How George Soros Predicted the Mortgage Crash

Though its first edition dates from 1987, George Soros' book The Alchemy of Finance is surprisingly relevant to current events. Soros, a billionaire hedge fund manager whose Quantum Funds once cleared $1 billion in a single day, predicts exactly how the mortgage boom and bust would eventually unfold with eerie accuracy. Better yet, his theories offer Fools a tool for recognizing future market crashes.

Gaze into my crystal ball
Within the book, Soros includes a research report titled "The Case for Mortgage Trusts," correctly predicting the rise and fall of mortgage REITs (real estate investment trusts). Here's how Soros explains it.

Investors are attracted to mortgage REITs (mREITs) like Capstead Mortgage (NYSE: CMO  ) , Redwood Trust (NYSE: RWT  ) , and Annaly Capital Management (NYSE: NLY  ) because they pay high dividends. As a result, their shares often trade at premiums to book value.

When mREITs trade for greater than book value, they can increase earnings by simply issuing additional shares, then reinvesting the proceeds. This results in a self-reinforcing cycle: Investors bid up mREIT shares because they can increase earnings and pay out higher dividends, but in turn, the mREIT can increase earnings because of the higher share price.

If you're having trouble understanding, think of it this way: Paris Hilton is famous because everyone pays attention to her. Everyone pays attention to her because she's famous. The cycle feeds off itself.

Thus, the traditional approach of figuring out future earnings and an appropriate multiple doesn't make sense, because the share price of the mREIT helps determine its future earnings, and vice versa. Instead, investors should try to figure out the current phase of the boom-bust cycle, which Soros describes in four acts.

Act One
The boom begins. Dividend yields are high, losses are low, and pent-up demand exists for homes from builders such as D.R. Horton (NYSE: DHI  ) and Lennar (NYSE: LEN  ) .

Act Two
Let's get this party started! Construction is booming, and liquidity is abundant, which allows homebuilders and mREITs to leverage up. The leverage allows mREITs to increase earnings and issue more shares, which in turn allows them to increase earnings even further.

At this stage, all the factors happily feed off each other: abundant liquidity, low mortgage rates (caused by mREITs competing for business), housing price appreciation, and low loss levels. The success of the existing mREITs spawns copycat mREITs, which investors eagerly snap up.

Act Three
No one realizes it, because the music's too loud and everyone's having so much fun, but the party's almost over. The influx of new mREITs ratchets up competitive pressures. The smart ones pull back, but the less scrupulous ease their underwriting standards to maintain growth and market share. Toxic loans, like negative amortization and liar loans, are originated solely to be sold to unwitting buyers.

However, the cracks eventually start to show. Losses start creeping into the picture. The big investment banks, like Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , and Lehman Brothers, panic, cutting off many mREITs' lines of credit. That leaves them holding the bag, and brings the party to a screeching halt.

Act Four
Everyone -- lenders, borrowers, and financers -- scrambles for the exits all at once. Investors dump their shares of mREITs, which cuts them off from both bank and equity-market financing. Many mREITs go bankrupt as a result. At this point, the factors that fed off each other to create the boom now work in the opposite direction, to hasten the bust.

History repeats itself
Like the ins and outs of the tide, the mortgage and homebuilding cycle is inevitable, given the self-reinforcing mechanisms that create the boom and then cause the bust. Soros calls this theory "reflexivity," and he has successfully applied it to equity, fixed-income, and currency markets.

Likewise, Fools should recognize how the pattern works, and try not to get caught in acts three or four. I should probably also mention that Soros wrote "The Case for Mortgage Trusts" a bit earlier than the rest of the book -- in 1970, to be exact. Fools, never believe anyone who says, "This time, it's different."

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Dan Caplinger updated this article, originally written by Fool contributor Emil Lee and published on Sept. 19, 2007. Dan does not own shares of any company mentioned. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (9)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 14, 2009, at 2:07 AM, maysjoe wrote:

    I'm glad you brought this one out and recycled it. It seems to hit the mark perfectly in light of the current economy.

  • Report this Comment On August 17, 2009, at 10:32 PM, Montereyjackson wrote:

    A few words in behalf of Annally, used as an example above, of which I'm a holder. It currently invests only in government-backed mortgage-based securities, so it neither creates questionable mortgage demand nor runs the risk of carrying questionable mortgages.

  • Report this Comment On March 16, 2010, at 6:10 PM, Aristocrisis wrote:

    An additional question should also arise. Exactly where are we in the cycle today? Most mREITs have low leverage (say 5-8), and are trading close to book value. Will rising short-term rates crush their businesses completely, or just slow them. Or is there anyway they can hedge their profits through interest-rate swaps or the like?

    It also seems there are at least two (NLY and MFA) which has survived many market meltdowns. I personally think the fear of REITs are overdone; given the low premiums they're trading at.

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