Thursday, October 2, 2008

misplacing blame for the housing bubble

many people have blamed alan greenspan's low interest rates for creating the housing bubble. while low rates in the late 1990s and into 2001 helped get the bubble going, in my view, it was not the real factor that caused the bubble to reach its fever pitch in 2005-6.

this was a credit bubble first and foremost.

let's consider the sequence of events

mortgage issuance was about $428bln in 1999-2000, representing 4.6% and 4.3% of GDP (the economy got bigger, so the proportion fell.)

the fed cut rates starting at the start of 2001, lowering the overnight rate from 6.5% to 1% in June 2003.
in 2001, mortgage borrowing leapt higher, hitting 5.5% of GDP.
in 2002, it was 7.2% of GDP or about $760bln... but here's an odd fact:
in 2003, it was only 7.3% of GDP, or $801bln.

that's barely any increase at all -- even though the fed cut rates by 25bp to 1% in June 2003.

then, in mid 2004, the Fed starts to steadily raise rates... by the end of the year, the overnight rate was 2.25%... so mortgage issuance dropped, right?

nope.. in fact, it surged in 2004, leaping 29%!

then the fed kept raising rates in 2005, a total of 8 times, ending the year at 4.25%. mortgages must have dropped, because the Fed was raising rates, right?...

wrong again. this time, it rose another 7.2% to $1.1 trillion, or 8.9% of GDP.

so the Fed kept raising rates throughout 2006, lifting them all the way to 5.25%. finally, mortgage issuance slowed.. but only by about 2%.. it still represented more than 8% of GDP that year.

to me, this utterly debunks the notion that low rates by the fed caused the housing bubble. yes, the fed's low rates, plus many other government incentives promoting home ownership laid the ground work. but like all bubbles, it required a real liquidity event... an actual slug of capital that poured into the market.

in my view, this resulted from trade. the US, pursuing the policies of globalization embraced by corporate america, allowed its trade gap to surge from 3.9% of GDP in 2000 to 5.75% of GDP in 2005 and 2006. this is a sizeable increase, representing an more than $1.4 trillion dollars of capital that left the economy in those two years alone. at the same time, foreign buyers snapped up about $869bln of US corporate bonds and other credit instruments.. both by far the biggest numbers on record. (all of this data is from the Fed's flow of funds report.)

I was covering the corporate bond market during this entire period. the strong foriegn demand was the subject of frequent discussion and cited as a reason to remain bullish on credit.

I now realize that this was, in fact, the final gusher of liquidity that juiced up the market. and, I'm not the only one.. ben bernanke, in fact, referred to it as the global savings glut, and alan greenspan called the persistently low interest rates a conundrum.

now I want to be clear... I am not even saying foreigners bought the mortgage bonds.. they probably didn't. but it doesnt matter. the entire credit market is a big world where all fixed income investors go for extra return, a little "alpha", or "excess return". when all the yields are driven lower, they start looking elsewhere. and, investment bankers, ever eager to please, were known to concoct complex structured assets to satisfy their needs.

I know that the USA didn't have a bubble only in houses, it was in all credit. valuations across the board, whether in LBOs valued based on debt to ebitda ratios, spread to libor or inflation-adjusted yields.. it was all extremely tight. money was literally oozing out of the woodwork. I covered it every day for 3+ years. and it lasted long after the Fed started tightening rates.

this is actually a pretty common phenomenon. in the 1970s, oil exporting countries put their massive piles of petrodollars into western banks. at that time, the safe looking credits were latin american governments... banks lent them so much money they had their own huge bubbles, which then burst, resulting in the "lost decade(s)".

japan was also awash in dollars after their trade surged in the 1980s.. their banks had so much money they pumped it into tokyo properties, creating the greatest real estate bubble in history.

also looking at spain, or italy, in the 2002-7 period.. their credit markets did amazingly well thanks to the unified monetary system under the euro, which opened up much larger capital markets to their debt.

overall, people should look at where money actually comes from and how it actually reaches the borrower, rather than just blaming the central bank.

after all, the fed has cut interest rates aggressively since september 2007, and home prices have done nothing but decline.

people need to remember that the Fed rate is the pure cost of riskless money. mortgages are CREDIT.

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