Our True Enemy Has Yet to Reveal Himself

I don’t quote from The Godfather, Part 3 very much because it’s not a great movie and isn’t even in the same solar system as Part 1 and Part 2, but Al Pacino has two all-time great scenes here: the “pull me back in!” scene after the failed assassination attempt and the final, wordless cut scene of the movie, where — in a mirror-image contrast to Vito Corleone’s heart-attack-while-gardening death scene in Part 1, immersed in green and laughter and love — Michael collapses and dies alone in a silent, gravelly gray Sicilian courtyard, attended only by a stray dog. Pacino is great throughout the film, honestly, and IMO his realization that the plot against him goes a lot deeper than a blustery Joe Mantegna mobster is better acted than Marlon Brando’s far more famous “it was Barzini all along” scene.

Michael Corleone’s realization of a deeper problem (and yes, it’s copied wonderfully by Silvio in The Sopranos) is summed up in this line — Our true enemy has yet to reveal himself — and it’s a line I couldn’t get out of my head in 2008 and it’s a line I can’t get out of my head today.

No one remembers this anymore, but in the second half of 2007 auto prices and auto sales rolled over in the United States, as did home prices and home sales — two classic indicators of an economic slowdown and a recession. The Big Question was whether we were going into a recession or whether this was just a ‘mid-cycle slowdown’, to use the Wall Street lingo. If you go back and look at the financial media articles and Wall Street analyst reports in Q4 2007, you’ll see tons of stuff about that and surprisingly little about the mortgage-backed securities that would actually blow up the world in 2008. I tell people this story all the time, about how ‘normal’ the Wall Street discourse was in late 2007, and they don’t believe me. But if you were there, you know exactly what I’m talking about.

It’s not that the true enemy — an insanely over-financialized US residential mortgage market — didn’t show itself in 2007. Two Bear Stearns credit funds blew up that summer from their exposure to mortgages that were defaulting at an unexpectedly high rate, and the stock price of mortgage originators like Countrywide took a huge hit, as did every bank with a mortgage book over the second half of 2007. But the STORY was that this wasn’t a problem for the entire mortgage market and the entire financial system, that it was only a problem for mortgage lending to the poors subprime (low credit score) market. Hell, according to Fed Chair Ben Bernanke throughout 2007, the ‘subprime crisis’ was not just contained but ‘well contained’ for any major impact on the broader financial system. Sure, maybe mortgage underwriting standards had gotten a little too lax, especially at ‘rogue’ companies that took crazy risks like Countrywide and Bear Stearns, but if you just took those two bad apples off the board (Bank of America agreed to buy Countrywide in January 2008, and JP Morgan bought the corpse of Bear Stearns in March 2008), then everything would be fine. “Systemic risk is off the table” was the dominant market story in April and May 2008, and both equity and credit markets absolutely rocked.

It was all a lie, of course, that whole ‘well contained’ bit about subprime loans, and it wasn’t even a particularly well-crafted lie. I remember like yesterday the Countrywide earnings call of August 2007, where the original Orange Man — tanning bed aficionado and CEO Angelo Mozilo — told the world that ALL of their mortgages, from subprime through alt-A through prime, were deteriorating at a crazy clip. I mean, it’s not like the data was hidden … every month you could look at the delinquency and default rates for the mortgage securitizations, and every quarter the banks and the originators would take another write down and shuffle their portfolio to avoid taking marks. I remember Countrywide just dumping their Q4 loan data in late January 2008, not even bothering to have a conference call because BofA had announced the acquisition and sidelined Mozilo. Contained to subprime? LOOOL. By Q4 2007 delinquencies and defaults were spreading through every mortgage class and every geography like a highly contagious virus.

The first six months of 2008 were such a psychic struggle for me as an investor. We had gone slightly net short in the hedge fund portfolio in Q4 2007, but the truth is that we went net short more because of a recession view – which was a perfectly comfortable place for my partner and the larger value-oriented firm of which we were part – than because of my ‘true enemy’ and systemic risk view. We got paid for that net short positioning in both Q4 2007 and Q1 2008, but it was REALLY tough to stay the course in April and May if you weren’t prepared to adopt the systemic risk view. From a value investor’s perspective, honestly from any normal-times investor’s perspective, it sure seemed like a meaningful buying opportunity after the public execution of Bear Stearns and the associated all-clear signs from the Fed at the end of March. We did, in fact, shift from the recession view to the systemic risk view (that’s as much a credit to the larger firm and my partner than to me), and in retrospect that was obviously the right call, but man, those months were not easy!

I feel as strongly today as I did in 2008 that our true enemy has not yet revealed himself.

I feel as strongly today as I did in 2008 that the ‘normal’ market discourse around recession and jobs and inventories acts as a distraction from the systemic risk that is manifesting itself.

I feel as strongly today as I did in 2008 that to the degree systemic risk is being discussed, it is described as ‘well-contained’ by the US government even though we can all see with our own eyes that it is not contained at all.

I feel as strongly as I did in 2008 that because tens of trillions of dollars and thousands of financial careers are predicated on the systemic risk not happening, it is very hard to ‘see’ the true enemy and even harder to act proactively to protect yourself. I’ll go farther than that. I think that if you’re in the belly of the beast it’s probably impossible — and almost certainly it’s irrational — to act proactively on what I’m writing about. Which is maybe the biggest problem that the world has right now, that the people who are most aware of the true enemy to the global economic system find themselves in a position where it is career suicide to do anything about it.

In 2008 the true enemy was the over-financialization of the US residential mortgage market, and the catalyst for the true enemy to wreak havoc in the global financial system was a sharp, universal decline in US home prices.

In 2025 the true enemy is the over-financialization of the US Treasury market, and the catalyst for the true enemy to wreak havoc in the global financial system is a sharp, universal decline in the full faith and credit of the United States.