Toward an etiology of the current credit crisis

by Rob Horning

10 August 2007


It’s not a good thing when central banks decide that they need to pump money into the financial system on an ad hoc basis in response to a market meltdown. This means the system as a whole has unexpectedly frozen up, or to put it another way, that liquidity has dried up, which means simply that no one wants to buy the assets that everyone is desperate to sell. In this case, that means mortgage-backed securities, which the Fed is now buying as a means to inject cash into that market.

Why won’t investors playing with their own money touch these? That’s a somewhat long story, but it boils down to a massive failure to responsibly assess the risk of lending to borrowers with questionable ability to repay. What drove this irresponsibility was not naivete or ignorance but, not surprisingly, greed. Investors grew restive earlier this decade at the unexciting yields offered in the bond market. Because Asian central banks were buying so many Treasurys (in part to keep their currency weak relative to the dollar and keep their exports affordable in the American market), the yield curve was unusually flat. This created an appetite among institutional investors for more risk, which seemed capable of being well-hedged via various derivatives, collateralized debt obligations, and the like.

The main strategy, apparently, was to get good ratings from credit-rating agencies (Moodys, S&P) for once-risky loans made to subprime borrowers—people in America who wanted houses they probably couldn’t afford in the past—which made them salable to a wider span of pension-fund and fixed-income investors. Good ratings were obtained mainly by dividing loans into tranches by quality and regrouping them in various proportions into packages that the raters would certify. With the loans readily resalable, it became exceedingly profitable to get into the mortgage-writing business, as you could collect fees for making the loan and then sell off the risk without having to worry about whether the borrowers could ever repay.

That was the hedge-fund investor’s problem, not the small-time mortgage brokers’. These brokers had virtually no incentive to investigate a borrower’s credit history or prospects, and plenty of reason to help these borrowers falsify information to qualify for loans with the larger banks the brokers were working with. The banks could turn a blind eye, because the investment banks were eager to suck up the loans from them to securitize the debt (turn it into something more easily exchanged) and sell it all off to hedge funds. This NYT graphic from Sunday has a good graphic representation of the process, though I don’t think it was as sequential a situation as the chart implies—many of the stages were occurring simultaneously. Securitization was meant to so widely disperse risk so that it wouldn’t compound itself. But as we are seeing now, it merely spread it so that all corners of the world’s markets would be affected by the same group of borrowers’ failure to pay. As economist John Kay explained in this FT editorial, “If trading was motivated not by differences in attitudes and preferences but by differences in information and understanding, risk would gravitate not to those best able to bear it but those least able to comprehend it.” Risk doesn’t end up spread out, it ends up consolidated with the greedy and ignorant.

So what happened to make so many borrowers suddenly default or fall behind on payments? Basically the housing bubble popped. Previously, as real-estate values were doubling yearly and buyers were falling over one another to buy properties, the brokers and small banks, as we have seen, had plenty of incentive to say whatever they had to overcome the subprime borrowers reluctance to get in over their heads. If they could write them loans, they could pocket the fees and sell the risk down the line. Thus they advertised the availability of credit heavily in less-than-affluent areas and pushed loans with attractive initial rates (teaser loans, interest-only loans, ARMs, no money down loans, etc.) to make payments seem within borrowers reach and they downplayed the long-term consequences of such loans—the way payments would skyrocket when interest rates reset.

For a while, though, none of this mattered, because the housing market was booming. The expansion of mortgage credit meant that housing prices were bound to bubble up, fueling speculative interest. The increase in value of the properties borrowers were buying with their non-traditional mortgages meant they could always refinance if they fell behind in payments. Others took out home equity loans against their houses’ new value. Interest rates remained low, in part because of Greenspan’s generous rate policy in the wake of 9/11, so ARMs did not reset to higher rates for many borrowers. And those who got into the home-buying frenzy early were among the better credit risks.

And as Paul Krugman argues in his column today, this led to a sense that risk itself had disappeared, prompting investors to act as though there was no difference between junk bonds and T-bills. (The yield spread between the two was at a unusually low level as of a few months ago.)

But eventually inflation began to leak out of the housing sector and into the economy at large. Bernanke took over for Greenspan as Fed chairman, and needed to prove his bona fides as an inflation fighter to assuage Wall Street. Rates began their inexorable climb to their present level. And everyone who was paying attention knew that this meant trouble for all those borrowers. Mortgages would become more expensive and more difficult to come by, leading eventually to a downturn in the housing market. This would make it harder for existing owners to refinance, or to sell if worse came to worse. And higher rates meant that ARM borrowers would face higher payments, ones they may not have been prepared for. Also, grace periods began to come to end, also presenting borrowers with steeper payments. Inevitably, defaults began to climb—and the pain of these losses began to spread through the financial system, into all the corners where the dicey loans had been hidden away.

So now we have lots of nervous investors, who, thanks to the complicated diversification of risk, have no idea how much exposure they or their money managers have to bad mortgage debt, and have no clue which hedge fund will implode next. And the people who were lured into mortgages they couldn’t afford—whether by unscrupulous lenders or by their own optimism—find themselves in danger of losing their homes and having even worse an even worse credit rating. Only the institutions that collected fees and walked away from these loans have made out scot free. But it will likely turn out that we have all paid their fees, in a way, as a likely outcome is that the government will have to bail out the default-ready debtors by extending them fixed-rate loans they can afford (perhaps through Fannie Mae and Freddy Mac, though our wise president rejects such an arrangement, preferring to have faith in the wonderful market that brought us the current crisis) while buying up the securitized bad debt that no one else wants to touch, all with taxpayer dollars.

It would seem that regulators should step in and prevent this kind of crisis from happening again by curbing the abuses the previous arrangement invited. But it is at this point that free-marketeers and conservative skeptics of government intervention step in and start whining about “credit snobbery” as in this recent Economist editorial. Such critics reject regulation of the subprime market on the basis that it will restrict credit availability, contending that lenders were doing otherwise uncreditworthy debtors a favor by extending them credit at usurious rates, because the borrowers could decide for themselves whether it was worth it—despite the heavy advertising, misleading terms, and fraudulent representations of brokers in many instances. But banks didn’t decide to lend to bad risks out of moral generosity; they did so because they thought they could charge rates usurious enough that Wall Street would have incentive to make the risk seem to disappear through their dark arts of securitization. And even if the subprime borrowers (i.e. poor people) elude the debt traps that the editorial writer seeks to convince us are myth, they still are saddled with a burden that the middle and upper class borrowers escape, and this burden stigmatizes. Credit snobbery, in the minds of conservative critics, is when we don’t trust the poor to borrow on whatever terms they can, but it’s better understood as the institutionalization of the idea that those without a good credit history should be exploited to preserve the advantages of those who’ve managed to climb out of that situation. 

If we want to expand credit—if we are willing to wager that poor credit risks are simply needing an opportunity to establish a reputation—better that the risk be borne socially, and the loans administered through the government offering market rates available to ordinary borrowers. Let Fannie Mae and Freddie Mac issue more loans—that is what they are for, to broaden credit availability without magnifying risk due to borrowers’ ignorance and lenders’ greed and irresponsible fee-taking. If government agencies were involved in expanding credit, and the costs and risks truly spread out via use of tax dollars, this would have the beneficial side effect of making it clear that the society as a whole was determined to leave behind “class warfare.” But if we leave credit expansion up to the market and for-profit banks, risky borrowers will continue to be exploited and their ignorance reinforced so that it may be taken advantage of and so that the government’s ultimate largesse (in bailouts or loan repurchases) will go toward underwriting profits already booked by middlemen.

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