Friday, January 25, 2008

The Credit Crisis Explained (or at least a weak attempt); Part I: What happened?

**Disclaimer** The following is an analysis of the recent credit crisis throughout the last approx six months. It is really inappropriate to pick an arbitrary point and just start explaining. Everything at one point would need to be understood from the previous events, ad infinitum. Also, this story is overwhelmingly complex and I will inevitably leave out many relevant factors. I seek to create a framework for understanding the problems; past, current, and future. And finally, I realize that understanding the past holds no predictive power for future timing of investments. It is important to understand general themes, however, that show up time and time again. We can get a framework for how individuals will respond to certain incentives, and, indeed, predict these responses based on estimated future incentives.

So everybody wants to know what the hell is going on with a supposed credit crisis. What happened? What’s happening now? And, of course, what’s going to happen? Well the world will finally be able to rest easy because the answers are upon us. I present the first part in my three part series: What happened?

First off, let’s get the perspective of the homeowner throughout the past few years. As we all know home prices have been rising dramatically (and rising since about 1996, but I don’t know if this is in real or nominal terms as of yet). Low interest rates set by the Greenspan Fed put some fuel on the home price fire. This heroic rise in prices led to pretty easy borrowing terms for homeowners. No down payments, low rates, and the like.

These easy terms were partly responsible for the high prices. To illustrate, if borrowing costs are lower, individuals have greater purchasing power. Let’s say a home cost $100,000. But lower relative borrowing costs yield the individual an additional $5,000 of wealth. Well, someone who is able to purchase a $95,000 home (considering all relevant costs) can now afford this $100,000 home. The home will get bid up to the extra relative amount of purchasing power since everyone shares these lower borrowing cost conditions. The value of the home really doesn’t change, but easier money makes for greater purchasing power. At the margin, this effect may pull renters into the homeowners market, further increasing demand (which would presumably throw some of the new homeowners back into the renters’ market, and we’re faced with a circularity problem, but let’s not get bogged down in the details. We know in the real economy a million factors are changing at once. I don’t think anyone can say that equilibrium is reached at any given moment.)

Ok, let’s talk about one more issue with the homeowner before we continue. No down payments. Not requiring a borrower to make a down payment is a dangerous thing. It essentially assumes there is no downside risk on home prices (“home prices have been rising for a while and will do so forever”). What this does create is a loan for the full price of the home. If the home declines in price, the homeowner owes more on the loan than the house is worth. He has negative equity in the home. This creates a substantial incentive to walk away from the home (and would be the rational choice expect for it affects your credit record). With no down payment, even the slightest depreciation of home price in the short term will lead to this result.

Next, let’s move onto the banks. Banking has two general areas commercial and investment banking. Both these operations may occur within one organization (per the repeal of the Glass-Steagall Act in 1999). In house or out of house, both areas definitely feed upon each other in a myriad of ways.

Commercial lending may be deemed to be the root of all this recklessness. Once again we’ll look back to home prices. With ever rising home prices, banks provided ever easing credit terms. Why do home prices correlate to lending terms? Well, the loans are mortgages, which means they have a lien on some asset. In the housing world this is the house. A mortgage is an asset-backed loan—collateralized. If the price of the house keeps rising, then the collateral is safe. Even if the borrower defaults, the bank can reposes the home and probably get its money back (maybe make some money, I’m not sure of the particulars, I think the homeowner keeps any equity in the home). So if prices are always going to rise, what the hell? Who needs a down payment? As this is what often happened.
But the funny part of it is that these no-down-payment mortgages were not made to borrowers of strong credit records, but rather to the least credit worthy—the subprime. Reason being is that the subprime became the competitive battle ground. Banks were flooded with capital and had no interest in building up reserves (and arcane notion in banking due to Federal Deposit Insurance). They had money and needed a place to use it profitably. It looked like these subprime borrowers were sure things because even if they defaulted, the collateral would be rock solid. Banks were competing for prime borrowers as well. Prime terms eased accordingly. But, it is in your interest to put up a down payment, despite the cash flow pain. A down payment lets you whether a storm (recession) and deceases your debt obligations. The reason many subprime borrowers provided no down payment is because they couldn’t afford one. A whole new market segment was opened up! But then again maybe you really can’t afford to buy a house if you can’t afford a down payment (which many of these borrowers found out through the foreclosure process). To top it off bankers provided adjustable rate mortgages and teasers (which have the similar effects—especially when the Fed is raising interest rates. A teaser is a common practice that has been over-publicized.), which gave less margin for downside risk of a homeowner’s income stream.

Ok, then lets package these babies up and splice them out into tranches and sell them to investors—creating CDO’s (collateralized debt obligations). The tranches all have different risk levels for different investors. Let’s go one set further and create complex securities using options on these things (SIV’s) that are so complex to value only the bank can do it. The credit agencies certainly don’t have a prayer. Furthermore, options are off balance sheet assets—therefore, under less scrutiny. This is the investment banking world. Really, these are great ideas, but when they are applied to heavily risky commercial loaning practices they too become very risky. The SIV’s even more so because of the valuation difficulties. They these become popular for a variety of reasons, but mainly because investors wanted to partake in this great housing bull market. So money flowed in and spreads shrank. Spreads between the Fed Funds rate and 30-year mortgages were reduced dramatically. This type of spread, generally speaking, is the key to profitability of a commercial bank. Banks borrow short and lend long to make a profit on the difference. The Fed Funds rate is the most short term rate there is (overnight holding rate for banks), whereas the 30-year mortgage is about the longest that a loan will go for. So as the Fed raises rates steadily, the commercial lending business is becoming less and less profitable.

Furthermore, for a period between the end of 2006 and the beginning of 2007, there was almost no spread between AAA rated corporate debt and the Fed Funds Rates. But the competition between banks surged on. This may be the root of the exuberance problem in commercial banking leading to credit cycles.

Let’s talk about investors for a second. China is a heavy investor. They have a huge trade surplus to the US, but also an equally huge capital deficit--which means they are investing big time in the US. This acts to pull interest rates down, allowing investment that once might not have been profitable to become profitable. Also, it’s a bull market in the US so people are looking to grab some of this return. Investors see the profit being made in subprime and want in. Naturally, risk premiums get bid down (probably below the actual level or risk, which always spells trouble). It is the bidding down of the risk premium that will fuel another industry—private equity. That the AAA corporate debt almost had no premium to the fed funds for a time is particularly telling of this story.
Onto private equity. These are presumably a bunch of smart MBA’s that look for undervalued or mismanaged companies and clean them up. They like leverage; maybe because they are real confident in their abilities (this is like the hot chick that knows she’s hot, smart people that know they’re smart). The bidding down of risk premiums opens up a lot of new doors for them. They will have a larger set of potentially profitable takeover opportunities. This story is fundamentally the same as the housing market. Easier borrowing terms led to company’s valuations being bid up. Acquisitions were all over the place. A heavy season of acquisitions is shown no place more dramatically than stock price indices. The indices steadily climbed upward. But maybe it got to a point where private equity overdid itself and took on opportunities that will be profitable only if market conditions experience no downside (much like mortgage lending). We’ll see how smart they are, or were.

Now we’ve done it—connected the debt story to equity. This is just a glimpse of the story of the bull market. Now for the interesting part—what can we learn from this situation? And where did it go wrong?

First of all, this is a credit cycle like any other. Credit cycles have been happening since time has been recorded and certainly since the US was founded. Lots of regulation or a little, they still happened. I would argue that more regulation usually leads to more distortion and larger swings. At the end of a long period of success, people seem to push the boundaries of profitability and, inevitably, fall off the edge. A realization must be made that individuals act according to incentives and constrains. Therefore, we need to structure a system which creates as accurate of feedback mechanisms as possible.

The basic problem was that lenders lent money that couldn’t be paid back. Investors then threw their money after these loans too. (Hindsight helps us judge these decisions.) Let’s take the mortgage industry for example. Somewhere in the bull market borrowing conditions eased to a point of unprofitability. Lenders seemed to stop asking questions like: What are the drivers of wealth and price appreciation for this geographical area? What are the risks in this borrower’s future income stream? What unexpected events might occur? What kind of leeway should we leave to deal with unexpected events? How much down payment should we require? How extensively should we check the borrower’s credit history? There is a time lag between this decision and the consequences of that poor decision, which enables poor decisions to persist. Pressure to make these decisions come from competition. Market share is a big driver of profitability in commercial lending since the banks products are very similar. The irony of these short term competitive pressure is that long term competitive pressures favor an opposite approach. If a bank would hold off for a period of time when things got excessively bullish they would lose profits/market share to their competitors in the short term. But they would pull dramatically ahead when the crash comes. Compensation bonus incentives on a one year timeline may partially explain this problem, since credit cycles certainly have a longer timeline than one year. But also it’s really hard to know exactly at what time things start to get hairy and then just pull out—especially with loan officers working for commissions. In a sense they are being rewarded for quantity not quality—but of course only in the short term. Many of the mortgage brokers probably lost their jobs.

My final thought will be a suggestion to remove the Federal Deposit Insurance. This insurance (or more properly insulation) has a large effect to increase bank lending. Therefore, leading bankers into every more risky areas. First of all, when your deposits are insured by the Federal government you don’t need nearly the reserves that you would otherwise carry without this distortion. The Federal Reserve is then charged with putting regulation on top of regulation (trying to fix their own problem) by requiring a certain amount of reserves. Who knows if this level is accurate or not. One thing that is for certain is that bankers will never worry about a bank run (this raises a myriad of incentive distortions). Therefore, they will use the least amount of reserves possible because there will be competition from other banks to do so. Banks use capital that otherwise wouldn’t have been lent and find the next best opportunity, which is certainly riskier than the previous best opportunity. Federal Deposit Insurance makes banks riskier institutions (but it’s “all right because taxpayers will just bail them out”).
Also, tax deductibility of interest makes no real sense. I will come back to this in further posts, but it distorts business into issuing more debt than they would otherwise issue.

Next issues:

Part II: “What’s going on now?” Uncertainty in the market

Part III: “What’s the future?” How does this lead to a recession? Do bad loans jeopardize good loans?

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