August 08, 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.
On balance, the credit markets have had an incredibly beneficial impact on the housing market. When you get a loan from a lender, the lender sells the loan to an investment back. The investment bank then pools that mortgage with mortgages of similar quality (same interest rate, maturity etc..) and securitizes the pool. In short, they make a bond out of the pool and then sell that bond to a variety of investors like insurance companies, mutual funds etcÃ¢â‚¬Â¦ This has created a ton of liquidity in the mortgage market, which allows more people to buy homes. Overall, this is a good thing.
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%."
Until the late 1990s, the subprime market was dominated by home-equity lines used by borrowers to consolidate debt and by loans on mobile homes. But when the Fed held rates down after 2001, lenders could offer borrowers with sketchy credit histories adjustable-rate mortgages with introductory rates that seemed affordable. Mr. Barnes says customers were asking about "2/28" subprime loans. These offered a low starter rate for two years, then adjusted for the remaining 28 to a rate that was often three percentage points higher than a prime customer normally paid. Customers, he says, seldom appreciated how high that rate could be once the Fed returned rates to normal levels.
Demand from consumers, on one side, and Wall Street and its customers on the other side prompted lenders to make more and more subprime loans. Originations rose to $600 billion or more in both 2005 and 2006 from $160 billion in 2001, according to Inside Mortgage Finance, an industry publication.
But let's also remember a basic rule of economics: when you lower the price of a good, you increase the amount of that thing you can sell. And when you lower interest rates to 0% after inflation, you are basically giving money away. And that's what happened with the record low rates of the early 2000s.
Now let's add two other factors to the situation and learn who was buying all of these new loans.
OK -- let's go over some bond market basics. Prices and yields are inversely related. When prices go up, yields go down. The reverse is also true. Keep this central fact in mind as we go forward.
In June 1998, U.S. Treasury officials made a plea to China that they would be reminded of repeatedly in the following years. Thailand had devalued its currency in 1997, touching off a crisis in the region that led other countries to devalue and in some cases default on foreign debt. The yen was sliding. Chinese officials, who pegged their currency to the U.S. dollar, "let it be knownÃ¢â‚¬Â¦that if things kept going this way they'd have no choice but to devalue," recalls Ted Truman, a Treasury official at the time. The U.S., fearing such a move would trigger another round of devaluations, urged the Chinese to hold their peg, and praised them when they did so.
Long after the crisis passed, China's economic fundamentals suggested its currency should rise against the dollar. China let it rise only slowly, continuing to juice exports and produce trade surpluses that pushed China's foreign-exchange reserves above $1 trillion. When the U.S. pressed China to let its currency float, China reminded the U.S. of the fixed exchange rate's stabilizing role in 1998. China put much of its cash -- part of what Mr. Bernanke has called a "global saving glut" -- into U.S. Treasurys, helping hold down long-term U.S. interest rates. Chinese government entities also recently poured $3 billion into U.S. private-equity firm Blackstone.
When the Fed started to raise rates in 2004, long-term rates should have also increased. If this had happened -- if long-term rates had naturally increased with the Fed raising short-term rates -- the current mess would probably not be as severe. High long-term rates would have decreased the demand for long term loans like mortgages.
But long-term interest rates didn't rise. The main reason is there were a ton of buyers for US debt. So long as there was an incredibly large pool of willing buyers, US interest rates would remain abnormally low. In other words, interest rates weren't low because of fundamental reasons (like rising short-term rates), they were low because of technical reasons like a lot of buyers. Therefore, when the Fed started raising short-term interest rates, long term rates didn't follow.
Here's the final piece in the puzzle. Low interest rates completely screws up an entire class of investor -- conservative money. Low interest rates mean this class of investor's traditional way of making money isn't gong to work very well. In a 0% fed funds environment this investor has to find other ways of getting more yield. Hence, they are more likely to take risks. Therefore,, the more exotic loans structures like credit derivatives become more attractive.
The subprime and LBO booms required willing lenders. The stock-market collapse and low interest rates of 2001 to 2004 nurtured a class of investors and products to fill that role. Managers of pension and endowment funds long had divided their assets among domestic stocks, bonds and cash. The funds saw their performance suffer when the stock market and then bond yields tumbled.
A few endowments, most notably at Yale and Harvard, had for years been spreading their investments more broadly, going into hedge funds, real estate, foreign stocks, even timberland. The goal was holdings that wouldn't suffer in sync with stocks in a bear market. Sure enough, in 2000 and 2001, even as stocks tumbled, Harvard Management Co. earned returns of 32.2% and -2.7% respectively. Yale's returns were 41% and 9.2%.
Other institutions wanted their money managed the same way, seeding a flood of hedge funds that bought other untraditional investments such as credit derivatives. University endowments poured roughly $40 billion into hedge funds between 2000 and 2006, according to Hedge Fund Intelligence, a newsletter. "I call it the 'Let's all look like Yale effect,'" says Jeremy Grantham, chairman of Boston money manager GMO LLC.
Low interest rates made many investors willing to buy exotic securities in an effort to boost returns. Wall Street had just the vehicle: securitization, or turning loans that once sat quietly on banks' books into securities that can be sold in global markets.
So, let's sum up with a few simple bullet points.
1.) The Fed lowered rates to 0% after inflation. They did this to stimulate the economy. However, this
2.) Made it too easy to loan money to higher-risk borrows, and
3.) Made it more likely that conservative investors would buy risky products to get a better yield.
4.) US long-term rates were kept artificially low because of foreign purchasers of US debt.
Personally, I think Bernanke has realized the fundamental problem and is so far unwilling to bail out the US economy with cheap money. Instead, I think his objective is to deal with inflation and contain inflation expectations to create some stability for the economy to deal with this. At least that's my read so far.
In summation, this is a big mess that's going to take awhile to clean-up. And the clean-up is going to do some damage.
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