For the faint of heart, I have included this short video by Mr. Hilsenrath who gives a five minute Cliff Notes' version of the article. But don't short-change yourself. For those on the fringe of the financial inner-office, this article is a very good in-depth explanation of how we got here. I have also offered up some highlights from the article below.
Although the article doesn't get off to a promising strart..."An extraordinary credit boom that created many first-time homeowners and financed a wave of corporate takeovers seems to be waning." No Kidding? "Home buyers with poor credit are having trouble borrowing." What's wrong with that picture? But these smart journalists came through immediately.
The origins of todays credit woes are convincingly traced to the 1980 changes in bank regulations due to the savings and loan debacle, the Asian financial crises of the 1990's, and the Fed's cut of interest rates in 2001 to the lowest rate in a generation.
Greenspan Redux was quoted today, "These adverse periods are very painful, but they're inevitable if we choose to maintain a system in which people are free to take risks, a necessary condition for maximum sustainable economic growth." The WSJ explains further, "The evolving financial architecture is distributing risks away from highly leveraged banks toward investors better able to handle them, keeping the banks and economy more stable than in the past, he says. Economic growth, particularly outside the U.S., is strong, and even in the U.S., unemployment remains low. The financial system has absorbed the latest shock."
In June 2003 the short-term rates were cut to 1% and stayed there for a year with the intent to bolster housing and consumer spending until business investment and exports recovered. Mission accomplished, but at the same time the seeds of excess were planted.
Did rates stay too low too long? Pay me now or pay me latter. In June 2004 the Fed began to raise short-term rates eventually reaching 5.25% where it has been for the past year. Long-term rates did not follow which was unusual. Greenspan also says today, "We tried in 2004 to move long-term rates higher in order to get mortgage interest rates up and take some of the fizz out of the housing market. But we failed."
Both Greenspan and Bernanke believe that demand from investors also fueled the surge in capital pouring into the U.S. from overseas. "Chinese government entities recently poured $3 billion into U.S. private-equity firm Blackstone." When the U.S. begs, cajoles, and threatens China to let their currency float (as Congress is currently doing), they remind us of their cooperation in 1998 when we begged them to hold their currency valuations. They agreed and the U.S. praised them. Well they just kept the currency pegged instead of floating it again when we said "release it now."
Then came the suction from Wall Street in the mid 90's wanting more and more paper. 90% no-doc loans went to 100%. Well, you know the story from there. "Demand from consumers, on one side, and Wall Street and its customers on the other side prompted lenders to make more and more subprime loans." Originations went from $160 billion in 2001 to over $600 billion in both 2005 and 2006. Defaults were low because home prices were rising so much borrowers who fell behind could easily refinance.
The S&L crises in the 80's and early 90's shifted much of the lending from banks to unregulated lenders who financed themselves by Wall Street credit lines and by selling their loans to investors.
Example of the painful consequences: New Century Financial was the 2nd largest subprimelender by 2006. When its borrowers began falling behind, Wall Street cut off its lines of credit and forced it to buy back some of its poorly performing loans. Result - they filed for bankruptcy protection in April wiping out shareholders and triggering market-wide fears about the health of the subprime business.
"The stock market collapse and low interest rates of 2001 to 2004 nurtured a class of investors and products to fill that role." Anything to get those yields up, and up they went. "Low interest rates made many investors willing to buy exotic securities in an effort to boost returns." Mortgage-backed securities became big business on Wall Street and the offerings became larger as the investor appetite fueled the fire. The risk spread and the credit ratings however were superimposed on opaque portfolios and funds.
But the upside was evident: Everybody could get a loan, banks shifted the risks to investors and investors could pick either more-risky or less-risky pieces of pie - supposedly. Now the downside, too, is painfully evident.
"Recent events show that financial innovations meant to distribute risk can end up multiplying it instead, in ways neither regulators nor investors fully understand. Fed officials believe that even if their policies led to housing and debt bubbles, the strength of the overall economy shows that the policy was, on balance, the right one."
Market veterans predict the most egregious underwriting practices and products will disappear, but the benefits of innovation will continue.
Yes lessons have been learned. Glenn Reynolds of CreditSights sums up quite aptly the credit industry, "...you have to run it like a prudent risk-taking venture, not like it's casino night and you're on a bender. "
Well said. Good night.