Credit Contagion
In the face of the worst credit and financial crunch since the Great Depression, many of our politicians, commentators, and even nonfinancial CEOs seem to be in a state of virtual denial of the risks we face. Mere talk about change and hope will not cut it. The past has caught up with us, and there won't be much of a future until we work those problems out.
We are having a bad hangover from easy money. Very easy. Thanks to low interest rates and an expanding money supply, people and companies borrowed more than they could reasonably pay back. The average debt-to-income ratio for the middle class in America has climbed to 141 percent, twice what it was in 1983. In the United States as a whole, the ratio of all debt to GDP rose to 342 percent at the end of September 2007, more than double what it was in 1975. It grew rapidly after 2000, in what could be described only as a bubble.
Asset prices increased and economic growth accelerated with a double bubble in credit and housing. Banks were willing to lend more and more to purchasers who bid more and more for a house, causing home prices to rise and giving the banks and other buyers even more confidence that prices would increase, justifying even more lending. So, too, with other asset prices. Banks set up off-balance sheet subsidiaries that piled up debt; leveraged-buyout groups borrowed many billions to take companies private; hedge funds borrowed to invest in assets—and the beat went on.
Spreading problems. But the way up is also the way down. As the price of assets began to decline, the result was a contraction of debt as banks lost billions, first on subprime mortgages that rested on declining residential real estate. Then the contagion spread to other categories of debt: credit cards, car loans, student loans, leveraged-buyout loans, commercial mortgage-backed securities, and other financial instruments—all of which once looked solid and now began to experience capital losses. Banks had to call in lines of credit because they needed to rebuild their capital and fulfill their capital ratio requirements, which meant reducing loans, forcing more borrowers to sell assets, which begat lower prices, which begat further declines in the collateral of the bank loans, which begat banks cutting their loans and credit lines again. This became the inverse of the original debt buildup that once fueled asset prices.
One symptom of the bubble was that investors and lenders had come to depend on cheaper short-term borrowing to finance higher-yield long-term holdings. When lenders got nervous, short-term borrowing became either unavailable or too expensive. This is unprecedented, for in the past 26 years the yields on longer-term paper—the 10-year treasury notes—have been higher than the yields on the short-term paper—the 3-month treasury bills—for all but 22 out of 313 months, according to the Wall Street Journal's Jon Hilsenrath. This borrow-short, invest-long strategy has worked over 90 percent of the time. When it doesn't, the consequences are proving to be catastrophic because of the degree to which this kind of leveraged structuring took place. Where lenders once seemed to overlook this risk, there is now a crisis of confidence, causing bubbles to burst all across the credit markets.
With all this money available, credit cards, auto loans, and other consumer debt were extended to almost everyone who could walk, resulting these days in a dramatic increase in loan delinquencies and defaults. And this is coming even before the unemployment rate has increased cyclically and before a formal recession has struck. American Express has responded by raising its provisions for loan losses by 70 percent to $1.5 billion. Goldman Sachs predicts credit card losses will reach $100 billion out of the roughly $1 trillion in the revolving balances of all U.S. credit cards. Lending standards are being tightened on nearly all types of consumer credit, and this may lead to the first full-scale contraction of consumer credit in over 15 years. The concern is that consumers may be pushed to the breaking point, reflecting not only the shutdown of the their buying spigot but a fundamental shift in their optimism and confidence in the economy.
Public views of the economy are the most negative in 15 years. Six in 10 believe the United States is already in a recession, according to a recent Washington Post/ABC poll. As a result consumers, especially those nearing retirement, will increase their savings the old-fashioned way, not out of asset appreciation but out of income, raising the possibility that the consumption share of GDP will likely drop from the current level of 72 percent back to the 25-year trend level of 67 percent. This may mean a recession that will be longer and deeper than anything we've had since the end of WWII.
Credit problems have emerged in many other financial corners. Leveraged buyouts once financed by corporate bonds in the multibillion-dollar private equity boom of recent years are also in trouble. During the past weeks, prices on these loans have been falling, jeopardizing more than a half-trillion dollars of related securities. Banks are now having a hard time reselling these buyout loans and will have to write some of them off. The same is true of commercial mortgage-backed securities used to finance large office building projects. Estimated losses here again are in the tens of billions of dollars, and this market has virtually shut down.
The greatest area of concern, though, is falling prices in the biggest asset category in the U.S. economy—homes. The consumption binge of the last decade was, to some extent, a reflection of the housing market bubble that made it possible for homeowners to refinance their homes and free up over a trillion dollars. The binge suddenly reversed as house prices fell for the first time in decades last year. Estimates are that this decline will continue in 2008 and 2009 by as much as 10 percent each year. The derivative markets are predicting further declines of about 20 percent in home prices, which would wipe out some $5 trillion from the net worth of American households.
The feel-good factor for American consumers conferred by ever-rising home prices is now over. More and more homeowners are finding that they owe more on their mortgage than their house is worth. This negative equity is prompting many to walk from their mortgages and homes, making the debt the problem of the banks. As foreclosed homes get put on the market, it puts ever more downward pressure on home prices, which gives even more homeowners the incentive to walk.
Abandoned homes. If prices decrease by as much as 20 percent in 2008 and 2009, as Merrill Lynch estimates, this may mean that over 10 million American homeowners will have no equity left. No one knows what effect this will have on our national economy. The potential tidal wave of home foreclosures will throw many families into the streets, erode home values of other properties, and damage neighborhoods. There are some estimates that more than 2 million foreclosures could take place over the next two years.
What can public policy do under these circumstances?
The impact of the Federal Reserve is limited. The Fed cannot restore relaxed lending conditions or create mortgage rates that forestall defaults. Nor can it maintain today's unsustainable home prices. What the government must do is prevent hundreds of thousands of foreclosed homes from being thrown on the market, provoking an accelerated collapse of housing prices. The challenge is to find a way to help stressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners can afford. This can be done by following the precedent of the Great Depression, when a government agency bought up mortgages held by banks, traded them in for safe government bonds, and then issued new loans at lower rates to homeowners so they could afford to keep their homes. The government agency, called the Home Owners' Loan Corp., granted over a million mortgages, roughly 1 in every 5. Adjusted just for population growth, it would amount to 2.5 million mortgages today.
Alan Blinder, a former vice chairman of the Federal Reserve Board of Governors, recommends such an agency that would refinance only owner-occupied residences, leaving speculators to fend for themselves and excluding second homes and vacation homes, along with very expensive real estate. Also excluded would be mortgages where the borrower misrepresented himself—although Blinder recommends that cases of fraud or deception by the lender be treated generously. The lenders whose mortgages were bailed out would bear some of the cost by paying for half of the rate reduction the government would offer. Former Treasury Secretary Lawrence Summers also urges a focus on measures that will prevent unnecessary foreclosures by facilitating more-efficient settlements between homeowners and their creditors and thereby induce lenders to let families remain in their homes.
Such a new institution might well have to refinance as many as 2 million mortgages. Given low interest rates and the interest support from the lenders, this agency could borrow cheaply and find it easy to earn a profit, just as the old one did. But its purpose is not to make money; it is to prevent the housing market from collapsing if too many foreclosed homes are thrown on the market. The intent is to head off a crisis of financial confidence in the value of all securities, which might lead to even good credit being thrown out with the bad.
The Federal Reserve, the Treasury, and the rest of the government must prevent a wholesale breakdown of the financial system. The risks have risen sharply, given the unpredictable consequences of a multitrillion-dollar decline in the value of homes and the loss of hundreds of billions of dollars by the banking system in various categories of lending and investing. Never have such broad and severe credit problems preceded a recession. It is critical to preserve the viability of the banking sector and its capacity to lend. And, above all, to avoid a systemic financial crisis.
We are in uncharted waters with unprecedented risks that could result in a longer and deeper recession than any we have experienced since WWII. Bold leadership and new thinking are urgently needed.
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