The Great Deleveraging: Warning Signs, Causes, and Solutions

November 23rd, 2008

The Great Deleveraging: Warning Signs, Causes, and Solutions

It seems like every day, I read an article in the newspaper or in the blogosphere about job losses. record declines in the stock market, nationwide housing price declines, massive bankruptcies, and government bailouts. Warning signs were ignored and the root causes of the current crisis have yet to be adequately addressed.

For years, I have been telling my friends and coworkers not to buy houses because the market was due for a correction. It was evident from looking at graphs of real housing prices over time that housing prices as far back as 2004-2005 were showing clear deviations from historical norms without any underlying change in the fundamentals that usually drive regional housing prices, namely real wage growth, population increases, and employment rates.

The obvious question to ask is: how were people able to afford houses at prices that were substantially more expensive relative to income levels than they were historically? The answer to that question gets right at the heart of what caused the current economic crisis–households were assuming greater debt burdens than ever before to purchase housing at inflated prices and increase consumption. The graph below show household debt as a percentage of income over time and the site it is from has a good article on household debt levels.

The fact that people were borrowing more than ever before begs the question: how were people able to borrow so much relative to their income? Banks, eager to boost their profitability by issuing a greater number of loans began creating and popularizing exotic mortgage products with lower initial payments relative to the amount of the loan. Before the Garn-St. Germain Depository Institutions Act of 1982, nobody had adjustable rate mortgages, Alt-A loans, or negative amortization loans. Deregulating the savings and loan industry was at least partially responsible for the savings and loan collapses in the 1980s and and has precipitated the larger financial crisis that we are faced with today. Banks were willing to issue these loans because they had a false sense of security from rising housing prices and the belief that consumers could either refinance or sell their houses rather than default, and consumers who wanted to purchase houses (particularly in the hottest markets) were left with no other way to afford the properties they desired. Housing prices went up because it was easier to borrow larger sums of money and banks were willing to lend consumers more money because of the belief that housing prices would continue to go up–it was a cycle that fed on itself and was helped by historically low interested rates that created a “cheap money” environment.

As soon as the house of cards began to fall as the housing prices started to decline, banks were left with loans that consumers could not afford to pay back and which could not be refinanced–loans that should never have been issued in the first place. You might expect the impact of these defaults to primarily affect the banks who issued the loans and the consumers who borrowed. However, in an effort to avoid keeping all of the risk of these loans on their own balance sheets, banks securitized these loans and sold them to institutional investors. Insurers began issuing credit default swaps to further mitigate the risk taken on by banks and investors relative to these loans. Within the span of a couple decades, the risk associated with bad mortgages spread from just the issuing banks and their creditors throughout the entire economy. This bad debt has devastated the balance sheets of formerly stable financial institutions like Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, and AIG.

In addition to recognizing that more stringent lending standards would be needed to avoid future defaults, lenders have begun reassessing and tightening their lending standards for business loans, commercial real estate loans, and all other forms of credit they were previously more willing to extend. As a result, many companies that were depending on credit availability have found themselves without access to the credit they need to run and grow their businesses. This has put many companies without exposure to the mortgage mahem at risk. In addition, consumers ability to spend has been diminished by their inability to continue to fund their consumption through borrowing and any business that depends upon discretionary consumer spending has found itself in a difficult position. Only consumer-facing businesses like Wal-Mart, that are counter-cyclical and reflect consumers’ desire to “trade-down” in their purchasing habits, seem to be benefiting from the crisis.

The collapse of premier financial institutions, the slowdown in consumer spending, the lack of adequate credit availability, and the lack of knowledge as to companies’ level of exposure to bad debt has scared investors and prompted what is essentially a global bank run that has caused substantial declines is public equity values. People are exiting the asset class en masse and fleeing to the safety of cash, gold, and treasury bills.

In the face of so many factors that are contributing to the mess we find ourselves in, what can government do to limit the damage to our economy as a whole and ensure that we do not repeat the mistakes that precipitated this crisis? First, it needs to regulate the banking industry to codify fair lending standards and limit the proliferation of high-risk exotic mortgage products to ensure that banks do not repeat their mistakes. Second, all public companies should be required to disclose each counter-party risk, above a certain percentage of revenue, in their financial statements to renew investors’ confidence in the markets. Finally, banks must be prohibited from using government TARP loans to fund M&A activity or bonuses; instead, it must be mandated that every dollar borrowed from the government needs to be lent to a credit-worthy consumer or business–this should improve credit availability.

Failure to address the warning signs of this crisis head-on is one of the greatest failures of the Bush administration. In an upcoming blog post, I will explore how this administration’s massive government bailouts and huge budget deficits are also putting us at risk of a future financial crisis very different from the one we find ourselves in today.

ePolitical.org