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The Day After Tomorrow, Part 4

Helicopter Commander

by James J Puplava CFP, President & CEO, PFS Group. November 23, 2005

Part 1 | Part 2 | Part 3

Web Note - The following short story is hypothetical in nature, but is based on what was, what is and what will be.


There would come a day that would be unlike any other day. There would be an event unlike any other event. It would precipitate a crisis unlike any other crisis before it. It would emerge out of nowhere at a time no one would expect. It would be an event that no one anticipated—a crisis the experts didn't foresee. It would be an exogenous event—a rogue wave.

When the crisis arrived it caught market participants by surprise. Its arrival was swift and unexpected. Losses hit every sector. The devastation was encyclopedic in its breadth and utterly cataclysmic in its destruction. A financial nuclear chain reaction had been set in motion that rippled across every market and reached into every corner of the globe. It shook the very foundations of the global financial system leaving fear and destruction in its wake.

At the epicenter of this storm was the titanic hedge fund, WedgeBook Partners, and its captain J. Gordon Grecko. WedgeBook had $20 billion in equity, of which two-fifths belonged to Grecko and his partners. At the core of the storm was the firm's $150 billion in debt and its asset book of $1.5 trillion. In Wall Street terms $20 billion in equity was big money, yet it was absolutely insignificant when sized against the firm's debt of $150 billion and leveraged assets of $1.5 trillion. It took less than six weeks to lose it all. In the final stages of its demise WedgeBook was losing a billion dollars a day. WedgeBook's leverage of 75:1 was too dangerously high. In good times and in stable markets that leverage had magnified the fund's legendary returns. In unstable and declining markets that leverage proved to be fatal.

In times of extreme duress markets can seize up, liquidity can dry up, and panic can overwhelm the whole financial system. When crises erupt, investors eject out of every market with alarming speed. They abandon exotic and emerging markets and run from risk wherever it lurks. Like fire in a movie theater, everyone runs for the exits simultaneously. When everyone is selling at the same time, sellers can overwhelm markets. When a firm has to sell in a market that has been seized by panic, there are no buyers. When there are more sellers than buyers, market prices plunge to extreme lows— far below what investors ever anticipated. This is what happened to WedgeBook Partners. In the final days of WedgeBook's demise, leverage and lack of liquidity unleashed hell on the world's markets.

What transpired in the end was beyond anyone's comprehension. There was a flaw in the system that all the models had missed. The probability of systemic risk, ever present, lying invisible in the background, was considered a once-in-a-lifetime occurrence and a statistical impossibility. These were the "fat tails" that lingered at the end of the bell-shaped curve, waiting patiently to explode. Although statistically possible, they were considered improbable and therefore they were kept out of sight and out of mind. The problem was that they reappeared more often than was acknowledged. The notion that relying on any formulaic model posed inescapable systemic risk eluded the financial elite. This was true of J. Gordon Grecko whose belief in himself and the predictability of his models bordered on conceit. The fact that one day, without warning, trades would leap off the charts was considered by the best minds to be an unlikely statistical freak.

The hubris of men like Grecko and others like him who worked on the Street and the financial capitals around the globe was rooted in their belief in the infallibility of their models. They assumed each roll of the dice or every trade would be governed by the same statistical model and the gods of chance would continue to smile upon them. There are reasons why financial markets can run to extremes. Markets are more random than certain. It is this arbitrariness that catches the markets by surprise. Each day's closing price is not a complete sample from which long-term trends can be projected into infinity, as if each trade or coin toss will come out the same. The only problem with this assumption is that more often than not, the patterns change. When they do, they became disruptive events. They turn into a one-hundred-year or perfect financial storm.

This was one of those times. The events as they unfolded had a beginning as they would have an end. The clues warning of the coming storm were there for all to see. They were simply ignored. However, before the storm, there was a beginning and it is to that beginning that we must now return. It is here that we find the clues that foretold this series of most unfortunate of events.

John and Terry Wheeler

Life was going well for John and Terry Wheeler. John was kept busy working weekdays and weekends at The Ranch. Most of the builders had sold out of their projects. They were now anxious to have them built before mortgage rates rose even further. Escalating interest rates would make it more difficult for buyers to close escrow. Many subcontractors were offering incentives to their workers to work weekends with time-and-a-half and higher pay for piece work. The builders were also anxious to close these projects as buyers had locked in their prices, but raw material prices and labor rates were rising, eating into profit margins.

John's overtime and Terry's high tips gave the Wheelers some financial breathing room. The refinance package that Jack Benson put together last Spring had cut their monthly payments by $650 a month. That savings, combined with the monthly rent they received from Terry's sister, Angela, had made all of the difference in the world. Besides, from the look of things, John's company had plenty of work. In addition to Big Sky Ranch, a bigger and more exclusive development was going up further west from The Ranch. Unlike previous building cycles, it looked like this one would last a long time.

John and Terry felt blessed. They had managed to consolidate all of their debt and at the same time increase their income. Their home continued to appreciate as well as their new investment in a condo. Terry was ecstatic when she read Sunday's home section of the paper. The median price home in San Diego was now $554,000. San Diego homes had appreciated by over 138% in the last five years. The Union Tribune was calling for another 6% appreciation next year due to strong buyer demand. It was hard to believe their 2,800 square foot home was now worth almost $850,000! Their new condo investment was also working out just as Jack Benson had predicted. The first three phases at St. Tropez were completely sold out. Because of the demand for the units, Prestige Builders had been raising prices by $5,000 in each phase. Their $2,500 investment had already appreciated by $15,000. There were only three phases left to sell and the sales office real estate agent expected that the builder would continue to raise prices in each phase. By the time it came to close escrow, their investment should be up by $30,000.

They were getting rich and Terry loved every minute of it. The key was to invest. Their struggles were finally paying off. In the beginning they had difficulty making ends meet, especially in furnishing their home. But now their investments were working for them. By owning part of the American dream, their home had turned into a cash flow machine. At first they had struggled to make their mortgage, furniture, and credit card payments. Furnishing a new house wasn't cheap. Thanks to Jack Benson's help, debt management, and the appreciation of their home, their financial problems had been solved.

The Subtle Things

Finances had improved enough to allow Terry to go back to her old habits. She and Shelly Benson now spent Saturdays at the malls with lunch and shopping. Everything was paid for with credit cards, but unlike the past, Terry usually had the money in her checkbook to pay off the credit cards when the bills came due at the end of the month. However, deep down she knew their good fortune was a precarious one. It depended on everything going well—John's overtime, Terry's tips, Angela's monthly rent, and real estate continuing to appreciate. What would happen if her world changed? What if the restaurant business declined, John's overtime ended, Angela moved out or if real estate prices went down? These were ugly thoughts and Terry quickly dismissed them.

Consumer Price Index 2001 - 2005 11/21/2005The only distressing thing in her life right now was that prices, along with real estate continued to go up. Terry and John spent more than $120 a week to fill the tanks in both their cars. That was thirty dollars more than last year. Their monthly bills had been creeping up and the local utility informed them that natural gas prices were going up this winter. Last month's utility bill was over $300! The monthly cable bill had risen by $8 and the cost of a movie ticket was now $10. You could add another $10 for a small coke and popcorn. Even John had noticed the price increase for Charger tickets. John and Terry paid $160 for two tickets to see the San Diego Chargers play the Oakland Raiders on December 4th. It was expensive, but it was John's birthday weekend.

It wouldn't be so bad, if it was just a few things. However, prices seemed to be rising on just about everything they needed or they liked to do. Their cost of "living"—going to the movies, a dinner out, an occasional Padre or Charger game, or their favorite bottle of wine—was all going up. Since the beginning of the year Terry noticed her weekly grocery bill had risen by $15. She also noticed that either the prices had increased or the packages seemed to be getting smaller. Their favorite restaurant had raised the average dinner price by 10%. Dinner and a movie now cost them $100. When she and John first starting dating five years ago dinner and a movie was less than $50. It now cost her $45 to get her hair cut and styled and if she wanted to splurge on highlights, her salon bill jumped to $125 and that was before the tip! Even her favorite shampoo and conditioner had gone up by $5.

Individually, these price increases didn't add up to much, but when added together, they became significant. Since Summer both John and Terry had noticed that the monthly surplus was shrinking. They had both resolved to turn down the thermostat this winter to reduce their monthly heating bills. The trips to the malls on weekends with Shelly Benson were starting to eat into their monthly budget. With Christmas coming up, there was no money in savings, so that meant the Christmas bills wouldn't get paid off. The Wheelers didn't need to cut back, but it was getting close. This holiday season would definitely put them back in the hole again. Then there were those stubborn price increases. They both couldn't help but notice that prices were rising everywhere. John always remarked that he didn't understand what the financial people meant by the 'core rate' of inflation. "Didn't the government people have to buy gas and food or heat and cool their homes? What kind of 'core rate' were they talking about?" As far as the Wheelers were concerned, the cost of living was rising in the suburbs. Maybe the "core rate" only applied to city people and not suburbia.

Even with these doubts, Terry was looking forward to Christmas. Shelly Benson had called and the girls were planning a marathon shopping weekend the day after Thanksgiving. She planned on buying a few new sweaters and a terrycloth bathrobe to keep her warm this winter. She also wanted to look at furniture. She had thought of buying John a La-Z-Boy chair for the upstairs bedroom. Since her sister Angela moved in, nightly TV was dominated by reality shows and chic flicks. John still wanted to watch football and sports, which left only the upstairs bedroom. There had been several arguments over the big screen TV. Angela seemed to think paying monthly rent gave her exclusive rights to the big screen. It irritated John on more than one occasion. A new recliner chair for their upstairs bedroom just might keep the peace between John and her sister. The La-Z-Boy chair would fit in the corner of the bedroom opposite the plasma TV. The girls could watch Fear Factor and John could watch sports in their bedroom. The La-Z-Boy chair would make watching Charger football more comfortable. That chair could be a peacemaker and the perfect Christmas gift. She was also thinking about an entertainment cabinet for the big screen TV, audio equipment, and family albums downstairs. With the kind of money she and John were making on their real estate investments, they could afford it. If the Benson's could buy nice things, why couldn't the Wheelers?

Erica Barry Moves Up the Ladder

By the end of September nearly two-thirds of Big Sky Ranch had been sold. Homes were selling faster than they could be built. This worried several of the builders because selling prices had been locked in while building costs were open-ended. Everything was going up. Construction material costs were up over 11% over the last year ending in September. Gypsum prices had risen 21%, lumber 12%, steel and copper construction products 62%, asphalt 12%, PVC up almost 100%, not to mention diesel fuel, which was up over 50%. There was a rush to get things built while buyers could still qualify. The problem for both buyers and sellers was construction costs were escalating along with interest rates. If rates went up too far, buyers wouldn't be able to meet higher mortgage payments. Several developers had experienced drop-offs prior to closing simply because of rising interest rates. The gap between variable rate loans and fixed rate mortgages had narrowed considerably. Lenders were now recommending interest-only ARMs to enable buyers to qualify.


Pine Brothers was anxious to close out their Big Sky project. The Paradise Village condominium project was half sold and completely under construction. The entire 180 units were being built at once. Erica Barry had come up with a marketing blitz to move the rest of the project. Meeting with project managers she developed a list of the most popular options: stainless steel kitchen appliances, washer and dryer, granite counters, crown molding in the living room and master bedroom, Hunter-Douglas silhouette blinds for the windows, and tile floors in the entry way, and master bath. The whole package didn't add more than $10,000 to the cost of a unit. The upgrades were priced wholesale, since the greatest mark-up was already built into each unit. She called the new program "What you see is what you get!" The option was available on three of the least expensive units. It was designed for newlyweds and young families, who were first-time homebuyers. The options package gave these first-time homebuyers everything they needed to move in and occupy their new home without all the hassle.

It was a smashing success. By November Erica had sold 120 out of the 180 units. Heavy advertising in the Sunday paper brought buyers out of the woodworks. In addition to the option package Erica had put together a special financing package with the help of Danny Garcia at CityWide Mortgage. The financing package included three attractive financing options: a 5-year, 7-year, and 10-year interest-only ARM. At today's rising home prices, buyers didn't have the luxury of paying off principal. Adjustable rate mortgages, negative amortization and interest-only loans were the only way to buy a piece of the American dream in southern California. By keeping payments to a minimum with creative financing, the real estate bubble was kept inflated. Historically low mortgage rates, which had been falling for decades, was the fuel behind the boom.

Source: FRED

The financing package not only made the purchase of the units affordable, but the option package made it easy to buy. There were no decisions to be made. There were no upgrades needed as the builder had already provided them. There were no extra appliances to buy when the package already included the kitchen appliances and now even the washer and dryer were included. The windows came with coverings. The buyer only had to choose from a limited variety of color choices for their flooring or counter tiles. It was kept simple. All you had to do was qualify. Once that hurdle was met, you simply bought and moved in. For first-time homebuyers, it was the right program and the right price with few headaches.

Erica had sold two-thirds of Paradise Village before the models had been completed. This did not go unnoticed by her superiors. Pine Brothers was partnering with a major developer and insurance company on a new planned community that was going to be even more exclusive than Big Sky Ranch. The new development would contain more than 5,600 acres of land, over 3,000 homes, a public golf course, a five-star resort hotel, a 5-acre regional park, a neighborhood pool for every 140 homes, a strip mall with exclusive shops and restaurants, and 18 miles of hiking, biking, and rough terrain trails for exercising as well as observing wildlife. It would be the company's most ambitious project to date. The whole community was being designed and targeted toward the new urban elite, the professionals—attorneys, doctors, dentists, professors, stock brokers and financial planners, software engineers and entrepreneurs. This would be a development aimed at six-figure incomes. You would need it in order to qualify. Inherited money was also welcomed.

Pine Brothers would have four projects within the new development, Hacienda Del Sol. There would be two different starter home projects, one luxury duplex as well as a gated community of two-story and single story luxury homes. Starter homes would begin at $750,000 before options. The luxury duplex would start at the upper 700's and low 800's. The gated community would be priced at $1 million and keep rising. The largest home would begin at $1.25 million. The company was excited about the project and the top brass knew exactly who they needed to market their project—the sales and marketing genius of Erica Barry. Not only was Erica good at marketing and selling, but her beauty and charm fit perfectly with this new upscale community. Bernie Taubman, Erica's boss, phoned Erica and told her that next Monday's sales meeting would be rather long. He asked her to get one of the other agents to fill in for her.

Erica had no idea what her boss was up to, but felt they had to be pleased with the progress she was making at Paradise Village. She knew the company had another project in the works. She had participated in some of the preliminary design meetings. Perhaps they needed more of her input on options? She was excited about the possibilities. Erica really enjoyed what she did for a living and it showed in her enthusiasm. Lucky for Pine Brothers, that enthusiasm was electric with buyers.

She had good news for her boss on Monday morning. She had sold five units over the weekend. That would certainly perk up the sales meeting. The meeting was mainly filled with construction difficulties. The company had an enviable problem—the homes were sold faster than they could be built. However, construction costs kept rising, while sales prices were locked in. To complete the project, the company wanted to limit price increases at a time interest rates were rising.

Her boss invited her out to lunch at the local bistro. It was at lunch that Bernie shared the good news. Erica was being promoted. Pine Brothers was making her Sales Director for all four developments at Hacienda Del Sol and she would work exclusively with corporate marketing. Erica would direct advertising budgets, work with the design team on floor plans, elevations, and options as well as direct the sales force. Her office would eventually be located at the design center at the new development. For now she was being pulled off Paradise Village and would work at the company's downtown headquarters. Erica's office would be next to Bernie's on the 10th floor with a view of San Diego Bay. That new office came with a substantial salary increase. She was now a six-figure professional with big bonus potential.

CityWide's John Millman

John Millman was employed as a financial analyst at CityWide's Newport Beach headquarters. He worked with finance and accounting on developing budgets, analyzing profitability, and tracking cash flow. What he was beginning to see in the monthly financial statements started to worry him. Non-performing assets as a percent of total assets had been steadily increasing since the beginning of the year from 0.13% to 0.20% of total assets. In addition to the increase in non-performing loans, the bank's profit margins were starting to narrow. The bank's weighted average costs of funds had risen from less than 2.50% at the beginning of the year to 3.17% as of its most recent Form 8-K filing. That wasn't what concerned him. What worried Millman wasn't the bank's profits. Profits were at record levels. It was the composition of profits that was starting to give him the butterflies. Over 25% of the bank's profits were accrued interest from negative amortization loans. Even more alarming, this trend was increasing.

Because of rising real estate prices, loan officers and builders were clamoring for lower mortgage payments. The bank was only too happy to oblige. Most of the bank's portfolio was comprised of variable rate mortgages, interest-only and negative amortization loans. Fixed-rate mortgages were less than 15% of the bank's total book. To accommodate builders' demands for lower payments, the bank had concentrated its business model on variable-rate and interest-only loans. Interest-only mortgages now represented almost a third of the bank's business. Of these loans nine out of every ten carried adjustable rates. When they adjust to higher payments, it increased the probability of default.

John Millman felt this trend was what was behind the increase in non-performing loans since the beginning of the year. This could turn into an alarming trend, if the Fed continued to raise interest rates. Over 80 percent of the bank's lending business was adjustable. This meant that over the next two years nearly all of the bank's loans would be bumped higher. This was good news for the bank, but bad news for the bank's customers. Since most mortgages required little money down, the bank didn't have a strong enough equity cushion. Low down payments, interest-only, and negative amortization loans meant buyers weren't building any equity. This also meant that the bank didn't have much collateral backing its loan portfolio. If interest rates continued to rise, home prices would eventually begin to decline and that would mean less equity for the homeowner and less collateral for the bank.

This could turn into the perfect storm for the bank and the bank's customers. Rising interest rates could create payment shock for homeowners. Many of them would not be able to cope with the increase in monthly payments, which meant non-performing assets would continue to increase. CityWide had become a major player in the hottest real estate markets in the country—California, Nevada, Florida, Arizona and the Internet. In the process of marketing loans to eager buyers CityWide may have stretched itself too thin by lending money to customers, who would have never qualified a few years ago. These were marginal buyers—who like the bank—had stretched their monthly budgets too far. They had very little equity in their homes and with negative amortization or interest-only loans, the only way to build equity was through price appreciation. What happens when home prices stop going up in value or begin to decline? To John Millman this was a trend that warranted close monitoring.

Tony Shapiro Cuts the Losses

Traders by their very nature are high-strung people. The constant stress and anxiety of buying and selling was taxing on the human body. If the stress of trading didn't wear you out, the eye strain would. Most traders spent their day eyeballing computer screens with their fingers on the trigger ready to buy or bail depending on the tiniest nuance in the charts. As far as trading was concerned, Tony Shapiro was one of the best traders on the Street. His ability to identify turning points in the markets is what made him number two at WedgeBook. Tony was simply good at what he did. The other traders referred to him as "The Knife." He could cut through all of the noise and clatter in the markets and pick out trends before they became obvious to everyone else. Tony's ability to read markets had bailed out WedgeBook on more than one occasion. Grecko's big picture calls were what made WedgeBook's returns legendary. However, there were times when Grecko's macro moves lagged the markets. That is when Tony really earned his pay. During these brief lapses in Grecko's performance, Tony's trading skills were what delivered the returns.

This was one of those times. Grecko's macro calls weren't kicking in, which meant the fund was losing money. They got bagged on the paired GM trades early in the year and repeated that mistake with Delphi bonds. Both trades (and similar ones like them) had knocked off half of the fund's performance for the year. Grecko had also been wrong on gold. With the dollar index up 14% this year, the price of gold should have been tanking. Instead it was setting new records. Currently WedgeBook was barely in positive territory. Tony was the relief pitcher and it was now time for him to deliver and win this year's game. Grecko's macro calls would take further time to play out.

Tony returned to the GM and Ford trade. This time it was one-sided. Kerkorian had thrown the markets through a loop. However, Tony felt the trade had merit. Oil prices kept climbing, which meant higher gasoline prices. Gasoline prices skyrocketed during the summer, which would eventually harm the big automaker's most profitable SUV sales. By mid-July Shapiro began going short on GM and Ford as well as other industrial stocks. By the time the hurricanes hit, gasoline prices were soaring and SUV sales were tumbling. It was a gutsy move, but by early August WedgeBook was short 5 million shares of GM between $35-32 a share. Tony also doubled the fund's short position in Ford, which had been bought in early January around $14. The summer shorts were added between $11 and $10 a share. WedgeBook was also short the big industrial stocks, DuPont, Alcoa, and Caterpillar. As the price of oil jumped after Katrina, Shapiro had also piled on shorts on the large cap integrated oils.

Light Crude Oil and Unleaded Gasoline

While most of the fund's equity positions were on the short side, the fund was also long the financial stocks. This was Grecko's call. Grecko held that the Fed would eventually relent after the economy headed into a recession. A drop in interest rates would be a big plus for financial stocks. Tony had nailed it taking on big long positions in Citigroup, JPMorgan, and the major brokerage firms such as Goldman, Morgan Stanley and Merrill. The men who ran these firms were Grecko's golfing buddies. Most of them had a stake in WedgeBook either as a counterparty to one of the fund's derivative bets or directly as a lender. Grecko loved dropping subtle hints at cocktail parties that the fund was long their stocks. It was good PR and would come in handy when he needed to call in a chit. Right now everyone was focused on year-end bonuses. The fact that WedgeBook was taking big positions in financials stocks only served to curry favor with his lenders.

Shapiro had also been trading the technology sector. WedgeBook had been rotating back and forth between long and short positions in technology. Currently the fund had taken a big stake in Microsoft, Wal-Mart, Costco, and Tony sensed Christmas wouldn't be as bad as the consensus believed. Little by little Shapiro was pulling the fund out of the hole. The only drag on the fund's returns was their gold short position. By Thanksgiving WedgeBook was back in the black and more importantly—ahead of the markets. Beating the markets is what generated the fund's 20% bonus fees. If everything stayed on track, WedgeBook should have another good year. Returns wouldn't be stellar, but they'd be good enough to beat the market and generate the bonus fees.

The intensity of trading was starting to wear on Tony's nerves. Between two pots of coffee and Krispy Kreme donuts, Tony's body ran on caffeine, sugar and adrenaline. Shapiro was popping as many pills as the number of cups of coffee he drank. Tony took Zantac to control the heartburn and acid, Nexium to repair the damage of the heartburn, alpha and beta blockers to control blood pressure, and Ambien to get to sleep. At the rate he was popping pills, he thought of buying drug stocks. Tony was earning his pay the hard way, but he had been called in as a relief pitcher. He rose to the challenge. Grecko sensed the wear and tear on his head trader and knew it was time to intervene. Gordon invited Shapiro to join him aboard his 130-foot yacht, Achilles, in the Grand Cayman for a long Thanksgiving holiday. The G4 was on its way to La Guardia.

The Set Up

The trip to the Caymans was just what the doctored ordered. Shapiro always felt calmed by Grecko's presence. There was a confidence in his boss that reassured Tony that things were going to be okay. Their relationship was one of master and student. Tony may have been agile as a trader, but it was Grecko's macro calls that really made the big money. The ability to call a trend, discover an arbitrage opportunity and then to leverage that opportunity was what had made the fund's returns legendary. Grecko wanted Tony to decompress. He needed him in top form to close out the year. The warm and balmy temperatures were refreshing after the snow storms and chilly weather in New York. The long weekend was spent relaxing, fishing and scuba diving.

Grecko's cook prepared Tony's favorite dinner, Beef Wellington, for Sunday night. Jasper served up the appropriate wine—one of Gordon's favorites, Opus One. At dinner on Sunday Grecko laid out his macro bet. It hadn't changed. It was his belief that what would unfold would play out in text-book fashion. As the Fed continued to raise interest rates, the economy would weaken, the yield curve would invert, energy prices would peak and inflation would subside. By next year the economy would be close to recession if not in one. Bernanke would have no choice but to lower rates. Grecko was convinced that Bernanke would be as friendly to Wall Street as his predecessor. By next summer the Fed would be lowering interest rates. Grecko pointed out that M3 had increased by almost $300 billion since the beginning of August. The Fed may be talking tough, but it was keeping the financial system liquid with plenty of money.

The fund had plenty of cash thanks to liquidations of its convertible bonds and real estate holdings. The fund's mortgage-backed bonds were in the red, but Grecko expected that to reverse once the Fed went on hold. The fund's derivative holdings in IOs (Interest Only) and POs (Principal Only) derivatives would be increased based on his call. Right now they were in the black, but not by much. Grecko was also looking at emerging market debt and junk bonds where the yields were much higher. When the Fed went on hold, Grecko expected credit spreads to narrow again.

Even though Gordon had underestimated the Fed's resolve, he still felt things would play out as planned. The key was holding on and waiting for spreads to converge again. The Fed had raised rates more than he anticipated, but he felt that was due to unusual circumstances with Katrina and the spillover effects of rising energy prices. The hurricane season was now over and he expected energy prices to eventually subside. Once they did, inflation rates would come back down and the threat of inflation would disappear. In fact, as the economy began to soften as a result of rising rates, he expected talks of deflation to resurface by late Spring when the winter inflationary chill had time to thaw out.

Tony's batteries were recharged. He slept in late and returned to New York late Monday evening. His job was to keep the fund in positive territory until the end of the year. He would cut losses by tightening stops and double-up on winning positions. There were only four weeks left to payday. He was determined to deliver by keeping the fund firmly in the black. The next four weeks would be a whirlwind of trading.

Abdul al-Jabbaar

In early October Abdul al-Jabbaar was called back to London. No questions. No details—just the command, "Be there." Perhaps there was a change of targets within the US or the timetable was accelerating. Abdul was curious. All of his preparations had been made for a strike as originally planned.

In London Abdul met with Al Qaeda's regional commander, Ben Yuusuf. Abdul's plan was postponed. Word had come down from Tehran that the attack was to be put on hold. There was a schism within the conservative establishment in Iran. A rift had broken out between Iran's top politician, Akbar Hashemi Rafsanjani and Iran's new, hard-line President, Mahmoud Ahmadinejad. Rafsanjani represented the pragmatic conservatives, while Ahmadinejad was backed by the hard-line clerics. The hardliners wanted to strike a blow against the US. The pragmatists thought it best to wait until Iran was capable of defending itself. Iran was close to developing its own nuclear weapons. The pragmatists didn't want to give the U.S. or the Israelis an excuse for an attack on its nuclear facilities. An attack now, if traced back to Iran, would be condemned by the international community and would provide justification for a military air strike by either the U.S. or the Israelis.

Ahmadinejad's extreme views were influenced by his spiritual mentor, the Ayatollah Mohammad-Taqi Mesbah-Yazdi. Mesbah-Yazdi favored isolating Iran from the West. It was thought that Mesbah-Yazdi was behind Ahmadinejad's inflammatory declaration that "Israel should be wiped off the map." Mesbah-Yazdi was intent on derailing peace negotiations in the Middle East. The hardliners represented by Ahmadinejad were in favor of accelerating terrorist attacks and keeping the region at war. The pragmatists were in favor of making accommodation with the West and lifting Iran from its pariah status through back-channel deals on Iraq and its nuclear program.

The pragmatists were pushing for inclusion, while the hardliners were in favor of exclusion from the West. While the pragmatists pushed forward with reforms, the radical hardliners, worried over the future of their radical ideology, pushed for conflict. At the moment the pragmatists were winning. Working through back-channels, word had been sent to call off the attacks in the US. For the present, Abdul's group would become a sleeper cell instead of a strike force.

Erica Barry Shines

Erica loved her new position and quickly got into the thick of things. The Hacienda Del Sol infrastructure was expected to be completed by year-end. Utilities, sewer, and water pipes were in. Streets and building pads were being cut and the first group of models was now under construction with the grand opening expected by early Spring. Hacienda Del Sol was definitely going to be an upper-end development. The average starter home in the new development would begin in the low $700s before options. Mid-sized homes would be priced between the mid $800s and lower $900s. The big homes in the gated community would all be priced well over a million. Land was a big premium. Most of the lots would be less than 5,000 square feet. The starter home lots would be less than 3,000 feet.

Like the Big Sky Ranch project, Pine Brother architects were incorporating popular options such as gourmet kitchens, elegant master bedrooms and master baths with roman tubs and large walk-in closets. Buyers could add optional studies, tech-centers and lofts. Other optional upgrades would include stainless steel appliances, upgraded countertops, bath lights and plumbing fixtures. There was also a plethora of high-tech upgrades from security systems, LAN locations and Ethernet hub, to home theater surround systems.

Hacienda Del Sol would be one of San Diego's most elegantly planned master communities. If you were an aspiring urban professional, this was going to be the place to live—but at a price. You had to have money. It took a six-figure income to live there. It also required equity. You had to have money to plunk down up front in order to buy in. At these prices, lenders wanted to see collateral backing their loans. Everyone would be pre-qualified before being put on a waiting list.

Pine Brothers would have four projects from starter homes to larger-sized estates within a gated community. The kick off was planned for Thanksgiving weekend with a special option bonus and attractive financing package. Erica would be overseeing sales the opening weekend. The goal was to sell out the first phase in all three of the smaller developments. If sales went well, the second phase would be released for sale in early December. Pricing and financing had been put together in an attractive package. Pine Brothers was eagerly awaiting the public's reaction to what they considered to be the best planned master community in the entire city. The first three projects were ready to sell.

Erica had been working with Danny Garcia at CityWide who suggested interest-only ARMs. Because of the price range, buyers were required to put down 20% in order to qualify for the lower interest rates.

Casita: Starter Home
1,700 - 1,970 sq ft
$717,900 - $766,900
Castilla: Duplex
2,100 - 2,570 sq ft
$774,900 - $832,900
Cortez: Larger Lot
2,420 - 3,020 sq ft
$842,900 - $860,900

Sales Price: $750,000

Program5/1 Interest Only*7/1 Interest Only*10/1 Interest Only*
Estimate Loan Amount$600,000$600,000$600,000
Interest Rate**5.625%5.750%5.875%
Down Payment20%20%20%
Proposed Monthly Housing Expenses
Interest Only Payments $2,813 / $3,4551 $2,875 / $3,5001 $2,938 / $3,5501
Property Tax (est) $1,235 $1,235 $1,235
Hazard Insurance (est) $70 $70 $70
HOA (est) $175 $175 $175
Total Monthly Payment*** $4,293 / $4,9331 $4,355 / $4,9801 $4,418 / $5,0131
* Interest rate on ARM loans is subject to increase after consummation. ** Interest rates subject to change without notice. *** The Total Monthly Payment can be higher depending on buyer(s) credit score and compensating factors. 1 Payment if principal was included.

With 20% down, interest rates were still attractive with rates below 6%. The interest-only ARM kept payments low. With 20% equity, lenders had enough cushion in case of a default. This reflected the growing sense of caution within the lending community. At this late stage in the cycle, lenders were now requiring larger down payments on homes priced at these levels. The banks were looking for qualified buyers—not the marginal homebuyer. Monthly payments of $4,200-$4,400 were a comfortable payment for couples or individuals with a six-figure income.

The Grand Opening weekend went beyond Pine Brothers' expectations. Erica and her sales agents sold out the first phase of the larger homes and six out of ten of the smaller homes. Even more promising was the response to the company's gated community. The gated community would feature 60 two-story and single story homes from 3,960 to 4,450 square feet. The gated homes were going to be priced from $1,050,000 for the smallest model to $1,250,000 for the largest model. With options and lot premiums, these homes could sell for $1,500,000. There would only be 60 homes. Erica already had over 200 names on her waiting list. More than half on the list were registered and pre-qualified.

Pine Brothers believed the response to their Grand Opening was a harbinger of good things to come. Their marketing research and focus groups pointed to a strong demand for a luxury planned community. Hacienda Del Sol offered urban professionals everything they would want from extensive biking and exercise trails, gourmet shops and restaurants and a community golf course, to neighborhood pools, an outdoor amphitheater, clubhouses and public parks. There were also plenty of amenities for the soccer moms and their young families with public baseball and soccer fields, lighted sidewalks and parks, tot lots, and even an animal park for the family canine.

As a result of selling out of phase one, Erica was pushing the company to release phase two by early December. She also wanted to accelerate plans for the gated community. Her waiting list for million-dollar homes was growing by the day.

Erica also thought about her own upgrading. Her condo wouldn't be ready to close until late Spring. She had already made $40,000 in price appreciation. With selling bonuses, a pay raise, and this price appreciation, Erica was thinking of flipping her condo and buying into the smaller starter homes at Casita. The company had a 10% discount program for execs. If she added the company discount to her profits on the condo, she would have enough to qualify and trade her condo for a starter home. Her new salary gave her the means to trade up. A quick phone call to Danny Garcia confirmed she would qualify. Erica decided to put her condo on the market. There was a waiting list at Paradise Village with anxious buyers willing to accelerate their move-in dates. It took only two days to sell. With her condo sold to a qualified buyer, Erica put in a reservation on a plan two, mid-sized model at Casita. Because of her executive discount, she would be in the home for not much more than $620,000. With option upgrades, maybe $650,000. Not bad for hard work. She was trading a 1,600 square foot condo for 1,930 square foot single-family home. On top of that, her executive discount meant options at cost as well. Her bonus of $25,000 would buy her a well-appointed home.

The Wheelers Reconsider

It was good to finally have a day off. John and Terry would have time alone. Angela was invited to dinner at her boyfriend's parents. They planned on a late Thanksgiving dinner since John wanted to watch the football games. John also planned on taking Terry out to Big Sky Ranch to walk through the condos while the turkey was roasting. The development was really taking shape. The community pool and cabana was just about complete. Landscaping around the stone entrance and the front entries to each complex had been put in to give the community a lived-in look. They awoke early and headed out to Big Sky, since John wanted to make it back in time for the games.

Terry noticed how attractive the development looked with the landscaping in place. She remarked to John, "You know, this really wouldn't be a bad place to live." She loved the private walkways and walled courtyards, which enhanced the Spanish and Tuscan elevations of each town home complex. Even though these were town homes, the walled-in courtyards and grass-lined sidewalks really gave you the look and feel of a home. Terry especially liked the end unit, which had a front as well as a side covered porch. The unit had 1,630 square feet with a very livable floor plan. The downstairs had a spacious kitchen and a nice-sized living room with fireplace and media niche. The upstairs was equally as spacious with a loft, two bedrooms and a large master bedroom with a walk-in closet and media niche across from where the bed would go.

John joked, "Hey, Terry, my plasma screen would fit perfectly here." Terry was lost in thought as she imagined what her furniture would look like in the condo. Was there enough space? What would it be like to live here alone with just John and no Angela? Was this big enough of a home to start a family? Where were these thoughts leading her? What was she thinking? John noticed Terry's silence. She seemed to be day-dreaming. He too was lost in his own thoughts. What would it be like to live here with just the two of them? How much cheaper would it be? Would he have to put in as much overtime? Payments on a place like this had to be a lot lower than what they were now paying. He thought about how much money they had made on their home. What if they sold? How much money would they walk away with—$200,000, $250,000, maybe $300,000?

John tabled the thought of selling, but perked up when Terry asked to see the other units. She wondered when would these units be available. "Why do you ask?" John responded. "I don't know. Just thinking." Terry replied. Both of them looked at each other. "Are you thinking what I am thinking?", asked John. "Maybe. It sure would be nice to be out of debt or at least not have big mortgage payments. How could we ever start a family with the amount of money we owe?"

Their minds were spinning as they headed back home. They arrived just in time for John to catch his game. He was so tired that he fell asleep halfway through the game. Terry fixed dinner with all of the trappings. It was so nice to have peace and quiet in the home and a little time with John. She thought about the morning's visit to Big Sky Ranch. The end unit was definitely affordable and it had enough room to accommodate all of their furniture. What would it be like to be out of debt or at least have a debt load that was manageable? She hated having to scrimp. It had only been recently with the refinancing and Angela moving in that had they had room to breathe. She was well aware that their debt load increased every month because of negative amortization. She saw the monthly bills and the loan balance each month and it frightened her. Terry enjoyed weekends at the mall with Shelly Benson, but how long could that continue? It sure would be nice to get off the debt treadmill.

At dinner John looked pensively at Terry. Then he posed the question, "Are you happy living here?" "If you mean do I want to go back to apartment living, the answer is no. But would I consider a change or an alternative like what I saw this morning, the answer is yes." Those were the words John wanted to hear. He had been thinking of this alternative from the moment he first started wiring the project. He clearly understood working seven days a week and having Angela as a renter wouldn't last forever. They were fortunate in that their home had appreciated enormously—enough to bail them out of their debts. Even so, their payments were still high and it took overtime and renting a room to Angela to make ends meet. Why not cash out now while they had the chance? Sure, it would be downsizing, but the condo was still a lot more room than their old apartment. The end unit had a living room, a media niche and three bedrooms plus a loft. That was more than enough to suit them both and maybe start a family.

They were both in agreement. They would do some homework and keep mum about it. John wanted to keep this private for the moment especially from the Bensons. John thought he would check with the real estate agent at Prestige Builders. Maybe they could transfer their deposit to a larger, end unit. Terry would call their real estate agent, Tom Bennett, to get an appraisal of their home and find out how long he thought it would take to sell it. The Christmas season was around the corner, but from what John said, sales activity around the Ranch was still brisk. Maybe they would have some luck.

Shelly Benson called for Terry at 6AM the day after Thanksgiving. She and the girls wanted to get an early start before the crowds flocked to the malls. All were excited about the holiday season. It was as if they needed a distraction or a reprieve. They started at Nordy's, where Shelly found several Faconnable brushed flannel plaid shirts for Jack at $115 a pop. A matching Nordstrom's cashmere sweater cost $185. Shelly was on a roll. She fell in love with a Tommy Bahama Havana watch, which set her back $350. By the time they got to lunch, Shelly had already blown a grand. The only thing Terry kept thinking was how does she do it? Jack and Shelly couldn't be making more then she and John.

For once Terry was more circumspect. The La-Z-Boy chair was going to cost $500, maybe less, if she could find it on e-Bay. Terry limited her purchases to a few Tommy Bahama sport shirts and men's cologne. She found a Karen Neuberger shawl-collar robe for $50 and two pair of DKNY flannel pajamas for $60 each. Terry was proud of herself. By the end of the day she had spent less than $500 and had gotten most of the things that she wanted. Terry had already nixed the entertainment center plan. She didn't have any idea what John would spend. But so far, Terry's purchases were manageable and could be paid off within two months. There would be no more long Christmas hangovers this year.

Shelly was another story. She spent as much on herself as she did on Jack. It must be nice. "How do you do it?" she asked Shelly at lunch. That was when Shelly told her Jack had taken out a home equity loan for the holiday season—enough to pay for Christmas and a holiday Caribbean cruise. The way Jack figured it, between their home and two condo investments, they had made over $100,000 on their real estate investments this year. No sense in saving it all. They were simply taking out a small portion—just $10,000—for a spin. "I keep telling you, Terry, Jack and I don't want to wait 'til we're old and gray to enjoy life. We want to enjoy a little now." Besides, with the way their real estate investments were going, Jack figured they could do more. Wow, Terry thought. She knew Jack was smart when it came to financial matters. She only wished John had a little of the same financial savvy. In some ways she was envious of Jack and Shelly, but in another way, she was tired of the debt treadmill they had been on the last three years.

At least they now had a plan of their own. As it turned out, Prestige had an end unit that had recently fallen out of escrow. She and John could buy the unit at phase one prices. The unit, with a few options, was priced at $520,000. The only bad news was that they couldn't transfer their profit to the new purchase. Since they were getting an end unit at phase one prices, it really came out to a wash. Tom Bennett also had good news. He felt their home should sell for $850,000 and should sell within six to eight weeks, depending on interest rate changes. There was only one other home on the market in their neighborhood right now, so selling wouldn't be a problem. He felt confident their home would sell due to all of the upgrades they had put into the home. The pool and spa were beautiful. John and Terry felt putting their home on the market during the holidays was out of the question. They agreed to list their home right after New Years.

Morgan Weld and the Meeting of Minds and Money

Meet Billionaire, Sam Beckman

Samuel T. Beckman was a media and real estate mogul. He had made his initial fortune buying small local radio and television stations in smaller cities throughout the U.S. in the late '70s and '80s. He sold out to Capital Cities in 1990 and redeployed his capital, buying properties throughout the U.S. after the 1991 recession and S&L crisis. Beckman had made a small fortune in the media business, but his biggest fortune would be made in real estate. Flush with cash after selling his media business, Sam was at the right place at the right time to take advantage of a bursting real estate bubble. He began buying a portfolio of bad loans from a failed thrift that the government had taken over for 50 cents on the dollar. Within a few years he sold those loans for 70 and 80 cents on the dollar, making $500 million in the process. His profits from selling his media empire and the profits earned from flipping under-priced mortgages gave Beckman the capital to form his own vulture fund. In the early-'90s, the government's newly-formed Resolution Trust Corp (RTC) was sitting on $350 billion in non-performing loans, backed mostly by real estate. It was the buying opportunity of a lifetime.

Beckman bought one loan package after another from the RTC. Often he sold back the same loans to the original borrower for 70-80 cents on the dollar. Many owners were anxious to hold on to their properties, so they paid Beckman handsomely to buy back their own paper. If Beckman wasn't flipping mortgages, he was buying distressed properties either from the government or Japanese investors, who were bailing out of their inflated trophy properties in the U.S. By the end of the '90s Beckman had become a billionaire. As tech investors lost fortunes in the new century from the technology crash, Beckman's fortune would double again. He financed and built large housing and condominium projects in San Diego, Phoenix, Las Vegas and Miami. Sensing money was going to be cheap after the 2001 recession and terrorist attacks of 9/11, Beckman expanded everywhere there was a hot market. He built large home tracks in Phoenix and Las Vegas and condos in Los Angeles, San Diego and Miami.

If there was a hot market, Beckman was there first. Sam Beckman had a nose for real estate sizzle whether it was Malibu, Phoenix, or Miami. By the end of 2004 the sum total of all of his properties was worth over $2.5 billion. But by the beginning of 2005, Beckman didn't like what he was starting to see. There was too much money chasing real estate. Money was coming out of the woodworks from hedge funds, pension funds, and private-equity groups, to rich investors. They were all bidding up the same properties. The way he saw it, there was too much money and debt, chasing very few good deals. Investors weren't paying attention to value or what they were paying for property. This was buying without thinking. To Sam Beckman, that meant it was time to start cashing out while the ducks were still quacking.

By the middle of the summer Beckman began to unload most of his U.S. properties. He was getting top dollar for his housing and condominium projects. As property prices continued to soar, his net worth skyrocketed. Still, Sam kept on selling. Beckman wanted to unload most of what he owned in the U.S. while property markets remained hot. Eventually rising construction costs combined with rising interest rates would bring about another real estate bust. Lending institutions were overextended. Loan portfolios had low collateral to back them as many lenders had lent to buyers who were putting very little down on their properties.

S & P 500 Index

S & P 500 Real Estate Group Index

Even worse, many institutions were making loans to marginal buyers through negative amortization loans. The soaring profits in the banking industry were a mirage. The financial industry was a house of cards waiting to fold. When it did, it was going to require another government bailout similar to 1991. This time the bubble was more inflated and would require a far bigger bailout. That meant another buying opportunity of a lifetime was directly ahead. Beckman was getting liquid, while speculators were leveraging up.

As the holidays approached, it was time for Beckman to relax. He had liquidated most of his holdings and had received top dollar for all of his properties. He was looking forward to getting together with family, friends, and close associates—men Beckman had partnered with over the years in his spectacular rise to the top. Every year the Beckmans threw a Christmas party at their Santa Barbara ranch. The ranch was nestled back in the Santa Barbara hills in what was some of the most exclusive real estate in California. Beckman had money, but he was also surrounded by it. Most of the invitations went to billionaires or centa-millionaires, the kind of people you would find on the Forbes 400 list. If you weren't a billionaire, you at least had the money to live like one. Neighbors included the famous as well as the rich. Morgan and Hank Weld had both received invitations.

A Holiday Gathering
What intrigued Beckman was to find out what his friends, neighbors and business associates were doing with their money. Was he alone in sensing the latest bubble in real estate was about to burst? This was the smart money crowd. Most of the money was self-made. If it was inherited, like the Welds', it was managed well and was growing. Beckman had done a few of his early real estate deals with Morgan's father and had developed a close friendship with the Weld family that grew out of a love for horses. Beckman kept a large stable of horses on his ranch—some for breeding and others for racing. If Beckman had a passion in life for making money, his other passion was his horses.

The Beckman dinner parties were always well attended. A conclave of fellow peers was a welcome event. The combined net worth of attendants that evening was equal to the GDP of a small country. Everyone was in a good mood that evening, which implied to Beckman that his guests were making money. He was surprised, however, by the tenor of many of his associates as they retired to the veranda for brandy and cigars. Some, like himself, had been making fortunes in real estate, but they too had been selling or thinking of cashing out. Others like Weld were heavily invested in oil, a family tradition, or in gold, which was a novel idea for Beckman and a few of his guests. While everyone had been making money either in real estate or their own businesses, very few—other than Morgan—had been making money in stocks.

Everyone seemed worried about something. Too much debt in the economy, the real estate bubble, the dollar or Fed rate hikes were topics raised on the veranda. Everybody believed that eventually Fed rate hikes were going to lead to a crisis somewhere. The question was, where it would erupt? Who would be the first causality? How bad would it get and how long would it last? Beckman proffered his assessment of real estate. "There is too much money, too much debt, and too few brains chasing few good properties. The amateur entrepreneurs and the public were now coming into the market. They have no clue about real property value. At current prices, very few deals pencil out. I believe this is the top."

Morgan Describes the Coming Crisis
Morgan Weld confirmed Beckman's view, taking it a step further. Morgan laid out what he felt was an approaching crisis for the financial industry. This time the crisis would be much worse. Morgan explained what made a real estate bubble different than a stock market bubble. Morgan contended that housing busts have larger wealth effects on consumption than do equity busts. More of the public is involved with real estate, so the economic repercussions would be far greater. Secondly, housing busts are usually preceded by a money and credit boom, so there are far more debt imbalances that are left to be unwound. Finally, a housing bust would have adverse effects on the banking system. Bank lending had become the engine that powered the boom. Remember what happened in the last real estate bust in the recession of 1991? The government had to bail out the banking system through the Resolution Trust Corporation. Everyone shook their head in agreement, especially Beckman. He had made a fortune by buying distressed properties and mortgage pools from the government.

A few asked what Morgan was doing. "Well, I'm in oil, a market I know well and I'm buying gold and silver, lots of it." Everyone was aware that gold prices had been setting multi-decade records.

Morgan had everyone's attention, especially since he was one of the few men in the room making money in the markets. Morgan went on to explain the trade deficits and the Fed rate hikes. Foreign money was pouring into the U.S. because it was felt that our economy was stronger and our interest rates were much higher than Europe and Japan. That picture was changing. The ECB had recently started raising interest rates and the Bank of Japan was preparing the ground to shift away from its zero-interest rate policy.

" At some point in time—and I believe it is soon, maybe Spring of next year—the economy is going to slowdown. The consumer is being hit on all fronts. Inflation is chipping away at the consumer's purchasing power. Wages are falling behind inflation and rising interest rates are raising the cost of debt for most households. The savings rate in the country is now negative and has been that way for the last four months.

That negative savings rate means that the consumer has no cash cushion, if the economy heads south and the unemployment rate rises. The negative savings rate means that U.S. consumers were now spending more than 100% of their after-tax income. At some point the consumer begins to retreat, the marginal homebuyer starts to default, and we are going to have a full-fledged financial crisis on our hands."

Everyone on the veranda urged Morgan to continue.

Morgan went on to explain that the problem this time around is going to come from the household sector. Unlike the last recession, which was brought on by a retrenchment in business and investment spending, this one would be brought about by the consumer. Consumption expenditures now made up close to 70% of GDP. This means that what happens to the consumer becomes more important. Over the last 15 years asset bubbles have replaced savings. When stocks went up every year by 15-20%, few households had the incentive to save. In fact debt replaced savings and consumption replaced investing. The average household felt they were getting richer, so they borrowed and consumed. Everyone felt wealthier because their stocks or mutual funds were going up in value by double-digits every year. When the equity bubble burst, interest rates plunged and a new bubble developed in real estate. Morgan now had everyone's attention.

Most of the men out on the veranda had made fortunes in real estate in one form or another or in their businesses, which were tied directly to the economy. If what Morgan was saying would unfold, a consumer retrenchment would have negative implications for business investment, inventory accumulation, and future profits for industry. Morgan went on to emphasize the direct impact of these asset bubbles on consumption, savings, the trade deficit, the dollar and inflation. Everyone knew that money had been cheap and plentiful, but few understood and could express it the way Morgan did. Most of these men understood real estate and their business, but few had a grasp of how the economy worked in the way that Morgan explained.

When money and credit were created, that money could go into the real economy or into assets. When money went into assets—the way it did in stocks or real estate today—it helped to fuel asset bubbles. The trouble was that money was now working its way into the general economy. The Fed clearly understood that inflation was taking root as asset bubbles spilled over into the real economy. It had to fool the markets by creating the impression that it was worried over inflation when in reality its real concern was another deflating asset bubble and its impact on the financial system.

Several of the guests cornered Morgan privately to ask him for advice. Morgan told them to watch the energy markets, inflation, gold, and the dollar. Morgan felt that next year was going to be brutal for the markets. Rising energy prices, especially heating oil and natural gas this winter, was going to drive inflation rates higher in the months ahead. Higher inflation rates would keep the Fed on offense, forcing the Fed to raise interest rates more than it wanted. At some point the Fed would raise interest rates too far, leading to the unwinding of the asset markets. When the crisis arrived, Morgan believed it would be quick and lethal to the financial system.

The party went on later than expected. Morgan Weld was literally holding court out on the veranda. Everyone seemed to want private time with Weld to get his advice. The Beckmans finally let their guests know that the evening was coming to a close. They all wished each other well and agreed to get together again. The golf and charity benefits in the Spring would be the ideal occasion.

Morgan and Hank stayed in town for a few days to go over family business, discuss the portfolio, and visit with Abigail and a few of her Hollywood friends. Morgan had been buying deep in-the-money calls on natural gas and oil stocks, and selling deep out-of-the-money puts to gain extra leverage. He was convinced of another energy spike led by natural gas and heating oil as the cold winter set in. The weather experts were forecasting a colder-than-normal winter. With oil and natural gas production still down in the Gulf of Mexico he believed prices would head higher. He continued to follow the futures market. Morgan couldn't help but notice that commercials continued to increase their net long positions, while large speculators and small traders were heavily short. Morgan was betting on the side of the commercials. He also added to the family's gold and silver positions with each pullback in the precious metals. The family portfolio was now heavily-weighted towards energy and precious metals and a sizable position in cash. When circumstances were right, Morgan intended to switch out of T-bills and into foreign currencies at the first sign of Fed easing. Right now he was enjoying the climbing yields on short-term treasuries.


John and Terry Wheeler thoroughly enjoyed the holidays and were excited about their future plans. They kept their plans secret and would not divulge them until the "for sale" sign appeared on the front lawn. Tips during the holiday season had been average, but enough to help pay for Christmas. There would be no holiday hangover this year. John loved his La-Z-Boy chair and surprised Terry with a matching pearl necklace and earrings. They spent the time off during the holidays making clandestine visits to their new home and on more than one occasion talked about starting a family. They had a lot to look forward to in the New Year. Getting out from underneath their debt burden had been a catharsis for both of them.

The Bensons were another story. Judging by what the Wheelers saw on Christmas Day, the Bensons gave the impression they were rolling in the money. While making coffee Christmas morning, Terry couldn't help but notice the huge, red bow on a brand new Lexus RX 400h in the Benson driveway. The Bensons were now a two-Lexus family. Jack owned an LX 300. The RX 400h was Jack's Christmas present to Shelly. Terry had always been impressed with Jack's financial prowess. She was even more amazed when they went to the Bensons to watch the games on New Year's Day. They had the thrill of watching football in high definition on their new Sony 60" Grand WEGA LCD projection TV. Terry had worn her new pearls, but they paled in comparison to Shelly's new diamond horseshoe pendant.

"How do you do it?" Terry asked Jack during a commercial break. Jack explained that he was simply monetizing some of the gains on their real estate holdings by rearranging some of their debt. Between their home and two condo investments Jack bragged that they had made over $100,000 in appreciation in 2005. He was simply taking advantage of the gains and low interest rates to enjoy a few of the nicer things in life. Speaking expansively, he went on to tell John and Terry that he was thinking of taking additional equity out of their home to buy another condo in a new development that was opening up in the Ranch. The new condo development would have smaller models and come complete with everything from appliances to window coverings. The only upgrades were in flooring. He was looking at buying the most popular model, a 2-bedroom, 2.5 bath residence with approximately 1,400 square feet. Jack told them they ought to do the same thing.

"You need to start pyramiding your wealth like Shelly and I have done. Just look at the money you've made on your home and your new condo investment." He and Shelly were going out to the Ranch next weekend to look into buying one of the new units. Jack asked if they wanted to go along. The Wheelers declined. Some people were meant to be investment tycoons. John and Terry knew they weren't. They wished the Bensons well, but said they were more than happy with what they had. As they went home after the game, they both remarked what a shock the "for sale" sign would be that following Monday. They were not looking forward to the next encounter with the Bensons. Terry was sure Jack would say what they were doing was foolish. She didn't care. All she wanted now was to get off the debt treadmill and start a family. If that meant downsizing, then so be it. Perhaps if they had got into a home much earlier like the Bensons, they would find themselves in different circumstances. All she knew was these were the cards they were dealt and she and John were determined to make the best of it.

WedgeBook had made the year thanks to Tony's trading skills. The fund had earned a nine percent return, which was better than the markets. The major indexes had finished out the year in the low single-digits. WedgeBook's returns were respectable and high enough to earn incentive fees. That meant big bonuses for Grecko and his partners. It would be their last respectable year. In less than six months the fund would be bankrupt, creating the biggest financial crisis since the demise of Grecko's mentor John Meriwether and LTCM.

Erica Barry had gotten her wish with Pine Brothers. The second and third phases at Hacienda Del Sol had been released by the second week of December. However, unlike the first phase, sales were going slowly. Erica attributed that to the holiday season. People had other things on their minds at the moment. She was encouraged by the weekend traffic, but no one was buying. They were just looking. She expected that to change after the holiday season was over and the New Year began. Meanwhile she was caught up with the holiday cheer and the prospects of moving into her new home. She had a lot to look forward to next year. Overall, 2005 had been a good year for Erica. She had received a big bonus and promotion, a substantial salary increase, and had traded up to her first home. She could only dream what the next year would bring.


Retail Sales

The end of the year closed on a fragile note. The markets represented by the major indexes ended up in positive territory, but just barely. The FOMC had increased interest rates for the thirteenth time on December 13th, taking the federal funds rate up to 4.25%. The minutes accompanying the meeting were like a Xerox copy of previous meetings. There was no hint of any let up in future rate hikes. This put a damper on the markets for the remainder of the year. There were a few brief rallies into the year-end as a result of robust on-line shopping. Retail sales weren't bad, but they weren't the kind of numbers that markets could celebrate over. There was a definite slowdown taking place with consumers and it was beginning to show up in consumer sentiment and play out on the retail front. The only way retailers were making sales was through steep discounting. Unless something was marked down or put on sale, it was hard to find buyers. There were a few bright spots such as the sale of iPods, Microsoft's X-Box 360, and big screen TVs as more households thought of getting their entertainment at home.

Rising Energy Prices

The problem by year-end was that weather and energy prices were back on the front pages. Heating oil and natural gas prices started to rise as temperatures dropped. The Mid-West and East Coast were covered with snow. Throughout most of the winter cold fronts collided with abnormally warm, wet ocean air and buried the East Coast in snow. Wind chill factors during winter blizzards dropped temperatures even further increasing the demand for heat. Energy draw-downs were huge at a time the energy sector was straining to meet demands. Production in the Gulf of Mexico was still in the process of recovering. Experts expected it would be Spring before all of the necessary repairs would be made. Even then 5% of the Gulf's production had been lost as a result of the damage from summer hurricanes. For the Northern Plains, the Great Lakes, Ohio Valley and the East Coast, it was one of the coldest winters in recent memory.

Cold temperatures and severe winter storms meant the demand for energy soared as did prices. The consumer was being hit on all fronts from soaring energy bills and rising food prices, to rising interest rates on home equity loans and credit cards as a result of the new bankruptcy bill. Rising heating bills were hitting consumers at the same time that their financing costs were going up.

Rate Risk in Real Estate
Every Fed rate hike meant interest rates on home equity loans went up the following month. Minimum payments on credit cards also rose as a result of the new bankruptcy bill. The cost of credit was increasing at the same time it became more difficult to file for bankruptcy.

The stage was set for the downturn to begin as the New Year began. Regulators were starting to bear down on bank lending practices, which were showing signs of breaking down. Bank lending standards had deteriorated considerably. Credit risk was on the rise. It had jumped in several places on the regulators' radar screens, most notably in commercial and residential real estate. The OCC's 2005 Underwriting Survey reported net easing of retail underwriting standards for the first time in 11 years.

In the commercial real estate sector lenders were routinely adjusting loan covenants, lengthening maturities and reducing collateral requirements. On the residential side the breadth and extent to which banks had relaxed lending standards was starting to worry regulators. Lenders had been scrambling to find ways to make inflating real estate prices more affordable. The result was not only the relaxation of lending standards, but also the proliferation of high-risk loans. Interest-only products made up approximately 50 percent of all mortgage originations in 2004. By the first half of 2005, interest-only options were replaced by payment-option ARMs, comprising nearly half of all new mortgage loans. Every other mortgage was a "piggyback" or reduced documentation loan. The trend in residential lending was toward the "layering" of multiple risks. Regulators were finding that the tendency toward higher-risk loans was taking place across both ends of the FICO spectrum, with the riskier borrower at the forefront. Nearly 50 percent of these sub-prime holders of option-ARMs had current balances above their original loans.

All of the ARMs, interest-only, and option-payment ARMs were due to be reset. The 3:1 and 5:1 ARMs, which dominated the residential lending market since 2003, were going to reset over the next few years. The resetting was already taking place and would accelerate next year. In the case of option ARMs, payments would go up each year for the first five years, resulting in negative amortization or a larger loan balance at the end of the first five years. Beginning in the sixth year, the loan would be repriced at a new interest rate. In the case of the Wheelers, the Option ARM used to purchase a condo was set initially at 5.487 percent. The first year payment was $1,179. It would rise to $1,575.47 in the fifth year. In the sixth year when full amortization begins, the payments would jump to nearly $2,500. The higher payment was the result of a bigger loan balance and full amortization. It could get worse, if interest rates moved higher at the time the loan was reset. If interest rates should increase 1 to 2 percent to 6.5 and 7.5 percent, payments could double from where they originally started to $3,000.

Consumer Slowdown Apparent

Trouble was coming to the financial sector in 2006. Several profit warnings from American Express, Americredit, and other consumer finance companies foretold of future events. American Express had warned that fourth quarter profits would be below analysts' estimates. The company blamed higher loan loss provisions due to the new bankruptcy bill. Several smaller consumer finance companies had also warned of lower profits. The rise in unemployment claims and increasing energy prices were heralding a sizable upturn in credit card and mortgage delinquency rates. This outcome had yet to be priced into consumer finance stocks even though consumer income expectations continued to deteriorate. The downturn in consumer sentiment also foreshadowed a major drop in home purchase plans. It appeared that real estate prices had topped out. With consumer balance sheets leveraged to house prices, any downturn or softening would fan the flames of a credit-quality fire.

All of the variables for a consumer slowdown in spending were now in place. The deterioration in credit quality had not been reflected in credit spreads. With liquidity pouring into the markets, money searched for the highest returns. The yields on high-risk debt had come down. In the U.S., corporate credit spreads had narrowed to less than 200 basis points, while in emerging markets, they had dropped to below 400. In Europe they were less than 50 basis points. The level of interest rates in the high-yield market was not priced for risk. If anything, credit spreads were reflecting permanent good times. Investors weren't being compensated for the risks that they were taking. Just as mortgage payments were due to reset, the whole risk continuum in the bond market would also be reset. It would take a financial crisis to bring this event about.

Corporate Profits Peak

While markets were still optimistic, pricing in a continual trend of rising profits, the signs were there for a profit peak. There had been five profit cycle peaks in earnings per share over the last thirty years: 1974, 1981, 1984, 1989, and 2000. Four of those peaks were associated with recessions. In each one of these cycles, there were common characteristics—a steep rise in energy prices, rising headline inflation, a rise in the federal funds rate, accelerating unit labor costs, and a drop in new orders for manufactured goods. Every one of these characteristics, with the exception of lower orders for manufacturing, was present at the end of 2005. Companies began to issue profit warnings as the year came to a close due to higher cost and inflation pressures. Although many companies had been raising prices, they were not raising prices fast or high enough to recuperate costs. A profit slowdown was in the works at a time Wall Street earnings estimates were overly optimistic. In past cycle peaks, the most recent in 2000, earnings typically decline for two years after reaching a peak. In each case the Fed stopped raising interest rates shortly after profits had plateaued.

Easy Money Takes Its Toll

As storm clouds hovered over the financial and economic world at year end, their arrival had long been foretold. Like the bursting technology and stock market bubble of the late '90s, they were fed and nurtured by the abundance of cheap credit. In response to a collapsing technology bubble, recession, and the terrorist attacks of 9/11, the Fed had flooded the financial system with money. From January 2000 to the end of 2005, M3 Money Supply had increased by $3.5 trillion. In one year alone, 2001, the Fed would expand the monetary aggregates by almost $1 trillion. In subsequent years it would slash interest rates and bring them down to levels not seen in the U.S. in over half a century—all of this to stave off a deflationary collapse brought about by a deflating asset bubble. The result was one of the shortest recessions on record, proving the thesis that a lender of last resort shortens the recession or depression that follows a financial crisis. Shortening the recession would come at the cost of even a bigger crisis down the road. A moral hazard had been created with the belief that if another brush fire erupted, the Fed would be there to extinguish it. This encouraged financial institutions to leverage and speculate. It led homeowners and households to borrow and spend. In the end the financial system and the economy would become even more leveraged than before. That debt would require a greater reflation the next time a crisis arrived.

The problem with central bankers and economists is that they think they know how to handle financial crises. The standard prescription is to throw money at the problem. When the crisis is over, you come in and mop up the money. This was done repeatedly under the Greenspan Fed. In the October 1987 stock market crash, the Peso crisis in 1994, Asia in 1997, Russia and LTCM in 1998, Y2K in 1999, and 9/11 in 2001, the response was always the same. Throw enough money at the problem until it eventually goes away. However, each new crisis would be followed quickly by another. Each rescue operation would require larger amounts of money and longer periods of recovery before mop-up operations could begin. The problem with mop-up operations is that they usually led to the next crisis. This next crisis was about to begin.


There was a pall that settled over the economy and the markets as the New Year began. Christmas sales had been weaker than expected with the exception of on-line sales. Retailers weren't meeting their numbers and they were anxious to get rid of inventories through aggressive markdowns. There was a plethora of sales in January, but the harsh winter weather kept most shoppers at home. A flurry of blizzards and snowstorms blanketed the Mid-West and East Coast. Weather and energy were back on the front pages again as were layoffs.

In the first week of the new year, Ford had announced restructuring plans designed to reduce debt and overhead in an effort to put the company back into the black. The first step was trimming back the white collar workforce by 5,000. Other layoffs including factory closures were in the works. The Ford layoffs had followed the 30,000 GM layoffs last November. Both companies were hemorrhaging from billion-dollar quarterly losses. The big gas-guzzling SUVs and trucks weren't selling to an energy-conscious consumer and dealer inventories were piling up. Both companies tried rebates and special financing in an effort to lure buyers. Unfortunately, buyers weren't taking the bait. Oil prices were back over $60 a barrel, gasoline prices were rising, and natural gas prices were headed back to their record highs of $15 by mid-January.

The near-record highs in energy were spilling over into the inflation indexes. The PPI, CPI, and import prices continued to rise, putting pressure on interest rates and the Fed. It was becoming clear to the markets that the Fed would raise interest rates for the fourteenth time at the end of the month. The Fed would take the federal funds rate up to 4.5 percent. The key would be the language accompanying the FOMC meeting. What would Bernanke do as he took over the reins of the Fed? The markets were beginning to price in higher rates.

In addition to layoffs, a number of companies were issuing warnings ahead of the fourth-quarter reporting season. Companies were anxious to air their dirty laundry early, hoping investors would forget about it by the time the actual numbers were reported. In addition to earnings misses, the economic numbers were no better. Housing sales and starts had begun to decline and home prices nationwide were starting to soften. Delinquencies were rising again as were bankruptcies. Higher interest rates and rising energy prices were acting like a vice, squeezing the consumer from both sides.

On the international front, the U.S. dollar continued to gain incremental ground thanks to rising interest rates, but the buck was starting to receive competition as central banks in Asia and Europe raised their interest rates. The dollar was holding on, but it was beginning to show signs of weakening. The trade deficits remained persistently high as the U.S. imported more oil and natural gas at much higher prices. As the US economy showed signs of slowing, as more companies reported profit shortfalls, and as delinquencies rose, credit spreads began to widen again to over 400 basis points. Nervous investors began to price in greater risk. The S&P, which reached a multi-year high in December, was beginning to break down as it fell below its 200-day moving average in early January.

On Main Street...

Wheelers Stick With the Plan

The "For Sale" sign went up on the Wheeler lawn the first week of January. It created quite a stir with the neighbors; especially the Bensons who were shocked. "What are you guys doing?" asked Jack Benson who had phoned as soon as he got home from their cruise. Terry handed the phone over to John. John forcefully explained their plan to get out of their home and downsize to the larger end-unit at St. Tropez. "We want to live more simply with a lifestyle we think we can afford," said John. "Cashing out of our home will allow us to put down a sizable down payment and reduce our monthly expenses. Maybe I won't have to work as hard," John continued. Jack Benson told John he thought he was making a big mistake by selling too early. Jack expected real estate prices to go up, which was why he and Shelly were thinking of buying another condo unit in a new development that was opening up at the Ranch. Jack's words fell on deaf ears. John was resolute. Jack relented in his plea as he recognized John had firmly made up his mind. He wished them well and hoped they would remain close friends. Shelly really enjoyed her weekly shopping jaunts with Terry.

The Wheeler home was listed at $850,000. Their agent, Tom Bennett, had planned on holding open houses on weekends in an effort to market the property. John and Terry were hopeful they could get full price for their property, which would give them more money to put down on their condo. They got a little discouraged when a "for sale" sign went up at the Goodmans the following week. The Goodman home was priced at $840,000, but didn't have a covered spa or patio like the Wheeler home. Tom Bennett was still hopeful they could get close to full price on their home. However, by the end of January, there had been no bites. Even worse, the Goodmans had dropped their price down to $829,900 at the end of the month. Dick Goodman had lost his job at a local media company. Local media companies were tightening their belts and cutting jobs, attributing their plight to the slowing economy and a weak advertising market.

Pine Brothers Are Discouraged

Erica Barry's boss, Bernie Taubman, was looking a little pensive at the Monday morning sales meeting. The reports coming in from Big Sky and Hacienda Del Sol weren't encouraging. Erica chimed in that it was probably due to the holiday hangover. Most people were just now getting their credit card bills. It was not unusual to see a slowdown this time of the year. Last year's busy streak at the same time was an anomaly and was attributed to dropping interest rates at the beginning of the year. Bernie wasn't convinced. The national trend pointed to a slowdown in real estate. Both housing starts and sales had been trending downward nationally. Taubman hoped San Diego wasn't following suit. He asked Erica to start putting together a sales and marketing blitz for March. He wanted to have something to run with, if the softening trend continued into February.

CityWide Scrambles as They Prepare for the OCC Audit

CityWide's financial trends continued to deteriorate. The company missed its Q4 profit numbers and had lowered estimates for Q1 of 2006. The spread on loans had narrowed considerably as the cost of funds went up and the price of loans was kept low due to competition. Even worse, as the company raised interest rates on its ARMs when they came due, the action was triggering a wave of delinquencies and defaults. The company was going to have to increase loan charge-offs in the first quarter. Non-performing loans had increased by 50 percent to 0.30 percent of total assets. A bank examiner from the OCC had called to set up an appointment to go over the company's loan portfolio. The examination letter had requested information on CityWide's non-traditional mortgages—85 percent of the bank's business. The examiner wanted to know if CityWide intended to hold them in their portfolio. The examiner also wanted details on the quality of loan underwriting with particular attention paid to documentation and decision making on non-traditional mortgages. The OCC also wanted to know if the bank was making layered or "piggyback" loans. Management was nervous. The OCC examiner had the top brass worried, especially now that those non-performing assets were starting to grow. John Millman was asked to put together a report for management that would supply most of what the OCC's bank examiner wanted to see. It wasn't an encouraging report and Millman wasn't looking forward to presenting it.

On Wall Street...

Tony and Gordon Get Nervous and Take Action

Tony Shapiro was starting to get nervous and he felt his blood pressure rise. What he was starting to see in the markets troubled him and he let his boss know the score. Everywhere he looked in the markets he was starting to see red and it was beginning to concern him. Natural gas prices were starting to explode as a result of unusually cold winter. They were back over $15 and looked like the old highs were about to be taken out. His charts told him that prices could be headed up to $20, if winter weather conditions continued. Higher energy prices were driving up headline inflation. Those headline inflation numbers were causing interest rates to rise and credit spreads to widen. Spreads had widened to over 400 basis points and were still climbing. Grecko told Tony to dump all of their financial stocks to raise cash. He also told Shapiro to sell any miscellaneous holdings in technology and retail stocks.

Grecko planned on raising cash. He made a note to call Trevor Jones at Piedmont Bank to put together a loan package that could help WedgeBook ride out the storm he sensed was coming to the markets. Grecko was reverting to the lessons learned at Solomon. He needed to ride out his losses until they eventually turned into gains. For that to happen, he needed his bankers. They would be the key. If you had access to enough capital, you could stay the course. Even though spreads were starting to widen, he felt they would eventually narrow. He played it cool with his bankers, telling Piedmont he was raising cash, which would make the bankers feel secure and just in case, he needed a line of credit of between $2-5 billion. "Any problems with the credit line?" Grecko asked Jones. Trevor Jones seemed hesitant. Collectively, the investment banks had $150 billion with WedgeBook. "How soon would you need the money, Gordon? And for how long?" Jones asked nervously. Trevor also wanted to know how much cash the fund was raising in total.

Grecko could tell the conversation wasn't going well. Piedmont was on the hook for not only $10 billion, but they were also counterparty to many of the fund's derivative bets. Jones said he would get back to him, which wasn't the answer Grecko wanted to hear. He could tell by the tone of Jones' voice that he was concerned. Grecko left out the part that the fund had lost $2 billion in equity in the last three weeks. Grecko was counting on the family name and track record to win over the bankers. He hoped it worked.

Shapiro informed him that the fund was hemorrhaging on all fronts. They still had plenty of equity, but Tony was worried. If he started liquidating their derivative book, he would send prices lower, telegraphing to the market that the fund might be in trouble. He wasn't sure many of their exotic and sub-prime mortgages were liquid anyway and he sure didn't want the market to confirm his hunch. He had raised $2 billion through selling off the firm's equity holdings. Traders on the Street were starting to get suspicious and he didn't want to alarm them. He also suggested that they start covering their gold shorts quietly. Tony told Grecko that he sensed gold was going higher and it would be prudent to cover at least a portion of their outstanding short positions. Grecko relented. He had been wrong on the gold market. Just how wrong he didn't know. Gold was acting especially strong given the strength of the dollar and that puzzled him.

Consumers Concerned

If investors and consumers were nervous in January, they would get no reprieve in February. Blizzards, Nor' Easters, and cold flurries sent temperatures to below freezing. Natural gas prices were now starting to go parabolic. By mid-February natural gas had touched $20. Only a brief warming spell had sent them back to $18 where prices remained firm. As energy prices rose, so did headline inflation. The PPI and CPI were now annualizing at double-digit rates. The money supply was starting to soar again as M3 grew at an annual rate of 10 percent. Even worse were the individual M3 components such as money funds up 4.1%, large denominated time deposits up a whopping 28%, repos up over 8%, and Eurodollar deposits up well over 17%. The money aggregates were growing as the Fed tried to keep the financial markets flush with liquidity.

It was obvious to everyone that inflation rates were moving higher. The Fed and the financial markets were trying to talk down inflation worries by pointing to the "core" inflation rate, which miraculously remained at 2 percent. However, many economists were now starting to question the "core" rate with oil back over $60 and natural gas at close to $20. Year-over-year US consumer and producer prices were now at the top in the world. This was beginning to spill over into the bond market as it looked like yields were making another run towards 5%. Those higher rates, along with Fed rate hikes, were definitely starting to have an effect on the real estate markets. Home prices continued to weaken, inventories of unsold homes were starting to rise, and housing starts were down two consecutive months in a row. Homes were remaining on the market for longer periods of time. Even the refi and cash-out market had been trending downward for three consecutive months.

Corporate Job Cuts on the Rise

Challenger, Gray and Christmas reported that corporate job cuts were now on the rise, averaging well over 100,000 a month. Over a million job layoffs had been announced by companies for all of 2005. Year-over-year, the pace was picking up. The auto industry was shedding jobs almost as fast as it built cars. If present layoff trends continued, the auto industry was on track to exceed the 2001 record of 133,686 job cuts. GM had increased its announced number of layoffs from last summer's 25,000 to 30,000. Ford was letting go 5,000 workers with more announcements in the future as the company underwent restructuring plans—"restructuring" being the euphemism for further layoffs. The next round would probably include plant closing and blue-collar job cuts. As the industry incurred large losses from its North American operations, it was shedding plants and downsizing its operations while it expanded in Asia.

The announced layoffs were coming from a wide spectrum of companies from technology, Ciena, Novell and AOL to old-line companies like Kodak. It didn't matter whether you were looking at technology, telecommunications, computer and electronic industries, retailing, or financial companies, layoffs were building and indicating an economic slowdown. Along with inflation and energy prices, job cuts were also on the front page. Consumer sentiment had turned for the worst as consumers felt the pinch of higher energy and interest rates. Now they had job security to worry about. The sentiment numbers translated to a sharp drop in the monthly retail figures. Big box store sales were down. Wal-Mart same-store sales were down two months in a row. Luxury retailers like Saks, Tiffany's and specialty retailers like Ann Taylor and Gucci were seeing downtrends in their stores. Even the rich were starting to feel the pinch. The only thing going up were sales of hybrid cars as energy prices continued to escalate.

Consumers were getting no relief—no matter where they turned. The rise in interest rates and energy and the resetting of mortgage rates were causing more households to become delinquent on their mortgages. Energy prices remained stubbornly high. Oil production in the Gulf, which had fallen from 1.6 million barrels a day before the hurricanes, had reached 1.4 million barrels by the end of February—still below their pre-storm peaks. Natural gas production was close to recovery, but not great enough to arrest the draw-downs in inventory as a result of winter storms. It was a dismal picture and it was becoming clear that the US economy, if it continued on its present track, was headed toward recession.

Washington Legislates

The recent turmoil in the energy markets had ignited a flurry of legislative proposals. A nightmare proposal was unfolding in the nation's capital that would only exacerbate the energy problem. Everything was on the table. Democrat representative, John Barrow of Georgia, introduced a bill to limit speculative trading limits on natural gas as prices hovered near $20. Republican Senator, Judd Gregg of New Hampshire, was joined by colleagues in calling for a windfall profit tax on oil companies. Hillary Clinton was proposing a tax on energy company profits to fund development of new energy technologies. These wrong-headed proposals and others like them were fueling a media frenzy in Washington to do something about higher energy prices. It was almost like a dreadful playback of a movie from the 1970s. While demonizing energy companies, Congress vetoed plans to open up exploration for natural gas and oil, vetoed plans to reduce the 800-plus permits necessary to build a refinery, and vetoed similar plans to reduce the number of gasoline mixes that refineries had to produce to satisfy state, local and regional authorities.

All of this wasn't lost on the energy markets. Natural gas prices spiked up briefly to $30 in early March due to a bad Nor' Easter. Oil prices hit their former highs of $70 and then again in April to form a double top. As energy markets were peaking, bond yields crossed over 5 percent and looked like they were making a break to 6 percent. The dollar was starting to turn and this was beginning to spook the stock market. By mid-spring, the S&P 500 had broken below 1,100 for the first time since the summer of 2004.


WedgeBook Bleeds in Every Sector

What completely shook the markets' confidence was the quarter-point rate hike at the FOMC meeting on March 28th. The fed funds rate was now at 4.75%. The minutes accompanying the meeting pointed to a softening in the language, which seemed to indicate that the Fed was close to the ninth inning. But what did that mean? Would another quarter point hike at the May 10th meeting be it? Or was another rate hike in June in the cards? The market wasn't sure. So, in doubt, it sold off another 100 points. It was beginning to look a bit grim. The dollar was in the process of breaking down, long-term interest rates were on the march, and stock prices looked like they were headed into a bear market. Rumors were starting to circulate on the Street that someone big was in trouble. Sensing danger, investors were starting to demand higher risk premiums, which meant credit spreads were starting to widen.

Tony Shapiro's briefcase was beginning to look like a pharmacy. Antacids, blood pressure pills, a bottle of aspirin, the purple pill, and an antidepressant to calm his nerves—he carried all of them to work. His doctor had recently prescribed an antidepressant to calm him. His work environment was definitely getting unhealthy. To say WedgeBook was hemorrhaging was putting it lightly. Right after the March rate hikes, the fund was bleeding in every sector. The unexpected rise in long-term rates, along with short-term rates, meant all of the fund's securities were in the process of being repriced by the markets. To make matters worse, Piedmont had rejected Grecko's plea for a credit line. The bankers were playing hardball or maybe they were just running scared, afraid to commit more funds to a sinking ship.

By the beginning of April, WedgeBook was losing more than a billion a week. Even worse, after being turned down by their bankers, the fund began to liquidate everything. Word on the Street was out. WedgeBook was in trouble. There was no way to hide it. What broke Tony's confidence was the look on his boss's face after the Piedmont's rejection. Gone was the look of confidence, the bravado, and swagger. Grecko knew the fund was in trouble and it showed on his face. He had the look of a man who was beaten. Not even his father, the senior senator from New York, could save him. The senator had called Piedmont and tried to lean on them as much as he could. It didn't work. Like bankruptcy lawyers, Piedmont was looking at their own exposure in trying to assess damage and how bad would it be. The fund's bankers were now selling and abandoning ship, which tipped WedgeBook's portfolio deeper into negative territory.

Trevor Jones had called several of his banker friends who were also into WedgeBook in a major way. Calls were also being made to wealthy insurance companies and pension funds to see if they were interested in picking up what WedgeBook was dumping. Trevor thought of calling Buffett when the time was right. Berkshire was flush with cash and was capable of conducting rescue operations. Right now the bankers were forming a band of brothers. They were all passengers on the same ship. Jones hoped the rumors could be squashed and if they could find buyers, place those trades "off the market."

A big problem for any hedge fund is that once a rumor begins, it is tough to stop. Wall Street is a big place, but a small community when it comes to the investment houses. When you are an elephant like WedgeBook, it gets harder to hide your tracks. Word was definitely getting out that Grecko was in trouble. The fund's problem was leverage and risk. Because of the difficulty in finding enough investments where the fund could win, WedgeBook strayed into more exotic tundra: sub-prime mortgages, emerging market debt, IO/PO mortgage derivatives, swap spread shorts, paired equity and debt trades, and gold shorts. The more exotic the investment, the less liquid it was, making it difficult for the fund to find buyers. The selling pressure that WedgeBook was putting on the market was causing credit spreads to continue to widen, the fund's worst nightmare. Widening credit spreads wasn't specific to any one security. Investors were bailing out of risk wherever it lurked. Swap spreads, the basic barometer of credit markets, were rising in a feverish pitch. There was a general contraction of credit as the markets finally realized that risk had been underpriced. The markets were now playing catch-up as spreads widened to 500 basis points. Its equity had fallen to below $10 billion. As bad as things were, the worst was yet to come.

Wheelers Drop Their Asking Price

John Wheeler noticed that activity around the Ranch was starting to slow down. Most of the builders were lamenting that sales had fallen off a cliff. They were still trying to play catch-up with sales that had already been made. The problem was that raw material prices kept rising. The cost of copper pipe had gone through the roof. Plumbing fixtures were up over 10%, cement prices kept climbing, and the cost of asphalt was up in the high single-digits. Builders were anxious for jobs to be completed, so they could offload their product onto the buyer and get paid.

John still had plenty of overtime, if he wanted. He took it, since business had fallen at the restaurant. Terry was now bringing home less than $400 a week in tips. By early Spring the Wheelers were starting to get worried. There were now three homes for sale in the neighborhood. The Goodmans had dropped their price to $810,000 without any buyers hitting the bid. Tom Bennett, their realtor, urged the Wheeler's to drop their price, if they wanted to sell in time for their move-in date on their condominium in May. At first John and Terry refused, hoping the market would turn around. But after several months of no buyers, they agreed to drop their price to $799,900. The lower price seemed to attract a few buyers. One couple, the Meyers seemed interested. They had been back several times and were definitely interested. Herb Meyer was a transfer from Atlanta. He was a top-flight biochemist. His job made him a good prospect. The Meyers had sold their home in Atlanta, so they had cash to put down. Higher interest rates were not a problem.

John and Terry were hopeful that the Meyers would be the ones to buy, so they could start to rest easy. They didn't need the stress of their neighbors, the Bensons. Jack needed to come up with their down payment next month in order to close on their two St. Tropez condos. Shelly hinted to Terry that they were having problems. Terry knew something was up since Shelly no longer called her to go shopping on weekends. It was just as well, since their budget had tightened with the drop in tips. They were also trying to pay off their Christmas bills, which she hoped would be by the end of March thanks to John's overtime.

Slump in Sales for Pine Brothers

By the end of February sales at the Ranch and Hacienda Del Sol were starting to slow dramatically. Over half of the second phase at Hacienda Del Sol was still available. Only three homes had been sold in the month of February. Things weren't any better at the Ranch. Pine Brothers were only selling five units a month. By the beginning of March there were still over 40 unsold units. Erica went into action, implementing her "what you see is what you get program." The package included stainless steel appliances, granite kitchen counters, crown molding in the living room and master bedroom, and washer and dryer. She got the company to include closing costs. That seemed to help as unit sales picked up again. It wasn't working at the company's new upscale, Hacienda project. "I'm afraid it is going to take a price reduction to move product," she told her boss. The option upgrades weren't doing it. At an average selling price of $750,000, rising interest rates were making the homes less affordable. Something had to give as interest rates rose. Erica knew it had to be price.

Jack Feels the Squeeze

Jack Benson was having difficulty arranging favorable financing for his two condos. The best he could do was a 3-year ARM at 6.5%. He needed close to $50,000 for down payments on both units. He was able to raise the money through a home equity loan, but he now had over $100,000 in debt that was subject to any short-term rate increases. The first mortgage on his home was now $500,000 thanks to continuous cash outs and refinancings over the years. Jack's last refinancing had been a 5-year ARM at 5.375 percent last Spring. The combination of his first mortgage and home equity loans were now running over $3,400 a month. The Bensons had less than $200,000 equity left in their home. Even worse, they were now going to be saddled with $800,000 of debt and monthly payments before property taxes of over $5,000 a month. Property tax payments and monthly association fees added another $1,800 a month. Jack definitely needed to rent out both properties ASAP! He sheepishly called the Wheelers and asked for their agent's number. He needed to find renters or the Bensons were in real trouble. He still had enough equity in his home to hold him over in case he needed to borrow more to meet his payments. He wasn't panicking yet, but he was getting close.

Global Markets in Decline

Currency markets were slow trending markets. They were like big oil tankers or aircraft carriers they changed direction slowly. But that was exactly what was happening with the dollar. By March the dollar had fallen below 88 and by April, it had broken below 84. Record trade deficits, rising budget deficits, a slowing economy, and faltering financial markets were beginning to turn the tide against the dollar. Not even rising US interest rates could turn the tide. Financial markets were turning down across the board. About the only thing going up was the price of bullion. Gold futures were now above $550 an ounce and looked like they wanted to head higher. The gold market was telegraphing trouble ahead for the financial markets. Asian central banks, especially the Chinese, had turned into big buyers as were many OPEC countries. Thanks to rising energy prices, OPEC's current account surplus was now surpassing Asia. Mid-Eastern countries were now big buyers of gold, sensing markets were about to unravel. Word was spreading that a major US hedge fund was in big trouble as were the fund's bankers. Credit spreads had now widened to over 500 basis points and everyone was looking for a safe place to land. Gold prices kept rising.


When the end came, it was quick and deadly. Like a big storm, it was destructive to anything in its path. For WedgeBook there was no chance of survival. Its entire portfolio was now under water. WedgeBook was technically insolvent. It just boiled down to salvaging what was left. The fund was bleeding in every corner. Its derivatives, mortgage positions, and short swap position were enough to bankrupt the firm. The gold shorts were so far under water, they no longer mattered. Grecko had been abandoned by his bankers. Credit had dried up and the bankers were now circling the fund like vultures over a dead carcass. They were in deep trouble themselves and were looking for ways to bail out of their own positions. They were not only on the hook with loans, but they also stood as the counterparty to many of the fund's trades. It wasn't just WedgeBook that was in hot water—it was all of Wall Street.

The problem with leveraged trades like derivatives is that you never know how secure your hedge or collateral is until you have to liquidate. That was the problem that the Street or Grecko's bankers now faced. In theory the way things were supposed to work is that collateral is what protected the counterparties to a trade. In real life and in times of crisis, that isn't the way things worked out. If a fund or party failed, it would immediately trigger selling by its counterparties. Everyone would be selling at once and the value of collateral would plunge. All at once prices would leap off the charts, plunging like a car driven off a cliff. Even worse many counterparties would be left "naked' or holding on to only one side of the contract when the other side no longer existed. What the markets and the authorities were now facing was essentially a bank run. But the crisis still had further to go. It was up to the currency traders to finish the job.

Currency Traders Move in for the Kill

Currency traders are a special breed unto themselves. They work in the largest market in the world. Over two trillion dollars trades in the interbank markets daily, making it one the largest markets in the world. The trader's battleground is the international capital markets and their weapon is money, lots of money. That money can move markets, raise or lower interest rates, send stock prices soaring or reeling depending on how they saw fit. They were the only group large enough to take on governments, if they chose. On many occasions they had humbled more than one president or prime minister. They were one of the few trading groups, a band of master-less samurai, feared by central bankers. They not only battled among themselves, but also fought against any government authority be it Parliament, Congress or the Federal Reserve.

If the currency traders were aligned against you, it didn't matter what you did. They were the only force powerful enough to humble governments. If a government opposed them through capital controls, that government would find itself a pariah and isolated in the international community. It was best to make terms with them. Like the Mongol horde, they would ride across markets and sweep away empires that lost their power to resist. Since the collapse of the Bretton Woods monetary order and the backing of the dollar by gold, they had become financial vigilantes. The traders enforced their own economic law. They are the only financial discipline the world knows. They were now about to enforce that discipline against the US. dollar.

The word was now starting to spread globally that Grecko's WedgeBook and the fund's bankers were in trouble. Long-term bond rates were inching close to 6 percent, gold prices were at $560, the S&P 500 was trading below 1,000 and still heading lower when the final crisis arrived. The word of WedgeBook's trouble was having repercussions around the world. The dollar fell below 84 and touched briefly below 82. The dip below 82 spooked the currency markets. It would be called "Black Friday" —black—just like the previous crashes in 1929, 1987, and 1989. The dollar began selling in early trading in Asia a half a day before markets opened in London and New York. The Nikkei had dropped 1,500 points or 8 percent, falling from 16,000 to 14,500. By the time markets opened in London, the dollar was in a full-fledge rout. Equity markets were tumbling. Markets across Europe were down 5-7 percent. Traders were dumping dollars and buying whatever currencies that looked safe. Money was pouring out of the dollar, pouring out of equities, and heading into cash, government securities, gold and anything else that looked safe.

By the time the financial tsunami hit the U.S. markets, the effects were devastating. The S&P 500 gapped down at the opening by nearly 25 points from the day before. By the time it hit bottom, it had come close to touching 800. It closed out the day at 810, a loss of 165 points or 17 percent. Gold prices soared. They would climb past the old record of $850, stopping just short of $900 an ounce before the crisis played out. Investors bailed out of equities and sold anything that was liquid. Bond yields began to drop as institutional investors headed for cover. The long bond dropped from a high of nearly 6 percent to 5.5 percent in a single session. Everyone was scrambling for the exits all at once, which simply drove prices down even lower.

If plunging markets didn't scare the bejeebers out of investors, the nightly news would finish the job. The major networks featured stories on J. Gordon Grecko, WedgeBook, and old film clips from the Crash of 1929. "Crash!" That's what it was. And everyone called it just that. The markets and the country were looking for reassurance. After the markets closed on Friday the White House called a hastily-organized press conference. Standing right next to the President were the new Fed Chairman Ben Bernanke and the Secretary of the Treasury, John Snow. The President tried to reassure the country that the economy was sound. He announced an emergency meeting would be held at Camp David on Saturday. Top cabinet members would be in attendance as well as senior members of Congress.

The meeting at Camp David over the weekend was intense. The country was in trouble and everyone in the room knew it. The Treasury Secretary made calls to his counterparts in Europe and in Asia. Bernanke had been in touch with the Bank of International Settlements and fellow central bankers around the globe. On Monday there would be a coordinated intervention in the markets. An ocean of money would flood the financial system as the markets opened.

The presidents of all the major investment houses, many of whom were WedgeBook creditors, had been called. Major brokerage firms and banks were ready to go into action on Monday, knowing full well they had an open-ended checkbook to keep buying. The Fed was willing to print as many zeros as needed in order to stem the tide. Bernanke reassured the President that the Fed would do all that was necessary to stop the hemorrhaging. It would fulfill its duty as lender of last resort. The New York Fed had already organized a meeting of WedgeBook's creditor banks. Phone calls were being made to large insurance and pension funds. The President of the New York Fed had phoned Buffett. He was interested, depending on what was offered. Berkshire was sitting on over $40 billion in cash.

A major plan was taking shape. Money was not an issue when it came to national economic security. Leaders around the globe phoned the President to offer their help and agreed to coordinate their efforts. No one wanted to see the markets tumble further or the dollar to collapse. For better or for worse, it was the only system the world had. The Euro, the Yen, or the Yuan weren't quite ready to replace it as the world's currency. The only universal currency or money of last resort was gold and it was performing its job splendidly.

The President looked to his new Fed chief for reassurance. He was relying on the Fed to pull out the markets. The economy was too weak and leveraged to withstand another bear market and recession. Bernanke told him that the Fed would announce a surprise rate cut of 50 basis points, taking the fed funds rate down to 4.25 percent again. Everyone agreed this was what the markets and the economy needed. The last thing the President or the Fed wanted right now was for the real estate markets to crash next. "Great. Let's get right on it," said the President. "Announce it tomorrow when the markets open. I'll hold a press conference first thing in the morning shortly after the markets open. I plan to unveil a plan to extend tax cuts and new spending plans designed to stimulate the economy. Ben, I want you to join me at that conference in the morning." "Mr. President," Andrew Card interrupted, "Tomorrow is Sunday." Then, the day after tomorrow," the President chimed back with a grin.


The Wheelers finally sold their home to that nice couple from Atlanta. The Meyers finally settled on $795,000. After sales and closing costs, John and Terry walked away with close to $200,000. Most of the money went toward a down payment on their new end-unit condo. Terry traded in her SUV and the Wheelers paid cash for a Toyota Prius. John put the rest down on their new condominium, which left the Wheelers with a mortgage of $340,000. He got a 6.5 percent rate on a 7-year ARM, which brought his payments down to $2,150 a month. The Wheeler monthly budget had been trimmed by more than $1,000 a month, which suited them just fine. They were now back to saving again. Terry's furniture blended in well in their new surroundings. John's plasma TV fitted perfectly in the master bedroom media niche. Terry still thought of going shopping, but now it was on account of a family addition. By the end of August, John and Terry were expecting their first child.

The pressure of down payments, home equity loans, and two additional mortgage payments on their two condo investments would eventually force the Bensons into bankruptcy. Jack Benson never could find renters that were willing to pay what he was asking for rent. There were simply too many apartments for rent at far lower prices. In the end, the banks foreclosed on both properties. The Bensons would lose all of their profits and their equity down payment of $50,000.

Erica Barry's marketing genius enabled her to pull rabbits out of a hat. She turned around condo sales at Paradise Village with an innovative marketing program she called "economy living." Pine Brothers had worked out a deal with a local Honda dealer to buy a fleet of Honda Civics. The company would give them away along with a basic option package to buyers of the last units in Paradise Village. The plan was working, which gave her hope to work on another plan at Hacienda Del Sol. She was looking forward to moving in to her new home in June. In July Erica and Danny Garcia were engaged.

J. Gordon Grecko would bounce back as always throughout his entire professional career. He was a survivor. WedgeBook hadn't survived, but Grecko still had enough capital to begin again. Many of the toys had been sold. He'd miss the G4, his 130-foot yacht, Achilles, and the penthouse overlooking Central Park. In the end he kept his sailboat, art, and home in the Hamptons. By late Fall he would be back in business, managing his own and select clients' money. He was still considered a legend even if it was a tarnished one. How many managers had brought the financial system to its knees?

Tony Shapiro retired on the advice of his doctor. The stress of the markets and WedgeBook's fall had been too much for his body. Thank goodness he had his money in T-bills. He was able to reduce his pill popping and still went sailing with Gordon.

Morgan Weld made another fortune in energy. That fortune nearly doubled again in the crash when gold prices soared. Weld wasn't quite a billionaire yet, but he was getting close. He was big enough to be added to the Forbes 400 list. He was starting to get offers from friends and acquaintances—big money that wanted Weld to look after it just has he had for his own family. Right now he was preoccupied with his new project, a new yacht. He was looking forward to taking delivery of his new Norhavn 86, the flagship of the line. This year's cruise of the San Juan Islands would be especially memorable.

Ben Bernanke, the new Fed chairman, continued his predecessor's legacy. He had done what Greenspan had done when faced with a crisis. He cut and slashed interest rates and flooded the markets with money. The stock market would experience another fall by summer, but after several more rate cuts the worst of it was over. The stock market had bottomed, the dollar had stabilized, and by buying out on the long-end of the curve, the rise in the long-term rate was kept manageable. He was reliquifying the banking system by resurrecting the carry trade. The next Great Inflation was about to begin.


Chart Courtesy: St. Louis Fed,, WSJ, BCA, FRED, FRBSF Economic Letter, "Spendthrift Nation," 2005-30; 11/10/2005

Special thanks to Frank Barbera for his theoretical charts.

© 2005 James J Puplava CFP, Storm Watch Update Archive

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