A Brief History of the Current Credit Mess

By Bonddad , Daily Kos. Posted August 8, 2007.

How on earth did we get here?  The credit markets are seizing up after 7 years of free-flowing funds.  Yesterday, the Wall Street Journal had an excellent piece on how we got here.  Below, I'll run through the basics with some commentary.

When a technology stock and investment plunge and the Sept. 11 terrorist attacks pushed the economy into recession in 2001, the Fed slashed interest rates. But even by mid-2003, job creation and business investment were still anemic, and the inflation rate was slipping toward 1%. The Fed began to study Japan's unhappy bout with deflation -- generally declining prices -- which made it harder to repay debts and left the central bank seemingly powerless to stimulate growth.

"Even though we perceive the risks [of deflation] as minor, the potential consequences are very substantial and could be quite negative," Mr. Greenspan said in May 2003. A month later, the Fed cut the target for its key federal-funds interest rate, a benchmark for all short-term rates, to 1%. It said the rate would stay there as long as necessary, figuring low rates would bolster housing and consumer spending until business investment and exports recovered. The rate stayed at 1% for a year.

Mr. Greenspan raised vague fears with colleagues over the possibility this policy could create distortions in the economy, but he says today that such risks were an acceptable price for insuring against deflation. "Central banks cannot avoid taking risks. Such trade-offs are an integral part of policy. We were always confronted with choices."

Central Bankers have an incredibly difficult job, especially during turbulent economic times.  They must choose between difficult policy choices -- especially when the economy is in trouble.  The economy grew slowly after the recession officially ended in November 2001.  Part of the reason for the lack of business investment was the post Y2K/1990s tech boom hangover.  During those years, US business invested a ton of money in technology.  At some point, all of this investment became over-investment, meaning business had added so much capacity it literally did not know what to do with it all.  Hence, the investment slowdown at the beginning of this expansion.

I should also go on record as being extremely critical of Greenspan's overall policy choices.  The markets nick-named him "easy Al", meaning there was no economic problem he could not throw a ton of cheap money at.  There are times when this is a good thing.  For example, after the stock market dive in October 1987, Greenspan opened the cash spigots and literally flooded the street with cash.  At the time and in retrospect, this was a good thing because it eased investors concerns.  However, there are times when easy money is a bad thing because it promotes reckless behavior.  In addition, the US thinks it has to always grow at 3% plus.  The reality is when an economy is overbuilt it must absorb that overcapacity, which takes time.  Simply put, an economy that experienced a period of excess investment must absorb that investment.  I would argue this is what happened at the beginning of this expansion.

However, Al lowered rates.  And we know what happened from the domestic perspective.

Lou Barnes, co-owner of a small Colorado mortgage bank called Boulder West Inc., has been in the mortgage business since the late 1970s. For most of that time, a borrower had to fully document his income. Lenders offered the first no-documentation loans in the mid-1990s, but for no more than 70% of the value of the house being purchased. A few years back, he says, that began to change as Wall Street investment banks and wholesalers demanded ever more mortgages from even the least creditworthy -- or "subprime" -- customers.

"All of us felt the suction from Wall Street. One day you would get an email saying, 'We will buy no-doc loans at 95% loan-to-value,' and an old-timer like me had never seen one," says Mr. Barnes. "It wasn't long before the no-doc emails said 100%."

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