The Oser View: November 2008

Former Federal Reserve Chairman Alan Greenspan recently told the House Committee on Oversight and Reform that “subprime mortgage originations were undeniably the original source of the crisis.” In the Q&A that followed his testimony, Mr Greenspan was forced to admit to serious errors in monetary policy on his watch. His conclusion about the cause of the present crisis is also wrong. The high default and foreclosure rates of subprime mortgages are not the cause but rather the first major symptoms of a crisis whose roots run deep into the bedrock of modern American culture. Put in the simplest possible terms, we are suffering from too much debt. There is too much debt at the individual level, at the corporate level, and at the governmental level. And the scariest part is that the only solution anyone has come up with so far is…more debt.

Before the advent of nearly universal consumer credit, living within one’s means meant paying cash for everything. Now it means being able to afford all your minimum monthly installment payments: your mortgage, your credit cards, your car note, and on and on. The change in meaning happened gradually over many years. Following World War II, consumer debt was a mere 6% of consumer assets; today it is 20%. Similarly, total mortgage indebtedness as a percentage of home value has risen to more than 50% from less than 20%. While there are still a few human dinosaurs who live debt-free, for the most part, the fear of debt passed away with the generation that lived through the Great Depression.

Regardless of borrowers’ psychology, though, debt could not have proliferated as it has without its being securitized through financial engineering. Debt securitization began in 1970 when the first Ginnie Mae mortgage pools were created and sold. From the start, debt securitization served two beneficial social purposes. It provided liquidity to lenders, allowing those who had the ability to make loans but not the capacity to hold them on their balance sheets to continue lending. Second, it packaged debt in forms that met the needs of a wide range of investors. The result was credit that was cheaper, more readily available, and more flexible for all concerned.

The original securitized mortgage pools were simple affairs. A large number of mortgages with similar terms and interest rates were gathered together, legally placed into a negotiable debt instrument, and sold in public markets. An investor who owned 2% of a pool received 2% of the monthly principal and interest payments it generated. Everything went smoothly until mortgage rates spiked to double digits in the 1980s, and prepayments of older 5% mortgages stopped dead. The cash flows coming from securitized mortgage pools slowed to a trickle, which was not what most investors wanted or expected.

American finance was up to the challenge. Business schools were breeding a corps of sophisticated financial engineers, and Wall Street put them on the case. Their solution was the Collateralized Mortgage Obligation (CMO). CMOs are bonds that divide pooled mortgages into segments, called classes or tranches. Each class has its own cash flow and risk/reward characteristics. Money market funds can own short term CMO classes, banks can own medium-term classes, and life insurance companies can own long-term classes, all constructed from the same underlying mortgages. But hidden within the math of CMOs were seeds that would eventually bear the toxic fruit of SIVS and squared and cubed CDOs that have so sorely wounded the global financial system.

To continue our story, Wall Street, by the middle of this decade, had moved beyond mere engineering. It was now operating at the level of genetics. Mortgages and other debt were combined and re-combined, tranched and re-tranched into ever more recondite structures. The financial geneticists relied on the mathematical models they built from too recent and too benign consumer data. The models “proved” that risk could be isolated in tranches for those aggressive investors willing and able to accept it. For the rest, the credit rating agencies were well paid to certify most tranches AAA, the highest grade of credit quality.

Meanwhile, unregulated mortgage brokers had discovered that Wall Street viewed debt merely as a commodity to be securitized, regardless of its quality. Once all the right people had been put into the right kinds of loans, and those loans were securitized, the brokers simply went down market. They put the wrong people into the wrong kinds of mortgages, which were securitized to the tune of $850 billion. They could not have done it, though, without willing borrowers. The people who signed the wrong mortgages took on debt out of all proportion to their ability to repay it. Some realized what they were doing and some were misled, but for all of them, debt was not something to fear. It was the American way of life. Too much debt, by definition, means too little equity. Without enough equity, it only took one small crack in the Tower of Debt to bring the whole thing tumbling down. That one crack was subprime mortgages.

The normal and natural reaction to a debt crisis is retrenchment. Lenders tighten their standards, and borrowers do their best to be more frugal. Unfortunately, in an economy fueled by consumer spending, we are too far gone for the normal and natural to work. In fact, the normal and natural would turn this crisis into a full-scale disaster. I strongly urge you to read Federal Reserve Chairman Ben Bernanke’s prepared testimony to the House Budget Committee on October 20. It is available on the Fed’s website, http://www.federalreserve.gov/newsevents/testimony/bernanke20081020a.htm . Mr Bernanke provides as cogent and insightful a summary of the financial crisis and current economic conditions as I have read anywhere. But a continuing motif running through the testimony is the need for more lending, not more saving, to “promote the return of solid gains in economic activity and employment.”

Mr Bernanke chronicles the Fed’s efforts to revive lending among banks and borrowing by primary securities dealers. He describes the many steps the Fed has taken to jump start the commercial paper market, on which major corporations depend for operating funds. Next he turns to consumers and businesses, explaining what the government is doing to “restore trust in our financial system and allow the resumption of more-normal flows of credit to households and firms.” He laments that the “increased difficulty in obtaining auto loans appears to have contributed to the decline in auto sales.” He highlights “reduced credit availability from banks and other lenders” as a primary cause for the fall-off in business investment. Finally, he concludes that “the time needed for economic recovery will depend greatly on the pace at which financial and credit markets return to more-normal functioning.”

That’s a lot of mentions of credit and no mention of saving. No one in or out of Government has said, “The solution is to save more and spend less.” Indeed, there is little the Fed and the Treasury are more afraid of. The Japanese call the 1990s, a period of recession punctuated with a few anemic attempts at recovery, “The Lost Decade.” No amount of fiscal or monetary stimulus could get Japanese citizens to open up their wallets and spend. Instead the Japanese built up one of the highest savings rates in the world to go along with an economy that hasn’t yet fully regained the position it held in the 1980s. Thrift is, without a doubt, a personal virtue. But America as a whole can’t be a creditor. To uphold our own and the global economy, our job is to buy what the rest of the world makes. And the rest of the world has to lend us the money to do it.

They will have to lend us a lot. Treasury debt issuance will rise to a record $550 billion in the fourth quarter, up from $530 billion in the third quarter, which was also a record. The previous record, $244 billion, was set in the first quarter. The economic consensus is that the Treasury’s budget deficit for the current fiscal year, which ends on July 31, will be $988 billion. Estimates of total Treasury borrowing in calendar 2009 as high as $2 trillion and federal deficits of $1.5 trillion are being made, and taken, seriously. And beyond the current shortfalls, we have the specter of unfunded Medicare and social security to look forward to.

Yet, somehow, we’ll make it through and things will get better, especially with a new administration in Washington. Probably we will save a little more and borrow enough to keep everything in motion. But, like those who lived through the Great Depression, we will bear the scars of this experience with us for our lifetimes.

Earlier this year, manufacturing was the clear leader of the US economy. Productivity was increasing and exports were booming thanks to the weak dollar. Economists were seriously concerned that robust demand for raw materials used in manufacturing, especially crude oil and industrial metals, was stoking the long dormant fires of inflation. Those concerns have evaporated as commodity costs have plummeted. Copper is often called “the metal with a PhD.” It is used in so many applications that it is an excellent barometer of general economic conditions. Since peaking on July 2 at $407.55 a pound, the price of copper has fallen almost 55% to just $185 a pound.

Today, the Institute for Supply Management, a trade group for purchasing managers, released its monthly survey of manufacturing conditions. The outlook declined for the third month in a row, but October’s drop was precipitous. The survey produced the lowest reading since the deep recession year of 1982, and the text referred to “significant demand destruction.” Every individual category but one was down sharply, including production, new orders, backlog of orders, export orders, and new hiring expectations. The only category that increased was the one that shouldn’t. Customer inventories grew as sales slowed.

Nowhere have sales been slower than in the automotive sector. Ford has already announced that its sales in October dropped 30% from a year ago, marking the 23rd decline in the last 24 months. GM and Chrysler are expected to post even larger percentage declines. Total vehicle sales are expected to reach an annualized rate of about 12 million units, which would be the least since the spring of 1993. The automakers’ problems are exacerbated by not being able to sell debt. Bloomberg reports that just $500 million of auto bonds were sold in October compared to $9 billion a year earlier. In fact, neither Ford, GM, nor Chrysler has been able to sell bonds since May. At its last sale, Ford had to pay a floating rate of 1.42% over the benchmark LIBOR interest rate, compared to just 0.03%, which it paid in June 2007. Meanwhile, the New York Times reports that the Treasury has refused to provide $10 billion in financing for a GM/Chrysler merger. If you had $10 billion, you could buy all the outstanding common stock of both Ford and GM…and have more than $1.5 billion left over.