Jason Bram and Andreas Fuster write.
many people who were pessimistic about the housing market simply stayed on the sidelines—which in turn meant that for a while, valuations in the market primarily reflected the beliefs of optimists.
Pointer from Mark Thoma. I found myself agreeing with most of what they wrote.
I think that the same thing happened with the Internet bubble. Some of us thought that the prices were ridiculous, but we just stood aside and watched. You have to be really greedy and risk-tolerant to try to go short during that kind of frenzy, and you have to be lucky in terms of timing.
Low-documentation loans were not a new invention. Before the boom, such loans were given to self-employed borrowers, for whom detailed income documentation could be very burdensome, or to wealthy borrowers who did not want to document their capital income. And perhaps not surprisingly, such borrowers do not default at particularly high rates. The problem was that this relatively weak statistical relationship between documentation and default was interpreted to imply that income and asset verification was not very important. This reliance on models based on data from a different environment is what opened the door for the proverbial “liar loans.”
Oops. There’s an important lesson in there about statistics.
Consider Cliff Asness and his fund’s focus on Value and Momentum factor investing. Over a long period, these factors generate higher returns. But in some periods, such as the tech bubble, there was a reversal and Value tanked. Also, when Momentum fails, it fails badly.
Asness said that during certain periods, the fund took massive losses. You need deep pockets to withstand weeks or months of failure until your prediction is realized. This is even more true for something as massive as the housing market and subprime crash. Didn’t Robert Shiller predict a housing crash as early as 2002 or 2003? The market can keep on being wrong for a surprisingly long time, especially in real estate.
“You have to be really greedy and risk-tolerant to try to go short during that kind of frenzy, and you have to be lucky in terms of timing”
But why? I know why. Because the price can stay irrational longer than you can stay solvent. Short losses are potentially infinite, and there are margin calls. But are the paper losses the result of inefficiencies in the shorting market and/or synthetic interventions into the long markets?
In the book there is more history about Dr. Michael Burry, who made 100s of millions on creating a way to short the sub-prime loans — and also had made millions in shorting the dot.com bubble stocks.
But his investors were NOT happy that his pessimism was accurate in general. And some year or so before he cashed out (2005? 2006?) at a huge profit, many of his investors were loudly demanding that he reduce the carrying losses he had begun to accumulate in pursuit of the Big Timing. Even when you’re right in general, and are sure of it, the 2 – 6 – 18 months of uncertain timing is a huge bet that becomes most costly most often just before it pays off big.