Can't Grasp Credit Crisis? Join the Club

[Guy Berger]

March 19, 2008 Economic Scene

Can’t Grasp Credit Crisis? Join the Club

By DAVID LEONHARDT Raise your hand if you don’t quite understand this whole financial crisis.

It has been going on for seven months now, and many people probably feel as if they should understand it. But they don’t, not really. The part about the housing crash seems simple enough. With banks whispering sweet encouragement, people bought homes they couldn’t afford, and now they are falling behind on their mortgages.

But the overwhelming majority of homeowners are doing just fine. So how is it that a mess concentrated in one part of the mortgage business — subprime loans — has frozen the credit markets, sent stock markets gyrating, caused the collapse of Bear Stearns, left the economy on the brink of the worst recession in a generation and forced the Federal Reserve to take its boldest action since the Depression?

I’m here to urge you not to feel sheepish. This may not be entirely comforting, but your confusion is shared by many people who are in the middle of the crisis.

“We’re exposing parts of the capital markets that most of us had never heard of,” Ethan Harris, a top Lehman Brothers economist, said last week. Robert Rubin, the former Treasury secretary and current Citigroup executive, has said that he hadn’t heard of “liquidity puts,” an obscure kind of financial contract, until they started causing big problems for Citigroup.

I spent a good part of the last few days calling people on Wall Street and in the government to ask one question, “Can you try to explain this to me?” When they finished, I often had a highly sophisticated follow-up question: “Can you try again?”

I emerged thinking that all the uncertainty has created a panic that is partly unfounded. That said, the crisis isn’t close to ending, either. Ben Bernanke, the Federal Reserve chairman, won’t be able to wave a magic wand and make everything better, no matter how many more times he cuts rates. As Mr. Bernanke himself has suggested, the only thing that will end the crisis is the end of the housing bust.

So let’s go back to the beginning of the boom.

It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred some useful innovation. Why, after all, should someone who knows that she’s going to move after just a few years have no choice but to take out a 30-year fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, demanded good returns. Wall Street had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people — by “people,” I’m referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners — decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything. That’s why a hedge fund associated with the prestigious Carlyle Group collapsed last week.

“If anything goes awry, these dominos fall very fast,” said Charles R. Morris, a former banker who tells the story of the crisis in a new book, “The Trillion Dollar Meltdown.”

This toxic combination — the ubiquity of bad investments and their potential to mushroom — has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.

The conservatism has gone so far that it’s affecting many solid would-be borrowers, which, in turn, is hurting the broader economy and aggravating Wall Streets fears. A recession could cause credit card loans and other forms of debt, some of which were also based on overexuberance, to start going bad as well.

Many economists, on the right and the left, now argue that the only solution is for the federal government to step in and buy some of the unwanted debt, as the Fed began doing last weekend. This is called a bailout, and there is no doubt that giving a handout to Wall Street lenders or foolish home buyers — as opposed to, say, laid-off factory workers — is deeply distasteful. At this point, though, the alternative may be worse.

Bubbles lead to busts. Busts lead to panics. And panics can lead to long, deep economic downturns, which is why the Fed has been taking unprecedented actions to restore confidence.

“You say, my goodness, how could subprime mortgage loans take out the whole global financial system?” Mr. Zandi said. “That’s how.”

E-mail: Leonhardt@nytimes.com

[GA Russell]

Thanks, Guy.

A college classmate of mine named Mike Mortara invented something about mortgages when he was with Goldman Sachs. I think he invented the CDO. I know he became very wealthy as a result, but he died (I think of heart failure) fairly young.

[papsrus]

Nice article. It doesn't say so explicitly (at least, I don't think it does) but there is a disconnect between the Fed's actions to cut interest rates and the 30 year fixed mortgage rates. This disconnect has to do with the supply of money, or credit, as I understand it. More conservative lending means the 30 year mortgage rates don't fall as the Fed rate falls, as I understand it. In fact, those mortgage rates have risen noticeably over the past month or so, and are more or less holding steady now.

Is this a correct approximation of things Guy? (or anyone who might understand this better than I do).

[Chas]

Nice article. It doesn't say so explicitly (at least, I don't think it does) but there is a disconnect between the Fed's actions to cut interest rates and the 30 year fixed mortgage rates. This disconnect has to do with the supply of money, or credit, as I understand it. More conservative lending means the 30 year mortgage rates don't fall as the Fed rate falls, as I understand it. In fact, those mortgage rates have risen noticeably over the past month or so, and are more or less holding steady now.

Is this a correct approximation of things Guy? (or anyone who might understand this better than I do).

More conservative lending ( income verification , increased down-payment requirements etc. ) mainly affects the availability of long-term fixed-rate mortgages not their cost . Unlike short-term adjustable-rate mortgage rates which are affected by Fed rate cuts , the rates on longer-term fixed-rate mortgages reflect long-term bond yields which are themselves a reflection of inflation expectations ( the persistent offshore bid under Treasuries from foreign central banks certainly complicates inferences from bond yields to inflation expectations , though that support has weakened of late ) . In any event , long-term mortgage rates have been downward sticky and not followed short-term interest rates down because the recent series of deep Fed rate cuts is occurring against a backdrop of rising inflation , thus stoking fears of even greater inflation over the longer-term . In addition , with mortgage originators having more difficulty selling into the increasingly risk-averse secondary market , they are now having to keep new loans on their own books , meaning that risk is now being more accurately priced , putting additional upward pressure on long-term mortgage rates .

[sidewinder]

Yep, a requirement by the banks for more funds on own books plus risk management kicking in (better late than never ) big time means that the bargain interest rates available over the last 5 years or so won't be returning - either for short term or long term rates. Not a totally bad thing, in my view as long as they don't do anything silly like go into the 10% range (a la UK circa 1992).

At the very least it will stop all those amateur property speculators and multiple-home merchants in their tracks.

Edited March 20, 2008 by sidewinder

[papsrus]

Thank you Chas and sidewinder. I think I've got it now. I'm was quoted a 6.25 percent 30-year fixed rate about two weeks ago (with 20 percent down). I'm hoping that will edge down slightly over the next 30 days or so. We'll see.

EDIT: Locked in at 5 7/8 about an hour ago. Things move fast.

Edited March 20, 2008 by papsrus

[Guy Berger]

Nice article. It doesn't say so explicitly (at least, I don't think it does) but there is a disconnect between the Fed's actions to cut interest rates and the 30 year fixed mortgage rates. This disconnect has to do with the supply of money, or credit, as I understand it. More conservative lending means the 30 year mortgage rates don't fall as the Fed rate falls, as I understand it. In fact, those mortgage rates have risen noticeably over the past month or so, and are more or less holding steady now.

Is this a correct approximation of things Guy? (or anyone who might understand this better than I do).

More conservative lending ( income verification , increased down-payment requirements etc. ) mainly affects the availability of long-term fixed-rate mortgages not their cost . Unlike short-term adjustable-rate mortgage rates which are affected by Fed rate cuts , the rates on longer-term fixed-rate mortgages reflect long-term bond yields which are themselves a reflection of inflation expectations ( the persistent offshore bid under Treasuries from foreign central banks certainly complicates inferences from bond yields to inflation expectations , though that support has weakened of late ) . In any event , long-term mortgage rates have been downward sticky and not followed short-term interest rates down because the recent series of deep Fed rate cuts is occurring against a backdrop of rising inflation , thus stoking fears of even greater inflation over the longer-term . In addition , with mortgage originators having more difficulty selling into the increasingly risk-averse secondary market , they are now having to keep new loans on their own books , meaning that risk is now being more accurately priced , putting additional upward pressure on long-term mortgage rates .

I think Chas does a good job of explaining this. There are three things keeping long-term rates up even when short-term rates decline:

1) Risk spreads on various interest rates have been shooting up at the same time as the Fed has cut its policy rate -- these countervailing effects mean that other rates have not decreased as much as the Fed Funds Rate and in some cases have incrased.

2) Inflation worries. If you think inflation is going to be higher down the pike due to aggressive Fed easing right now, that will push up longer rates. (Though as a purely technical aside, I find these arguments to be somewhat unsatisfying once you get into the long end of the yield curve, say 15 vs 30 year rates.)

3) The future path of rates. It is fairly unusual for rates to remain very low or very high for a long period of time -- moving into the future 2, 5, 10, 15 years you expect them to revert to the mean. That path is more important in determining long term rates than a short term blip up or down.

Guy