Though it dates from 1994, 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 has unfolded 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. Here's how Soros explains it.

Investors are attracted to mortgage REITs (mREITs) like Redwood Trust (NYSE:RWT) and Income Investor recommendation 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 strong builders like Toll Brothers (NYSE:TOL) and D.R. Horton (NYSE:DHI).

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 in order 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 Merrill Lynch (NYSE:MER), Goldman Sachs (NYSE:GS), and Lehman Brothers (NYSE:LEH), 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's 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."

Further Foolish flashbacks:

Anand Chokkavelu updated this article, originally written by Fool contributor Emil Lee and published on Sept. 19, 2007. Anand does not own shares of any company mentioned. Annaly Capital Management is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy. That’s hot!