The Oser View: May 2009

The US economy is now a year and a half into its most distressing crisis since, depending on point of view, the Great Inflation of the 1970s or the Great Depression of the 1930s. We have enough history to make a reasonable assessment of how we got into trouble and where we stand now. First of all, it’s essential to understand and accept the basic fact that the crisis is Nobody’s Fault. No person, group, business, or government desired or worked to achieve it. But all sectors of society are complicit. This crisis was not caused by some alien shock, some meteor crashing into the Yucatan. Somehow our own wishes, philosophies, drives, and achievements unintentionally conspired to bring us down. With that background, it should be clear that a thorough analysis of the problem cannot be encompassed in one commentary. My hope is that interested readers will remember that the electronic channel is two-way and tell me what I have left out or where I have gone wrong.

The crisis is international, but it began in the United States. Three powerful currents in American life, previously separate, were brought together by one catalytic event, which, within a very few years, led to catastrophe. The first current is social. It is the belief that nearly every American household should own a home; in short, the American Dream. Initially, ownership meant free and clear possession. The Dream was realized only when the mortgage was paid off. Following World War II, the Dream subtly changed. It could be realized merely by living in a home with a mortgage instead of renting a home from a landlord. Later still, the Dream added a further dimension, that home ownership would generate wealth through ever-increasing appreciation of the home’s price. By the early part of this decade, the belief that home ownership was an unadulterated Good Thing had become firmly embedded in the American ethos. More than two-thirds of American households, an unprecedented percentage, were homeowners. But mortgage debt had risen to an all-time high while home equity had fallen to an all-time low.

The second current is the evolution of the mortgage business. The demise of the Savings & Loan industry in the early 1980s left a void in the business of mortgage origination that came to be filled by mortgage brokers, who had no direct stake in the mortgages. The mortgage brokerage model, in which all mortgages are sold as soon as they are made, is purely transactional. It is low-cost and derives all its income from up-front fees instead of interest paid over many years. The creditworthiness of the borrower and the value of the property are not intrinsic concerns. They matter only to the extent they interfere with the sale of the mortgage. Moreover, because mortgage brokers are not depositaries, they are very lightly regulated. In the run up to the crisis, no one was looking over their shoulders.

The third current is financial innovation. The growing volume of mortgages made to borrowers with less than sterling credit or on homes whose value was exaggerated was enabled by securitization. Large banks and investment firms bought the mortgages, packaged them, sliced them into classes with varying degrees of support against default, and sold them to investors. Later, these pools of securitized mortgages were recombined, re-tranched, and re-sold until even the most sophisticated investors were hard put to understand what they owned. (This begs the question of why “sophisticated” investors would buy securities they did not understand. There are two fundamental answers, each of which is a commentary in itself. First, they were over-reliant on the major credit rating agencies—Moody’s, Standard & Poor’s, and Fitch. Second, the investors were simply unable to imagine and hence did not model, a deep, prolonged, nationwide plunge in home values.)

The catalyst that brought the three currents together was the deflation scare of the early 2000’s. The inflation rate fell sharply following the 2001 recession. The Federal Reserve Board, and especially its Chairman, Alan Greenspan, had been deeply disturbed by Japan’s “Lost Decade” of the 1990s, when that country was wracked by a series of recessions and a seemingly unstoppable deflation. Now, deflation is not supposed to happen in modern economies whose governments can print money to virtually any extent. Nevertheless, the Consumer Price Index early in 2003 pointed to a real and dangerous possibility of deflation in the United States. (These statistics were later revised to show that the danger was not nearly as great as perceived at the time.) In response the Fed kept the overnight fed funds rate at 1.00% from June 2003 to June 2004. Even when the Fed began to raise rates, it did so slowly, in 25 basis point increments every six weeks.

This period of low short-term interest rates opened the door for adjustable rate mortgages with extremely low introductory or “teaser” rates, as well as other exotic mortgage products. Would-be homebuyers who could not have afforded mortgages at more normal rates could now move into homes with small monthly payments and minimal or no down payments. Public policy, while not directly encouraging the spread of subprime mortgages, certainly did not discourage it, and regulation was absent. Cheap money and easy terms also led existing homeowners to refinance multiple times, in effect turning their homes into lines of credit. The appetite of investment banks and their customers for more and more product to securitize made it all possible by providing the cash.

Still, and this is a key point, the volume of subprime mortgages was not nearly enough to cause a major crisis. Only about $1.2 trillion of true subprime mortgages were originated. They have not all defaulted and the underlying properties of those that have are not all worthless. Delinquency rates of 40% or 50% of subprime mortgages initiated in 2004-07 would, by itself, be a serious social problem, but, to repeat, it could not possibly have touched off a global financial meltdown.

It’s a mistake to speak of a single crisis. We have experienced a series of interlocking and self-reinforcing crises. The first crisis began in the summer of 2007. As subprime mortgage delinquencies rose, investors began to question the value of the securitized instruments that held the mortgages. But because the instruments had become so complex and because it had become so hard to identify exactly who owned what, all non-government guaranteed securitized assets fell under suspicion. As a result, the securities’ market value dropped precipitously. Even this would not have been so terrible if the securitized assets were simply held in investors’ portfolios.

But—or rather, BUT—they weren’t just sitting in investors’ portfolios. They had been used as collateral for borrowing, usually in the form of repurchase agreements or “repo.” And not just once, but over and over again; that is, an entity that held securitized assets as collateral for a loan it made used that same collateral to borrow from some other entity and so on. In all, about $10 trillion of repo was outstanding in the summer of 2007. In repo transactions, borrowers have to post collateral in excess of the amount they wish to borrow. The difference is called a “haircut.” The more unsecure the lender feels about the borrower or the collateral, the bigger the haircut. The loss of confidence in securitized non-government-guaranteed loans meant that haircuts suddenly jumped from 2-3% to 30%, 40%, or even more. Many who borrowed on short-term repo did not own and did not have the resources to buy this much extra collateral. The resulting shakeout led to the demise of Bear Stearns, several high-profile hedge funds, and numerous Special Investment Vehicles (SIVs) that large banks held off their balance sheets. This was the first crisis.

Note that this was a crisis of confidence within the financial system itself. There were losers outside the system, such as, famously, the town of Narvik in northern Norway that put a major portion of its funds in subprime pools. At this stage, most people felt unaffected by the crisis, and the mantra among community banks was, “We don’t have to worry; we didn’t make those kinds of loans.” But, once lost, confidence is not easily regained. All sorts of loans that had previously been sold and securitized—jumbo mortgages, car loans, credit card receivables, student loans—no longer had a market. And if they couldn’t be sold, they couldn’t be made because banks, in contrast to global investors, did not have the liquidity to hold them on their balance sheets. Put very simply, banks were unable to take up the slack left by the sudden and nearly absolute shutdown of the securitization machine.

By mid-2008, a vicious cycle was emerging. New private securitization had stopped and the market for older, outstanding securitized loan pools was moribund. Banks and other investors with large inventories of these securities were forced to write them down to their extremely depressed market values. The result was a drain on capital, in some cases—Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, and Wachovia—to unsustainably low levels. These American institutions and others in similar circumstances in Western Europe were effectively insolvent. Because they were deemed too big, too complicated, or too important to fail, various government re-capitalization and merger programs were implemented. This was the second crisis, and it only served to intensify the first.

Not the least of the consequences was that the public’s confidence in the financial sector was severally shaken. The lack of confidence extended to stock markets, which by the end of 2008 had lost more than $30 trillion worldwide from their peak in October 2007, a massive destruction of wealth. If that weren’t bad enough, more than $3 trillion was sliced from the equity of Americans’ homes. The loss of equity meant that fewer people could afford to sell their homes and fewer could borrow against them. With fewer sales, fewer new homes were built and fewer homes were remodeled. As a result, the many industries dependent on housing, including construction, timber, appliances, and furniture to name just a few, began to falter taking their jobs with them. Another vicious cycle developed in which falling home sales led to falling home prices and job losses, which in turn led to higher delinquencies and foreclosures and even more homes being dumped on the market at fire sale prices. And, it wasn’t just housing. Car loans could no longer be securitized, so fewer cars could be sold. Student loans could not be securitized, so fewer students could afford to go to college. Job losses are now feeding on themselves, destroying purchasing power, reducing sales, and creating more unemployment. This is the third crisis.

The question now is, will there be a fourth crisis. The most likely candidate is a steep decline in the value of commercial real estate with corresponding losses in this sector. So far CRE has held up surprisingly well, but the recent bankruptcy of General Growth Properties, a real estate investment trust that owns more than 150 major shopping centers throughout the country, is not a good omen. Of even greater concern is, or should be, the effect of the crisis on the developing world. Just as community banks were in denial in 2007, some developing countries refused to acknowledge the risk to themselves in 2008. But recent drastic declines in their main source of revenue, exports to more developed countries, have alerted the developing world to its danger. At risk are not only their emerging middle classes, but even those whose connection to international finance is the most tenuous, the poorest of the poor.

On the other hand, the regulatory stress tests of the 19 largest US banks and similar tests in Europe may finally restore confidence in the banking sector. A total capital gap of $75 billion, affecting about half the 19 banks, has been identified. These banks have all expressed assurances that they will be able to meet the challenge, and the government has pledged to make up any shortfall. The Obama administration was elected in the belief that it would actively intervene to restore economic health. Government activism is not everyone’s political cup of tea, but so far the majority of the public supports it. There is absolutely no reason to imagine that this administration and Congress, with its strong Democratic majority, will back off, particularly if evidence of success mounts.

At best, we are far enough into the financial turmoil to suggest a coherent explanation of how it started and how it has developed to date. It is unfortunate and not a little scary that we cannot be similarly confident about how and when it will end.