How Credit Got So Easy
Greg Ip and Jon Hilsenrath have a very nice article on page A1 of the Wall Street Journal. I do think they underplay the most important factors: (i) they don't mention the surge in the profit share that made businesses less dependent on flows from the credit markets for their capital-expansion funds, and (ii) they don't give enough weight to the extraordinary surge in capital inflows coming from foreign central banks. These did most to drive easy credit over the past five years, and they don't receive sufficient stress in the article. And it's not a global savings glut: it's a global investment shortfall. And it's not that there is anything new about it being "easy for investors to buy complex securities they didn't fully understand"--the Bardi and the Peruzzi did so when they loaned to Edward III so that he could launch the Hundred Years War back in the fourteenth century. And many subprime borrowers have gotten a good deal: cheap rent for five years. (And many have not--have been effectively defrauded.)
But all in all, a very nice article:
How Credit Got So Easy And Why It's Tightening - WSJ.com: An extraordinary credit boom that created many first-time homeowners and financed a wave of corporate takeovers seems to be waning. Home buyers with poor credit are having trouble borrowing. Institutional investors from Milwaukee to Düsseldorf to Sydney are reporting losses. Banks are stuck with corporate debt that investors won't buy. Stocks are on a roller coaster, with financial powerhouses like Bear Stearns Cos. and Blackstone Group coming under intense pressure.
The origins of the boom... trace to changes in the banking system provoked by the collapse of the savings-and-loan industry in the 1980s, the reaction of governments to the Asian financial crisis of the late 1990s, and the Federal Reserve's response to the 2000-01 bursting of the tech-stock bubble.... Low interest rates engineered by central banks and reinforced by a tidal wave of overseas savings fueled home prices and leveraged buyouts. Pension funds and endowments, unhappy with skimpy returns, shoved cash at hedge funds and private-equity firms, which borrowed heavily to make big bets. The investments of choice were opaque financial instruments that shifted default risk from lenders to global investors. The question now: When the dust settles, will the world be better off?...
[C]redit problems once seen as isolated to a few subprime-mortgage lenders are beginning to propagate across markets and borders in unpredicted ways and degrees. A system designed to distribute and absorb risk might, instead, have bred it, by making it so easy for investors to buy complex securities they didn't fully understand....
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....
Fed officials who were there at the time generally maintain their policy was right, even in hindsight.... Edward Gramlich, a Fed governor in Washington from 1997 to 2005, says he failed to realize at the time that low rates were making it so easy for lenders to market subprime mortgages with low introductory rates. The Fed and other regulators could have prevented some of the resulting pain with more rigorous supervision of mortgage lenders besides banks, he says. "We didn't have that, and we're paying for it now."
In June 2004, the Fed began to raise the short-term target rate, eventually taking it to 5.25%, where it has been for the past year. Such a boost usually leads to a rise, as well, in long-term rates.... This time, it didn't. Mr. Greenspan expressed concern that investors were willing to accept low returns for taking on risk. "What they perceive as newly abundant liquidity can readily disappear," he said in August 2005, six months before retiring. "History has not dealt kindly with the aftermath of protracted periods of low risk premiums."... Something besides Fed policy was at work. Both Mr. Greenspan and his successor, Ben Bernanke, point to an unanticipated surge in capital pouring into the U.S. from overseas....
As recessions and depressed currencies held down imports and goosed exports in other Asian countries, the countries ran trade surpluses that replenished foreign-exchange reserves. Determined never to be so tied to the onerous conditions of the International Monetary Fund, they have kept those policies in place. Thai reserves... stand at $73 billion.... China's foreign-exchange reserves above $1 trillion.... 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....
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.... 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. At first, delinquencies were surprisingly low. As a result, the credit ratings for bonds backed by the mortgages assumed a modest default rate. Standards for getting a mortgage fell. About 45% of all subprime loans in 2006 went to borrowers who didn't fully document their income, making it easier for them to overstate their creditworthiness. The delinquency rate was a mirage: It was low mainly because home prices were rising so much that borrowers who fell behind could easily refinance. When home prices stopped rising in 2006, and fell in some regions, that game ended. Borrowers with subprime loans made in 2006 fell behind on monthly payments much more quickly than mortgages made a year or two earlier....
Bankers began marketing debt deals for companies that, unlike Yellow Pages, didn't have comfortable cash flow. There was Chrysler, burning cash rather than producing it. And there was First Data Corp., whose post-takeover cash flow would barely cover interest payments and capital spending, according to Standard & Poor's LCD, a unit of S&P which tracks the high-yield market. Last month, investors began to balk. Now many banks find themselves having committed to lend about $200 billion that they had intended to turn over to investors, but can't....
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.... In the late 1990s, Wall Street went a step further, packaging bigger pools of securities into collateralized debt obligations, or CDOs, and carving them into "tranches," each with a different level of risk and return. Riskier tranches suffered the first losses if some underlying loans defaulted. Other tranches offered lower returns because riskier tranches would take the first hits if the business went sour. Because of the way they were structured, some CDO tranches got triple-A ratings from Moody's Investors Service and Standard & Poor's even though they contained subprime loans. That lured traditionally conservative investors such as commercial banks, insurance companies and pension funds.
The upside was evident: Many borrowers got loans they wouldn't otherwise have had. The taxpayer-backed deposit fund was less likely to bear the cost of sloppy lending practices. Banks shifted risks to investors more willing to bear them -- leaving the banks able to make more loans. Investors could pick either more-risky or less-risky slices. And Wall Street middlemen made handsome profits. Now the downside, too, is painfully evident. Final investors were so many steps removed from the original loans that it became hard for them to know the true value and risk of securities they bought. Some were satisfied with a triple-A rating on a CDO -- seemingly as safe as a U.S. Treasury bond but with more yield. Yet as defaults ate through the cushion of lower-rated tranches with unexpected speed, rating agencies were forced to rethink their models -- and lower the ratings on many of these investments.
Some structures were so opaque that markets couldn't value them. But ratings cuts sometimes forced an acknowledgment that securities owned weren't worth as much as thought. In May, Swiss bank UBS AG shut down a hedge fund after a $124 million loss. In June, two Bear Stearns hedge funds saw as much as $1.6 billion of investor capital wiped out by bad mortgage bets and pulled credit lines....
Fed officials believe that even if their policies led to housing and debt bubbles, the strength of the overall economy shows that the policy was, on balance, the right one. Of course, that assumes the current problems don't culminate in a recession...
Subprime borrowers who put no money down and so have no equity and live in non-recourse states have done rather well over the past five years: they have gotten really cheap rent for several years, and now can decide whether to renegotiate or move.
Many subprime borrowers in recourse states, or who had substantial equity, are in trouble as the teaser rates expire--but in foreseeable trouble, it's not as though long-term dollar interest rates have spiked (although they may yet)--unless the terms of their contracts were fraudulently misrepresented to them.
