages for "good" credit risks, not the sub-prime borrowers. The guys and gals who appear to have it all together as long as the next commission check clears a day before the interest-only payment is due. Adjustments are certainly needed. But the more structural problem from my perch is a society of entitlements, namely that everyone should own a home in the first place. Any intern that asks for my secret hears the answer as the $500/month apartment in a terrible neighborhood that I lived in and why, because of it, I got to the office sometimes before they went to bed in the early morning. But that is another story, and few seem to agree anyhow since we elect folks to run this country who tell us the opposite is true – that we should all be comfortable in a home, which is why they win.

However…before you bury the stock market with these "Brand New Zero-Down for 12-Month Shovels" there is something else to consider beyond the universally agreed-upon and too-simple conclusion that when they adjust higher the borrower is doomed.

What if some of those borrowers are not who our graphs assume? I spoke with one recently for a few hours before I stopped scratching my head. He had taken out an interest-only adjustable rate mortgage despite having ample resources to use a silly old conservative fixed mortgage (like the knucklehead asking him why) or even pay cash and be done with it. Turns out the opportunities to invest and grow his business were more compelling while his balance sheet improved with tremendous capital gains (completely unaccounted for in the misleading reported savings rate).

This borrower that I spoke to sits as one tiny dot on those graphs showing the levered consumer plunging off a cliff and taking the stock market with it, when his mortgage rate goes up. His dirty little secret? He is worth millions, and he is not alone in taking out a mortgage that many on Wall Street assume he is in no position to adjust higher with, and also underestimates his willingness to adjust to even lower fixed rates – the other side of ARMs not written about as often but which has been stubbornly authoring plenty of 52-week highs in the disbelieving stock market.

I called him again last Friday and it was the first time he'd never returned my call the same day. The service at the company he started with nothing but a loan is impeccable. Turns out he took his entire shop to lunch, which spilled into the evening hours surrounded by several fine and empty bottles of wine celebrating their best first half in company history. If you had to guess which industry he was in, perhaps oil and gas might be the favorite, especially down here in Texas. Nope. But they make up plenty of his clientele. Of all businesses to be breaking all-time records, would a mortgage company be among your best guesses right now?

While everybody was staring at the reasons why his customers should go belly-up, they were busy bellying-up to his conference table and refinancing – an adjustment in mortgages from a group who can afford to pay them. Is he the exception? Perhaps. Are his customers the minority? Maybe. Are there countless more examples of the dreaded opposite occurring every day? No question about it. Could that very fact make the unlikely Black Swan to bet on look more like the other side of doom – a boom?

My fear? I have hundreds (including writing this and being misunderstood). To be clear, I am neither a bull nor a bear. I have long and short positions. I do not "believe in" or "like" markets: I look for mis-priced odds and my biggest success has come from understanding the other side of most of the likely outcomes. My biggest failures were born from agreement.

The growing agreement in another House is what scares me more than anything else in this stock market right now. US leaders, and those who choose them, seem to agree that unusual success, like this business owner's, should be taxed more to help others. Even if you want to somehow ignore the all-time record tax receipts rolling in because of lower tax rates, I just wonder what the waitress who served his company's party would say if Congress asked her whether she would prefer he paid a bigger tax bill or a bigger tip? She might tell them instead the tale about the Black Swan who walked into her bar in broad daylight that nobody saw.
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