Yeah, man…got stung for 48% of our net worth. It sucked. May as well get the moralizing out of the way, then: to survive such things you have to keep cash on hand and stick to the plan.
Right. For starters, I’ve noticed that the housing bubble—hereinafter called the “Tide Pod” thanks to the two years of britches-pooping it caused me—often seems ill-understood by folks who didn’t start investing until the recovery. I partially funded my early retirement by small-scale flipping, so here’s the story as I lived it.
The US economy collectively ate the Tide Pod just after Y2K, when to speed the dot com recovery the Fed lowered interest rates to 1%.1 Consequently, toxic mortgage-based financial products led to widespread overleveraging via:
Teaser-rate mortgages. Lenders wrote 30-year mortgages offering introductory 2%-ish rates. These helped residence-minded borrowers finance homes they wouldn’t’ve otherwise been able to afford, but enabled speculators to leverage into one/several/many homes at once—with the idea being to hold until the teaser rate expired, sell, and pocket what was assumed to be guaranteed appreciation.
Mortgage-flipping. Mortgage brokers flipped loans much like speculators flipped houses. Generous commissions spurred shady loan origination practices, which added fuel to what was called the “subprime” market. Buyers at high risk of default nonetheless got their loans funded; often through outright misrepresentation of their creditworthiness—i.e., fraud—to wholesale lenders.
Mortgage-backed securities. Asset managers in search of ever-higher yields bought mortgages and “packaged” them in a form analogous to bonds whose rates were pegged to default risk. But since many of the loans comprising these securities were based on speculation and subprime, their quality was often grossly misrepresented. Furthermore, major credit ratings agencies signed off on these misrepresentations.
Credit default swaps. Derivatives players essentially wrote insurance policies for mortgage-backed security owners. Viz., Party B would pay Party A a premium to assume the financial risk associated with Party B’s securities. The CDS market was poorly regulated and had no backstop; i.e., no mechanism for making Party B whole if Party A defaulted, meaning one default could cause a cascade of others: B to C to D, etc.
So check it out: trillions of dollars in bad-debt foam, all on the edge of exploding.
In August of 2001 I bought a triple-decker building in Boston, MA, moved into one unit, and renovated the other two for rental. Made good money renting them out. Everybody was doing the same, with the goal being to rent for a while, ride the appreciation up, and condo out the apartments.
We retired in 2005 and immediately sold off our units and moved to a much more rural area to take advantage of lower costs of living.2 My wife and I poured all the money into the stock market and cracked some champagne and drank it in the sun and went skinny-dipping.
But maybe the timing wasn’t so timely, for two years later the Tide Pod blew us all out. You can see its effects on our investments in the chart below.
In less than two years the value of our investments dropped from a high of ~$1.54 million in mid-2007 to a low of ~$750K in early 2009. And note that the shaded area was the cost basis of our total portfolio value, such that in December of 2009 we crossed into a net loss for our entire early retirement fund.
Well, here’s what. Back to the moralizing.
Keep cash on hand. In December of 2007 I’d used the downward drift to harvest tax losses on about $60K in stocks. I didn’t know, of course, the severity of the downturn that was coming, but having roughly fifteen months’ worth of expenses in a money market account meant I didn’t have to sell into a market that was bombing. I’m now religious about keeping at least six months’ expenses in cash, and preferably a year.
Don’t panic-sell. Wow. This can truly save one’s ass. I’ve covered this at length, but towards the end of October of 2008 I called my broker and directed him to sell completely out if/when our net worth was a million bucks even. But peace be upon him, he proceeded to talk me back to sanity. “You’ve always said you were a buy-and-hold guy,” he reminded me.
Truth…which leads me to another chart. Here, to put our recovery from the Tide Pod in perspective, is our net worth between June of 2007 and June of 2017.3
You can see, therefore, that during that period of time we clawed our way back and then some. Plus, we were also making our annual withdrawals of 3.5%-ish. Call it a half-million bucks or better in total w/d’s. Had I panic-sold, though…I don’t like to think about it.
So am I OK with losing $750K in paper gains to the Tide Pod? I wasn’t then, of course, but I am now. In the long term the Tide Pod proved to be…what, a fart in a hurricane? Doesn’t sound quite right, but whatever.
Which leaves us with the Big Question. The economy’s cyclical and many are calling for a recession and ensuing crash to happen soon. Will it? Hell if I know for sure, and hell if anybody else does either. So I’ll end with what I led with: your best chance of digesting a Tide Pod is to keep cash on hand and stick to the plan.
The best historical treatment of the housing bubble is Michael Lewis’s The Big Short, which oughtta be required reading for every FIRE-minded investor in the US. Take a look at the description and reviews and you’ll see what I mean.
- Insert many other contributing factors here, like the repeal of Glass-Steagall, that I won’t get into for the sake of brevity.
- Which proved to be timely: two of the three people I sold to got foreclosed on.
- I use these ranges because prior to 6/07 I was still unwinding our rental real estate, and post-6/17 I’ve been moving our assets away from this broker and into Vanguard.