Saturday, January 3, 2009

Trade and the Mortgage Stupidity Index

After many hours making dozens of charts, I have hit upon a measure that truly reflects what happened in the U.S. credit market. I call it the Mortgage Stupidity Index, depicted in the blue line below.

(All of the data in this entry comes from the Federal Reserve's Flow of Funds report.)

Definition of the Mortgage Stupidity Index: Purchases of Mortgages by Asset-Backed Securities Issuers / GDP.

Why? In my opinion two key underlying trends combined to make the housing bubble so special:
1-Housing as an asset class experienced a final surge in the 2003-2007 period after decades of positive growth. Most bubbles occur after years of healthy and sustainable returns. This gradually convinces sane people that "houses never lose value" or that "shares prices only go up" (a la late 1990s). This attitude is a part of most financial bubbles.
2-Securitization reached an apogee after more than 20 years of quiet growth. I am not an expert on securitization, but there is no doubt our financial system became increasingly dependent on packaging assets into bonds as a way of funding itself as the housing bubble inflated.

Another key aspect of securitization is that it separated loan officer from lender. This gave an incentive for reckless fly-by-night mortgage originators to generate as many loans as possible, regardless of the borrowers' ability to pay. Wall Street and the rating agencies also loved securitization because they made at least twice as much in fees selling the bonds to investors relative to corporate or municipal securities.

The Mortgage Stupidity Index combines these two trends. It can only rise when mortgage lending and securitization are both going up. Mortgage origination averaged 7.7% of GDP in the 2003-2007 period, compared with just 3% over the previous 50 years. At the same time, ABS issuers funded 35-53% of all home mortgages, a level essentially unprecedented in American history. (One data blip higher higher occurred in the early 1990s, but it's not material.)

To capture how securitization bred reckless lending, I took the amount of mortgages funded via securitization and divided it by GDP. The result is somewhat jaw-dropping: "Stupid" mortgages rose from less than 1% of GDP in 2001 to over 5% of GDP at the peak of the housing bubble in the third quarter of 2005.

This Mortgage Stupidity Index is reflected in the blue line of the chart at the top of that page. (The two bar charts above show the two components of the stupidity index. The green line in the same top chart shows Non-Financial Corporate Bond Issuance as a % of GDP. Why? Because nothing occurs in a vacuum. This wave of mortgage securitization occurred at the same time that "ordinary" borrowers like utilities, telecoms and railroads signficantly reduced their bond sales. They had been selling large amounts of debt through 2001 as they locked in long-term financing for capital investments made in the late 1990s. As that cycle waned and the tech IPO boom ended, Wall Street turned to home mortgages to compensate for declining fees.

The top chart establishes that in the 2003-2007 period, stupid mortgages surged. Everyone knows this anecdotally (after all, that's why we're now in the middle of a massive financial crisis), but I wanted to establish it using real data.
The lower chart highlights a trend that is much less commonly known: The role foreign capital played inflating the credit bubble. The purple line shows the trade deficit rising as a percentage of GDP from a mere 1-1.5% in the 1990s to more 6% in late 2005. As those dollars piled up overseas, they were recycled into dollar-based assets like U.S. debt securities, reflected by the red line. (It's called ROW for "Rest of the World", which is how the Fed labels this data series. Also, the data lumps all corporate bonds and mortgage-backed securities under the label "corporate bonds," so we don't know what was buying what. It doesn't really matter however, because the yields on all these securities moved in tandem.)

It is no coincidence the trade deficit and foreign purchases of U.S. bonds peaked at the same time as stupid mortgage lending!

If Americans had been buying products made domestically, those dollars would have filtered through the U.S. economy in the form of higher wages. That's how it worked in the 1950s-1970s, when imports were a tiny portion of GDP and inflationary pressures mounted. Only a small amount of that money would have entered the credit market via savings and the purchase of things like life insurance. But between 2003 and 2007, a whopping 54% of the trade deficit flowed directly back into the U.S. credit market -- into corporate bonds and mortgage-backed securities. (They bought such securities at a much quicker pace they they purchased GSE debt, Treasuries or U.S. stocks.)

What happened? After the emerging-market crisis of the late 1990s, Asian exporters turned to the U.S. to prop up their own economies. Even more importantly, China ascended to the World Trade Organization December 2001, and quickly flooded the U.S. with cheap merchandise. As China grew, it started buying lots of commodities like petroleum. This drove up the price of oil and everything else, which in turn forced Americans to send even more of their dollars overseas. That's why the trade deficit got so big in the 2003-2007 period.

To me, the Age of Globalization truly exploded in 1997, but it took a few years for all those dollars to find their way into the U.S. credit market. And, in the early stages of that period, companies like WorldCom and AT&T were soaking up a lot of the money by selling bonds. The chart below shows how the trade deficit surged to levels previously unseen in the post-WWII era:

One final note: Trade was one of a few key factors that inflated the credit bubble. But, like any huge historical development, such as a war or social change, there is never a single cause. Many forces converge at one moment in space, time and finance. An important subtext was an ongoing multi-decade bull market for U.S. bonds after the Fed defeated inflation in the early 1980s. This trend is now arguably in its own bubble phase with long-term Treasury yields below 3%.

Two other factors worth mentioning that contributed to the boom from 2003 to 2007:

1-Low interest rates in Japan channeled large amounts of capital into foreign economies like the USA and Australia in search of higher returns.

2-The rise of leveraged bond investors like hedge funds and structured investment vehicles (SIVs), which channeled hundreds of billions of dollars into the mortgage market at the same time it grew increasingly "stupid," according to my index.

My personal suspicion is that the Fed inadvertently faciliated this process in the 2003-2007 period by raising interest rates. That ensured a steady appreciation of the dollar versus the yen between 2004 and 2007, making the "yen-carry trade" a sure money maker. (This was strategy that involved borrowing in yen at say 1% and buying mortgage bonds yielding say 5%. The difference is called "positive carry.") Also, by rising short-term rates, hedge funds' borrowing costs rose. Over time, this forced them to buy increasingly risky assets to break even.

I have hypothosized that by cutting rates so aggressively, the Fed contributed to the current crisis. Most Wall Street professionals have reacted in shock and anger at this suggestion, which means it may contain a kernel of truth. I shall elaborate in a subsequent posting.

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