What follows is a highly simplified account of the very complex state of the U.S. and global credit markets.
Wild cards aside, the biggest potential story of 2008 will be the U.S. economy and the risks in the American credit markets. Right now almost all the potential forecasting errors are on the downside, which is to say that the end result may be worse – and possible much worse – than current projections. The reason is the unraveling of the credit markets. This is a saga that has been given a great deal of play in the media already, but not as much as it deserves because there’s an outside chance that we may be heading into a global economic disaster in 2008.
Let me take a step back and review where we are, and how we got here. The previous asset price bubble took place in tech stocks in the late 1990s and into 2001. When tech stock prices collapsed, they threatened both the U.S. and global economies with a recession. In response, the U.S. Federal Reserve Bank (the ‘Fed’) flooded the system with liquidity, lowering interest rates far more than would normally have been the case, and keeping them low an abnormally long time. They did this in part to stave off recession, but, more importantly, to prevent a slide into deflation – an unusual and exceptionally dangerous economic condition, as Japan learned in the 1990s. However, when the danger of deflation passed, the Fed didn’t raise interest rates far enough, or fast enough to soak up the excess liquidity.
As a result, low interest rates and the easy availability of money encouraged borrowers to borrow more than they might otherwise have done. In particular, potential homebuyers were able to buy houses they would not otherwise have been able to afford because low interest rates meant lower monthly mortgage payments. This ignited the demand for housing in the U.S., with the result that house prices rose.
In turn, rising home prices, coupled with continuing low interest rates, encouraged some homeowners to trade up to bigger houses, and others to borrow against the increased equity in their homes to increase their lifestyles, mostly by buying consumer goods. This latter effect was described as using your home as a credit card.
A fool’s paradise
These two things together created a rosy glow in the economy, a continuing upward surge in housing prices, and a strong U.S. dollar, which made imported consumer goods even cheaper. This triggered what seemed to be a ‘virtuous cycle’ where rising home prices allowed people to borrow more money to buy bigger houses, or to buy more consumer goods, which strengthened the economy and the dollar, which, in turn, increased housing prices further and lowered consumer prices.
But, as with many things that seem too good to be true, this was a temporary aberration which had to stop eventually. In particular, two kinds of excess started to creep into the marketplace. First, house buyers, including many new get-rich-quick speculators, decided that house prices would keep increasing forever, and therefore, they could only gain, and never lose. This is called the ‘Greater Fool Theory,’ that speculators could afford to buy at any price because some greater fool would come along and buy the property from them at an even higher price. Many real estate investors made paper millions, and started to borrow even more to buy even more to profit even more. This added fuel to the real estate fire.
Meanwhile, the second set of excesses came from lenders. In this kind of environment, profits seemed easy as investors really didn’t care what kinds of fees or interest rate margins they were paying, as they were planning to flip their houses at a fat profit soon anyway. And lending also seemed safe – safe as houses – because prices were always going up, so the equity cushion available to lenders to protect their loans kept increasing as time went on. Soon, even staid, old fashioned banks plunged in, lending with both fists, and fighting for market share of a rich, vast, and rapidly expanding market.
But the financial markets can never be interested in a good thing without trying to gild the lily, and Wall Street geniuses responded with new ways of raising capital to lend into this market through a vehicle called ‘securitization.’ Securitization meant that you packaged up a bunch of loans, and effectively sold shares in them. This meant that while any individual loan might be risky, the group of loans would be less risky because there was a range of differing qualities of loans in the package. Even better, if you had a big batch of loans, you could segregate them into different tiers of quality, selling shares in the best quality loans to the most conservative investors, and the highest yields and highest risks to the most aggressive investors. This allowed the packagers to attract even more money into real estate loans, further fuelling the spiral.
Then they improved on that by arranging for companies to insure the securitized loans, taking a slight premium from the packager, and guaranteeing to pay any loans that defaulted. Since real estate prices were steadily rising, there were hardly any defaults, so competition for selling this kind of insurance rose, and rating agencies gave some of the insurers AAA credit ratings. So investors were happy to buy the guaranteed securities since they appeared to offer both high yields, and negligible risks. All of this caused even more money to gush into the housing market.
By now, it seemed foolish not to jump in and make money – or at least buy a home. Individuals who, in normal times, could never even get through the doors of a bank, let alone borrow from one, were now welcomed with open arms. Such borrowers, who came to be known as ‘NINJAS’, meaning ‘No Income, No Jobs or Security’, were given loans they had no right to ask for, and no way to pay, even at low interest rates. Many lenders implicitly or explicitly encouraged these borrowers to lie on their applications so they could issue the loan. They didn’t have to worry about getting it paid back.
If this seems strange, it’s easily explained. Normally conservative bankers didn’t really care how bad a credit risk a given borrower might be. They would make the loan, collect the banking fees, and then turn around and sell the mortgage to a pool that securitized a collection of such mortgages. Since the bank wasn’t going to hold the mortgage, they really didn’t care how bad the credit was. And the investment house that bought the mortgages, securitized them, and sold strips of them to investors, collecting their packaging fees along the way, didn’t care how bad the mortgage borrower was, because they weren’t going to hold the mortgage, either. And the investors who bought the mortgage securities didn’t care how bad the mortgage borrower was because he was only one of many, and besides, the mortgages were insured by financial companies that the rating agencies said were AAA credits. And the insurers didn’t really care how bad the mortgage borrower was because he was only one of many, and besides, the housing market kept going up, so even if a given borrower defaulted, the house could be sold for more than it was purchased for, and the mortgage would be paid back. And as long as interest rates were low, and no one really looked too closely, everything seemed fine, everyone was making money, everyone was happy, house prices kept going up, the dollar stayed strong, the consumer was happy consuming, and the economy roared like a blast furnace.
What made the music die
When you describe the situation like this, it’s easy to see that it was a fool’s paradise, and wonder how anyone could get sucked into it. But at the time, you looked like a fool arguing that this was foolish. It was like trying to stop an express train by standing in its path. In this way, it was very like the tech stock bubble of the turn of the century. But the damage from this bubble will be very much worse than the tech bust.
What probably made the music die was two things. First, some of the individual mortgage borrowers who couldn’t afford their mortgages started falling behind in their payments. At first, the lenders found ways of avoiding foreclosing, because that wasn’t part of the beautiful money making system they were involved in. Eventually, though, they had to start kicking bad risks out of their houses, and putting the houses on the market.
The second thing that stopped the music was that the Fed had been very slowly, but very steadily, raising interest rates. Since many mortgages had variable rates that moved with bank prime, as the Fed raised rates, the interest rates on those mortgages rose, raising monthly mortgage rates. Other mortgages had short-term, below-market ‘teaser’ rates that were lower than market rates in order to attract even more mortgage borrowers. When those teaser rates came up for renewal, monthly mortgage payments rose, in some cases quite dramatically. When these lenders couldn’t meet their new, higher monthly payments, their houses, too, started going on the market.
Now the beautiful money machine was revealed for what it really was: an asset bubble, a fool’s game in which everyone had thrown prudence to the winds and focused on profit, and no one had considered consequences. And forced-sale houses started to drag the housing market down, first slowing, then depressing prices. But when housing prices started declining, the equity securing all of those loans started to shrink, foreclosures started happening more rapidly, and mortgage insurers started to be called upon to make good on losses. As that gathered speed, insurers started going bankrupt, even the ones that were deemed to be AAA credits. And that meant that the securitized mortgage loans were no longer investment grade – heck, many of them weren’t even of junk bond grade. So investors started dumping them. But as they started to dump them in earnest, other investors, who had earlier happily filled their portfolios with these apparently high yielding, low risk investments, got scared and stopped buying.
And that’s more or less where we are today. But if you stop thinking about this impersonally, and start thinking about who all these lenders, investors, and insurers are, you realize that some of the biggest financial companies in the world, and many others as well, are at risk. This includes companies like Citicorp, one of the biggest banks in the world, that has already written off more than $18 billion in these cheesy securities, and may well write off a lot more. It includes non-financial companies, including airlines, media companies, manufacturers, and others, whose only sin was to buy investments that seemed to offer above-average returns. And the bond and stock markets themselves are at risk of losing their liquidity, which means they stop being able to operate, because the worst part about this all is that no one knows who has how much of the underlying bad debts.
All of that mortgage lending without proper prudence means there are a lot of bad loans out there, and they are getting worse as their mortgages come due for renewal at much higher interest rates. And housing prices continue to fall as more mortgages are foreclosed and the houses are dumped on the market, with the result that housing prices continue to fall, putting even more pressure on the market, and scaring homeowners who wonder if they’re next. And consumers start behaving as consumers always do when they get scared – they stop buying and try to hold onto their money. This slows consumer purchases, and causes economic growth to fall, and is one of the classic things that can trigger a recession.
Because of that, the U.S. economy doesn’t look so rosy, and foreign investors start edging out of the U.S. dollar, which starts to fall. The decline of the U.S. dollar, which has long been forecast, causes other investors to try to get out of dollars, putting even more pressure on the greenback. This raises import prices to the U.S., putting a further damper on the U.S. economy. So now we have all the ingredients necessary for a U.S. recession. but that isn’t the worst of the story.
Our worst nightmares
We are now at the stage where we are vulnerable to some kind of nasty surprise that could trigger a panic. At this stage in earlier economic cycles, this would have been the unexpected bankruptcy of a major company. Suppose, for instance, a major car company, manufacturer, or some other blue chip company, a household name, becomes accidentally insolvent because they took some of their cash reserves and put it into one of these mortgage or asset-backed securities. With that market in chaos, and prices falling on even the best of these securities, it might be that a major corporation could find itself without enough cash to pay its bills, even though its business is good, even though its customers are still buying, even though it’s picking up market share, and even though it has lots of assets on its balance sheet. They might announce, typically on a weekend, that they are going into Chapter 11 to seek protection from their creditors because they’re short of cash.
And that announcement could panic the stock and bond market, because here’s a blue chip company, with no evident problems, suddenly going broke out of the clear blue, because they didn’t have enough cash on hand to pay the bills on a random Friday. And the markets would then ask a really dangerous question: Who’s next? If Company X can go broke on us when they seemed perfectly healthy, who else is teetering that we don’t know about? And investors and lenders would pull back from investing or lending to anyone who might even be rumored to be in trouble, no matter how good their name was. This would become a self-fulfilling prophesy, for without investments and loans to lubricate the wheels of the economy, many companies would find themselves in financial trouble, even though their businesses are solid and sound.
But that’s only the second-worst nightmare. The worst nightmare is that the markets get spooked about the banks, and that unease spills over into the general public, which has deposits in the banks. Then someone (and we never know who or why) decides that they’re worried enough that they decide to take their money out of the bank to keep it safe. When word gets out that people are starting to withdraw their money from a given bank, it creates a ‘there’s never smoke without fire’ mentality, and everyone who has deposits at that bank rushes to get their money out while they can. This is called a run on the bank, and when it starts at one bank, it can easily spread to some or all of the banks. And since banks don’t keep their deposits in their vaults, but lend it out in the marketplace, a determined run can destroy a bank, and simultaneously destroy confidence in the entire banking system. That was one of the triggers that brought about the Great Depression of the 1930s.
Nor is it just U.S. companies that are at risk. Many global players from all countries bought these asset-back securities, because they offered above-average returns at seemingly acceptable risks. That the risks were wrongly evaluated is now apparent, but there are lots of global companies with these securities on their books. So it could be a non-U.S. blue chip that goes bankrupt, or a non-U.S. bank that experiences a run, and starts a panic. Where the dominoes fall after that, no one knows.
Does it have to be this way?
Will this happen? Well, first, probably not. All the world’s central bankers know these risks are out there, and they are all acting together to make sure there is enough liquidity to keep the global economy running. That’s why the central banks of the United States, Canada, the EU, Britain, and others very publicly announced in mid-December that they were injecting liquidity into the marketplace. And they are also undoubtedly twisting arms behind the scenes to make sure that the banks and other major lenders are not suddenly withdrawing from the credit markets, causing the markets to dry up, stranding otherwise solvent and solid companies.
And if it does happen, then the panics are usually short-lived. Indeed, there has already been one run on a bank, in the United Kingdom. Northern Rock Bank was a minor bank, and other banks are now fighting over who will get to buy them out. However, that only happened because the Bank of England has effectively guaranteed any losses, at great cost to the British public purse. So runs can be stopped before they turn into panics, if they are small enough, contained early, and the public regulators are willing to accept significant costs to stop them.
But the risks are out there. Worse, they are hidden, and they are going to be out there for years, for no one really knows who is holding bad loans, or how many of them are going to go bad. And as mortgages come due in the U.S. housing markets, and the interest rates on the mortgages go up over the next several years, still more houses will be foreclosed and dumped on the market. Indeed, the biggest interest rate renewals aren’t due to occur until 2009.
We have not seen the bottom of this market, nor an end to the problems in the credit markets, and although the declines in both have been orderly so far, there are no guarantees that it will stay that way.
So this is probably the biggest story of 2008. At the absolute best, the U.S. economy will slow significantly. At worst, we could see a global financial panic that triggers a global recession. And no one knows what the odds are either way. That’s the really scary part.
© Copyright, IF Research, January 2008.
by futurist Richard Worzel, C.F.A.
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