Saturday, January 3, 2009

Breaking Down the Credit Bubble

I have written a lot about how the credit bubble formed, but wanted to quickly list the factors I view as the real driving forces. These factors all came to a head in the 2003-2007 period:

A 25-year bull market in U.S. bonds: Starting in the 1980s after the Fed defeated inflation, this bull market saw the yield on 10-year Treasuries collapse from over 15% to less than 4%. As the entire yield complex declined, overall borrowing costs fell and the financial industry went into a major boom period.

Less need to borrow by normal corporations: For centuries, corporate bonds were mainly issued by non-financial companies like utilities, telecoms and railroads. But after a surge of capital spending in the late 1990s, these companies had less need for debt capital. Ever inventive, Wall Street created new kinds of credit securities to fill the vacuum.

Trade dollars were recycled into the credit market: Thanks to globalization and free-trade policies, imports flooded the U.S. economy. Americans bought much more from the rest of the world than we sold to it, causing a huge transfer of dollars from the U.S. economy overseas. Between 2003 and 2007, we imported $9.9 trillion of goods and services, while exporting $6.6 trillion, resulting in a running trade deficit of $3.3 trillion.

As dollars piled up overseas, the same exporting countries needed to do something with it. They weren't wise investors like Warren Buffett, who carefully examine all investments with an eye on both expected profits and recovery in case things go badly. They had a big pile of money with nowhere to go until it found its way into our credit market. Of that $3.3 trillion trade deficit from 2003 to 2007, 54% of it went into corporate bonds, asset-backed securities and private-label mortgage securities (that means stuff cooked up by Wall Street, not issued by Fannie Mae and Freddie Mac).

Proponents of globalization had claimed it would drive economic growth in the U.S. While it clearly destroyed many manufacturing jobs and lower skilled white-collar positions, it clearly helped drive construction and investment banking.

Securitization: This is the practice of taking lots of individual loans and bundling them into bonds. Lenders liked it because it allowed them to lend more aggressively and remove assets from their balance sheets, transferring the risks to bond investors. Wall Street liked it because they did the securitization, charging big fees to sell the bonds. The rating agencies liked securitization for the same reason: They charged much higher fees rating the bonds. And, finally, investors liked securitization because the bonds typically paid a little bit more yield for "comparable" credit risk. (The rating agencies made that call.)
The big thing about securitization is that it allowed certain people to originate loans, which they then sold to someone else. Essentially, fly-by-night mortgage companies lent other people's money without any risk if they messed up. This produced one of the biggest instances of moral hazard in financial history because
Securitization took off in the mid-1980s and, along with the bull market in fixed income mentioned above, reached its peak in the 2003-2007 period.

Declining Inflation: Consumer prices steadily edged lower throughout the post-1982 period. This mainly resulted from the Fed's high interest rates early on, aided by a collapse of oil prices, increasingly cheap imports from around the world, higher productivity thanks to technology and a stagnation of per-capita incomes.

Government endorsement of housing: For decades, the Federal government pushed homeownership as a cure to the economy's ills. It poured money into everything from subsidies for roads and mortgages and flood insurance.

Deregulation: Everyone likes to blame deregulation for the credit crisis. I think it played a much smaller role than many people might initially think. First, it seems to me that the places where the growth occurred were not contemplated by existing rules. Our regulation didn't contemplate things like massive securitization or trillions in foreign capital flowing into the economy. But the general attitude that the market is "self-policing" certainly didn't help matters.

Much more important than deregulation was complacency. This is key to any bubble, because when people are making money, no one wants it to stop. Wall Street was making money, investors were making money, homeowners were making money... Most importantly, the watch dogs in government were making money. They would jump from the SEC to Wall Street, work as lobbyists or as outright thralls of the financial industry -- such as Charles Schumer, who repeatedly intervened on behalf of the investment banks.

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