Some things I learned this week: 20/5/18

This is the first of what could hopefully become a weekly review of some of the things I learned and found interesting over the past week.

  • Steve Eisman (of The Big Short fame, played by Steve Carell) speaking on the drivers of the ’08 subprime mortgage crisis. 
    • Excessively leveraged banks: between ’97-’07, the financial system tripled its leverage (take Citigroup in 2002, which was leveraged 22:1 when it had $1T assets on its books. In June 2007 those numbers became 35:1 and $2T). The risk-weighting system banks used were backwards-looking, which meant if something had a low historical loss-rate, it was rated “low-risk”, while ignoring the fact that the underwriting standards can change. The key actors in the financial system saw virtually little increase in the leverage over this decade because of this relatively “low-risk” weighting method, while the absolute leverage skyrocketed. In addition, by “mistaking leverage for genius,” the incentive structure encourages increasing leverage in the system. The high leverage meant that banks could offer higher volumes of loans (therefore more profits), but when the surge in defaults ultimately came, excessive leverage turned to bankruptcy.
    • Large asset class that blows up: subprime mortgages were nicknamed “228s” or “327s” – customer pays a teaser rate for 2-3 years, followed by an upwards re-pricing for the next 27-28 years (these usually went from a 3% teaser to a 9% re-price). Customers who couldn’t pay 9% would re-finance after a few years, which required an upfront payment, resulting in further commission for the loan originators, and due to a volume-based compensation scheme, “anybody with a pulse” would be granted a loan. Between ’02-’04, delinquencies and losses on mortgages came in much lower than expected. As a result, the underwriters loosened their standards for the purposes of increasing volume (and therefore compensation) while while maintaining loss expectations. However, they missed the fact that the reduction in losses was a result of a surge in home ownership (due to loan accessibility) which drove up housing prices and therefore pushed down delinquency rates. When people started to notice in August of 2007, investors stopped buying the paper, so Wall Street stopped buying from the loan originators, who in turn stopped allowing customers to refinance, causing massive volumes of defaults, thereby blowing up the asset class.
    • Large companies/banks that are holding the asset class: the industry was generating massive volumes of product (the volumes of loans was dwarfed by the volume of CDOs and synthetic CDOs, which in a way allowed investors to “bet on” these loans, as explained in this clip from The Big Short). This volume became hard to move, so banks decided to begin to hold some of it on its books which it wouldn’t otherwise do; however, because they were superficially rated as “low-risk”, they began holding more volume than should have otherwise been allowed by their risk management standards.
    • Why Eisman had the insight: he was a sell-side analyst at Oppenheimer in the ’90s, covering the 1st generation of mortgage companies. He oversaw the first set of bankruptcies of these firms, and was surprised when, in ’02, the 2nd generation of these companies went public with mostly the same CEOs at the helm. As a result, he was watching for these CEOs to repeat their previous behavior.
  • The Financial Times offers some doubt about WeWork’s future
    • Their business model: rent space from landlords, upscale the amenities and layouts, sublease them to small businesses at a profit. The business model is an old real estate play, supplemented by the technology, marketing and “pizazz” of Silicon Valley
    • By judging WeWork as a real estate company instead of your average Silicon Valley tech company, doubt emerges.
    • The property cycle demonstrates peaks and troughs about 10-15 years apart, and suggests that WeWork has taken leases from large buildings at the top of the market, and when the market turns, they will be on the hook for 20-30 years’ worth of leases, just as their own tenants won’t be willing to continue paying premium prices for space when cheaper alternatives begin to emerge.
    • Three metrics to analyze from their financials:
      • Assets – if WeWork goes bankrupt, bondholders can claim little else than the leases that WeWork holds on its balance sheet.
      • Profit – WeWork is lost $933M in 2017, exceeding top-line revenue of $900M
      • Cash – the only metric WeWork offers is “community-adjusted EBITDA” (non-GAAP) which excludes substantial expenses, and therefore difficult to measure cash flow

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