Here's something I wrote in August 2007, that was published the next month. Bear in mind it is written with a Hong Kong business readership in mind.
--DOR
Economic Insight September 2007
Submerging Credit Markets
One of the things I need to bear in mind when writing this column is the lag time between when the light bulb goes off, and when the issue hits your desk. What seems to be a good topic may be old hat by the time it his your desk. So, with that in mind, will the September reaction to America’s credit crunch be (a) “I’m glad that little scare is over!” (the optimistic scenario); (b) “How long is this going to last?” (the mid-range scenario); or (c) “Didn’t we just go through this 10 years ago?” (the nightmare scenario).
[Sept 2011 comment: I should have said, 80 years ago ! ]
A decade back, liquidity vanished when it became apparent that central banks had swept the last hard currency out of their vaults in a vain attempt to shore up indefensible exchange rates. This time, there is no lack of money, which gives us some small bit of relief. Rather, risk has been very badly mispriced, and as a result, risk-holders expecting to pass on the debt they hold are slashing prices while buyers are demanding bigger and bigger premiums.
First, the background. Subprime lending makes funds available to borrowers who wouldn’t get it any other way. In theory, poor credit risks pay more to borrow, as a reflection of the higher risk of default. Contrary to media reports, not all subprime lending is for real estate. Indeed, a very significant portion would be for the purchase of automobiles, furniture and other big ticket durable goods. Still, mortgages are a very large share of the total.
In the real estate market, subprime loans increased dramatically in the first half of the decade, nearly quadrupling (to $600 billion in 2006) in five years. Defaults tend to peak when such loans are 3-4 years into the repayment cycle. Interest is typically fixed at an attractive rate in the first two years, then rises sharply (to, say, five percentage points above a benchmark rate such as LIBOR). Put together a combination of rapidly increasing loan volumes, quickly approaching peak default dates and much higher interest rates than 3-4 years ago and it should be apparent that this problem isn’t going to go away just yet.
Why did risk get so badly mispriced? After the highly unusual investment-led recession of 2001, the benchmark Fed Funds interest rate was slashed from 6.5% to 1.0% and held there for a year. In combination with more innovations such as securitization, on-line loan approvals and no-doc loans (in which borrowers, for a price, do not have to document their incomes), borrowing soared and the housing market boomed.
Rising home prices and low interest rates gave consumers a sense of rapid wealth creation (rather than asset price inflation). To realize the benefits, they borrowed more which led to a very strong increase in imports. That fueled trade surpluses abroad, which central bankers socked away in reserves. Those reserves were largely in the form of US Treasury Bills, which helped hold down US interest rates which fed the cycle.
What is also missing from much of the discussion is that this problem isn’t really anything new. Auditors in the US Federal Deposit Insurance Corporation (the agency that backs deposits in US banks) warned about risks from subprime lending as early as 1997, and various banking related US government agencies updated the warning in subsequent years. The FDIC is rightly concerned because the banks it insures are exposed to the higher risks involved in lending to subprime borrowers (directly or through syndication), buying high yield subprime loans, or by buying asset-backed securities comprised of such loans.
What next? Meltdown is one option, but probably not the most likely. Rather, we are probably going to see a recession in the US. As the accompanying graphs illustrate, banks are reducing the portion of their loans given to consumers, and that tends to coincide with an economic softening. The ratio of past due mortgages to total mortgages is rising, as are real interest rates. And, new home buyers are wary, in a way they haven’t been before as shown by the vacancy ratio.
[2011 comment: Oh, the naivety, oh the embarrassment! I was SUCH an optimists back then ! graph omitted.]
--DOR
Economic Insight September 2007
Submerging Credit Markets
One of the things I need to bear in mind when writing this column is the lag time between when the light bulb goes off, and when the issue hits your desk. What seems to be a good topic may be old hat by the time it his your desk. So, with that in mind, will the September reaction to America’s credit crunch be (a) “I’m glad that little scare is over!” (the optimistic scenario); (b) “How long is this going to last?” (the mid-range scenario); or (c) “Didn’t we just go through this 10 years ago?” (the nightmare scenario).
[Sept 2011 comment: I should have said, 80 years ago ! ]
A decade back, liquidity vanished when it became apparent that central banks had swept the last hard currency out of their vaults in a vain attempt to shore up indefensible exchange rates. This time, there is no lack of money, which gives us some small bit of relief. Rather, risk has been very badly mispriced, and as a result, risk-holders expecting to pass on the debt they hold are slashing prices while buyers are demanding bigger and bigger premiums.
First, the background. Subprime lending makes funds available to borrowers who wouldn’t get it any other way. In theory, poor credit risks pay more to borrow, as a reflection of the higher risk of default. Contrary to media reports, not all subprime lending is for real estate. Indeed, a very significant portion would be for the purchase of automobiles, furniture and other big ticket durable goods. Still, mortgages are a very large share of the total.
In the real estate market, subprime loans increased dramatically in the first half of the decade, nearly quadrupling (to $600 billion in 2006) in five years. Defaults tend to peak when such loans are 3-4 years into the repayment cycle. Interest is typically fixed at an attractive rate in the first two years, then rises sharply (to, say, five percentage points above a benchmark rate such as LIBOR). Put together a combination of rapidly increasing loan volumes, quickly approaching peak default dates and much higher interest rates than 3-4 years ago and it should be apparent that this problem isn’t going to go away just yet.
Why did risk get so badly mispriced? After the highly unusual investment-led recession of 2001, the benchmark Fed Funds interest rate was slashed from 6.5% to 1.0% and held there for a year. In combination with more innovations such as securitization, on-line loan approvals and no-doc loans (in which borrowers, for a price, do not have to document their incomes), borrowing soared and the housing market boomed.
Rising home prices and low interest rates gave consumers a sense of rapid wealth creation (rather than asset price inflation). To realize the benefits, they borrowed more which led to a very strong increase in imports. That fueled trade surpluses abroad, which central bankers socked away in reserves. Those reserves were largely in the form of US Treasury Bills, which helped hold down US interest rates which fed the cycle.
What is also missing from much of the discussion is that this problem isn’t really anything new. Auditors in the US Federal Deposit Insurance Corporation (the agency that backs deposits in US banks) warned about risks from subprime lending as early as 1997, and various banking related US government agencies updated the warning in subsequent years. The FDIC is rightly concerned because the banks it insures are exposed to the higher risks involved in lending to subprime borrowers (directly or through syndication), buying high yield subprime loans, or by buying asset-backed securities comprised of such loans.
What next? Meltdown is one option, but probably not the most likely. Rather, we are probably going to see a recession in the US. As the accompanying graphs illustrate, banks are reducing the portion of their loans given to consumers, and that tends to coincide with an economic softening. The ratio of past due mortgages to total mortgages is rising, as are real interest rates. And, new home buyers are wary, in a way they haven’t been before as shown by the vacancy ratio.
[2011 comment: Oh, the naivety, oh the embarrassment! I was SUCH an optimists back then ! graph omitted.]
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