Oct012008

The Credit Bubble – Part 2

The Credit Bubble

Visualizing the Bubble

Home Page ImageWith a huge influx of capital into the secondary mortgage market when the Federal Reserve lowered interest rates in 2001-2004, the industry was under tremendous pressure to deliver more loans to hungry investors seeking higher yields. This caused the already-low loan standards to be all but eliminated. All of the worst “innovations” in the lending industry occurred during this period: Negative Amortization loans, Stated-Income loans (Liar Loans,) NINJA loans (no income, no job, no assets,) 100% financing, FICO scores under 500, and one-day-out-of-bankruptcy loans among others. The joke was if borrowers could “fog a mirror” or if they “had a pulse,” they could get a loan for as much as they wanted to buy a house. It is not hard to envision the impact this had on house prices.

Imagine a room with 100 people representing the pool of subprime borrowers. These are new entrants to the market. They were previously unable to buy due to bad credit, lack of savings, and other reasons. All of them are told they are going to bid on an asset that never goes down in value, and they will be given the ability to borrow unlimited funds (stated-income “liar loans”) The only caveat is the borrowed money must be paid back when the asset is sold (not that they care, they already have bad credit). Imagine what happens?

People start to buy the asset, and prices rise. Others in the room seeing the rising prices come to believe that the value of the asset never declines, and they join in the bidding. As the bidding drives prices even higher, a manic quality takes over the bidding and people compete with each other, often bidding higher than the asking prices. Nobody wants to be left out. There are fortunes to be made. Greed drives prices upward at a staggering rate. As the last of the 100 people buy, prices are very high, everyone has made money, and it looks as if prices will continue to rise forever . . .

Then something strange happens: there is nobody left to make a purchase. (A key indication of the end of a speculative mania is a huge decline in sales, as was witnessed over 2006 and 2007). Transaction volume drops off dramatically, and prices stop their dizzying ascent. Nobody is particularly alarmed at first, but a few of the more cautious sell their assets to pay off their loans. Since there are no more new buyers, the first selling actually causes prices to drop. This is unprecedented: prices have never declined! Most ignore the problem and comfort themselves with the history of rising prices; however, a few are spooked by this unprecedented drop and sell the asset. This selling drives prices even lower. Now those who still own the asset become worried, some continue to deny that there is a problem, and some get angry about the price declines. Some of the late buyers actually owe more than they paid for the asset. They sell the asset at a loss. The lenders now lose some money and refuse to loan any more money to be secured against the asset. Now there are even fewer buyers and a large group of owners who all want to sell before prices drop any lower. Panic selling ensues. Everyone wants to sell at the same time, and there are no buyers to purchase the asset. Prices fall dramatically. This asset which was sought after at any price is now for sale at any price, and there are few takers. People in the market rightfully believe the asset will continue to decline. Owners of the asset have accepted the new reality; they are depressed and despondent.

In any group of people, there are always a few who do not believe the “prices always rise” narrative. Some recognize that asset prices cannot rise indefinitely and cannot stay detached from their fundamental valuations. These people witness the rally and the resulting crash without participating. They wait patiently for prices to drop back to fundamental values, and then these people buy. As these new buyers enter the market, prices stop their steep descent and market participants start to hope again. It takes a while to work off the inventory for sale in the market, so prices tend to flatten at the bottom for an extended period of time; however, just as spring follows winter, appreciation returns to the market in time, and the cycle begins all over again.

What is written above is true of any asset whether it be stocks, bonds, houses or tulips. [1] In this case, it is the local housing market, and the room of new buyers represents subprime borrowers, but the concepts are universal. One phenomenon somewhat unique to the housing market is the forced sale due to foreclosure (stocks have margin calls). Even if the psychological factors at work during the panic could somehow be quelled, the forced sales from foreclosures would drive down prices anyway. True panic is not required to crash a housing market, only dropping prices and an inability to make payments. Subprime lending was one of the leading causes of the Great Housing Bubble, and its implosion exacerbated the market decline.

Responsibility for the Bubble

Who is responsible for the Great Housing Bubble? It is one thing to identify who or what caused the bubble, but it is another to assign responsibility and blame. Borrowers, lenders, investors, and the FED are all responsible; it is only a matter of degree. Irresponsible borrowers are like children, if you offer them something they want, no matter the terms, they will take it. The federal government realized this basic fact years ago when they passed predatory lending laws. This does not make the borrower any less responsible, but by definition, subprime borrowers are irresponsible. If they took responsibility for their debts, they would not be subprime. [ii] So if a large amount of money is lent to the most irresponsible among us, it is reasonable to expect them to spend it irresponsibly and not worry about paying it back. In this case, past performance is an indicator of future performance. It should come as no surprise that the subprime experiment ended badly.

Despite the low expectation of subprime performance, people need to be held accountable for their actions. It seems our entire culture is based on having victim status and being irresponsible. Borrowers should not be bailed out by any government program as it would just create more dependence and greater risk taking. The people who paid too much and cannot pay it back have to be allowed to lose their homes. That is life. The responsible should not pay to subsidize the irresponsible. This is one of those instances where irresponsible will be made to take responsibility.

Lenders are also responsible in this matter. Mortgage lenders provide a service because without them most people would be dead by the time they had saved enough money to buy a home for cash. However, when lenders start handing out home equity lines of credit for consumption, they are as bad as the credit card issuers preying on people’s reckless irresponsibility. Once mortgage lenders crossed that line, they ceased to be serving the needs of homebuyers and instead began serving the wants of the credit addicted: shame on them.

Of course, none of this would have happened without the contributions of the enablers at the Federal Reserve and on Wall Street. The Federal Reserve lowered rates and then Alan Greenspan told borrowers to take out adjustable rate mortgages under certain circumstances. As one might suspect, he did this so his fellow bankers would not be stuck with low-interest loans for 30 years, but he gave the world of homebuyers the “green light” for taking on high risk loans. Then Wall Street investors flooded with liquidity from cheap money from home and overseas started chasing returns. High-interest, subprime loans looked attractive, and as long as house prices went up and nobody defaulted, everything was fine. Who is to blame for that situation? The Bank of Japan for creating the carry trade? The Federal Reserve for lowering rates to avoid a recession? The financial wizards who invented collateralized debt obligations? The ratings agencies who labeled these investments “AAA?” The investors who were chasing high yields? Or all of them?

The borrowers are certainly at fault; if for no other reason than they signed the papers and took the money. The lenders are also at fault because they should have known better than to give borrowers loans they could not afford, provide loans with no income documentation, and ignore proven guidelines for loan-to-value and debt-to-income. Lenders simply cannot abdicate responsibility in this matter for financial, legal and moral reasons. The Federal Reserve and Wall Street investors are also at fault for creating the situation and enabling this to occur. In the end, all the responsible parties were ruined: borrowers lost their houses and went bankrupt, lenders like New Century went out of business and/or lost billions, Wall Street investors shared in the losses with the lenders, and Alan Greenspan is remembered by history as the architect of the largest, most painful financial bubble in history.

In assigning blame, it is also important to recognize that many innocent people were victims of the housing bust: children of the overleveraged and dishonest, neighbors of homes with dead lawns and graffiti, taxpayers whose money might be used in a bailout, responsible depositors who have to endure returns less than the rate of inflation, condo owners who have to pay the gap left in condo dues on foreclosed units, government employees who were hired in the optimism of rising budgets who are now laid off when tax revenues decline, and bubble buyers who were not motivated by speculative gains but merely looking to shelter their family. The decline of house prices punishes sinners and saints alike.

Summary

The Great Housing Bubble was a credit bubble. It was enabled by the widespread use of structured finance and collateralized debt obligations, and it was inflated by the irrational exuberance of buyers. The infrastructure for delivering capital to inflate the bubble was put in place years prior with the development and evolution of the secondary mortgage market. The system for delivering capital was greatly enhanced by the creation of collateralized debt obligations. Errors in the evaluation of risk to mortgage capital caused money to flow into this market that should have been diverted elsewhere. This free-flow of capital inflated the Great Housing Bubble.



[1] The Dutch tulip bulb mania was documented in the book Extraordinarily Popular Delusions and the Madness of Crowds (Mackay, Vega, & Fridson, 1996). The activities associated with the tulip mania have long been held as the archetype of a speculative bubble. Peter Garber in his paper Tulipmania (Garber, 1989) lays out the case that speculation in the Dutch tulip market in 1634-1637 was not necessarily irrational exuberance. He draws these conclusions based on the similar behavior of modern agricultural markets for rare flowers. The assumption behind his conclusions is that modern markets do not display symptoms of irrational exuberance which is highly suspect. Markets dealing with very rare commodities are always subject to wild price swings due to irrational exuberance because the commodity in question truly is rare. This plays to one of the central fallacies of irrational exuberance that the market is experiencing a severe shortage. Of course, like any market, even if the commodity is rare, if the demand is fickle and prone to irrational exuberance, there is a strong detachment from fundamental valuations due to excessive speculation.

[ii] There are circumstances where FICO scores of responsible citizens may characterize them as subprime. Some people do not use credit or maintain credit lines. They are very responsible, but their credit scores would make them subprime. Also, people who go through divorce, illness, a job loss or some other financial problem may temporarily become subprime. Responsible citizens who become subprime can generally recover their FICO scores in a short period of time. In fact, the original business plan for subprime was based on this idea.