Barry Ritholtz has written a must read book (assuming you’re interested in how we got in the pickle we’re in) called Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.  Basically I underlined the entire book when I read it.

Bailout Nation

Bill Fleckenstein (Foreword). Wiley 2009, Hardcover, 332 pages, $15.68

Reading back over my notes I was re-struck (is that a word?) by Barry’s point of view on what drove the vaunted American Consumer-led economy (we buy all the world’s doo dads): Real Estate.

According to a 2005 study by Asha Bangalore of Northern Trust Company, 43 percent of all new job creation between November 2001 and April 2005 was real estate related.

So what did that mean . . .

The housing boom was creating jobs for builders, contractors, real estate agents, mortgage brokers, and even employees at Home Depot and Lowe’s. But the most significant impact to the economy came from home equity lines of credit (HELOCs) and cash-out mortgage refinancings. With wages stagnant, Americans turned to home equity withdrawals in order to maintain their standard of living.

This was one of the single biggest and most unexpected elements of the debt-driven economic expansion. Outside of real estate, employment gains were modest and real wage gains flat. It was debt that drove the increase in consumer spending. Mortgage equity withdrawals normally a small portion of consumer debt‚exploded.

Without this home equity-based consumption, the nation would have been in recession territory, with GDP flat to 1 percent. At least, according to an unofficial Fed study by none other than Alan Greenspan

And this . . .

The wealth effect of home price appreciation is much more widely distributed than stocks. This made the generational-low interest rates the single largest factor that resuscitated the economy. Sure, tax cuts, deficit spending, increased money supply, war spending, and the like all played a role‚but it was the ultralow rates and the mortgage equity withdrawal they allowed that dominated U.S. economic activity.

As a result, the economy will continue to look  crappy to wage earners for some time to come (assets are still mispriced).

The book is just brilliant. Read it.

Here’s a story lead from the WSJ that should get your attention:

Even as the financial system collapsed last year, and millions of investors lost billions of dollars, one unlikely investor was racking up historic profits: John Paulson, a hedge-fund manager in New York.

His firm made $20 billion between 2007 and early 2009 by betting against the housing market and big financial companies. Mr. Paulson’s personal cut would amount to nearly $4 billion, or more than $10 million a day. That was more than the 2007 earnings of J.K. Rowling, Oprah Winfrey and Tiger Woods combined.

Wow, $20 billion seems like a lot of money, even in these post-trillion times.  How did he do it?  The short answer is that he went short the housing market and then financial services companies.  For those not in the biz, it means he bought a bunch of insurance on the first and then bet on the second.  For those still not tracking the story, he was on the other side of . . .

• All those credit default swaps that sunk the big financial companies, you know, the ones the tax payers bailed out? Well not all of them.
• Investors, some of whom were folks like you and me, some of whom were some of the “savviest” investors in the game who wanted a piece of that free money.
• Ultimately tax payers whose great, great grandchildren will still be paying the Chinese government for funding the clean up.

In retrospect, none of the bleating about “nobody could see it coming” was true. As a result of legislative changes pushed by the big investment banks, policies pursued by the Fed, and freaked out bond investors looking for higher fixed income yields where none existed (see the point about the Fed and ridiculously low interest rates), the Masters of the Universe leveraged up to the point where there was no margin for error and then kept going.  As long as you were comfortable with the idea that no margin of error anywhere in the “system” would ever be required, you were in tall root beer.

One of the reasons you might have felt safe thinking that way is that history told you that when the chips were down (apt image), central banks, led by none other than that free market, Ayn Rand loving Maestro himself, had already demonstrated that he would prop up asset prices and would bail out stupid investors.  That would be Alan Greenspan.

So lesson number one according to the author is “Don’t Rely on the Experts.”  He says . . .

Many investors lost big in 2007 and 2008 as housing crumbled and the stock market tumbled. But no one lost more than commercial and investment banks caught with toxic mortgage-related securities. These bankers were the very same ones who created these investments, and Wall Street’s top analysts had vouched for their safety, even as Mr. Paulson and others bet against the investments.

It’s actually a brilliant point, but a bad example.  For all sorts of good reasons, we rely on the apparent expertise of others as a heuristic for making quick decisions.  If we didn’t do that, we’d barely make it out the door every morning.  The trick of course is figuring out when to rely on the experts and when not to.  More on that in a minute.

The big players were in part relying on the experts to be sure.  Just not the ones mentioned here.  They were relying on the expertise of Moody’s and S&P who have since proven to be manifestly corrupt and craven.  The problem with the bankers was they were acting like street hustlers with better clothes.  Post bailout they still are.

The better lesson one is “If something seems too good to be true, it probably is.” Another version of that same idea is, “There is no such thing as a free lunch.”

Go back through any bubble and that’s what you’ll find.  People saying that real estate values will always go up because they always have.  People saying not to worry that you can’t afford the mortgage when it resets, you’ll just refinance it. People selling trillions of dollars of Credit Default Swaps that in effect created infinity leverage, priced like they would never default.  People bundling risky loans to create AAA rated securities, the same rating the US Government carries (at least right now), except they don’t have a printing press or an army.

Read the rest of the article.  You won’t learn much but it will do a nice job of pouring salt on whatever wounds you still have open about the melt down. Moral Hazard is alive and well in the financial markets.