By Kashan Wali, exclusive to the PTH
As the United States economy took off for most of the 1990s, the new found wealth across the world was staring at the best of both worlds; high economic output due to technological advances, cheaper labour entrance into the global economy from India and China, entrance of Eastern Europe and Latin America in the democratic capitalist system, all combined with a lower inflation. What could go wrong?
In some ways, the situation was similar to the roaring 1920s of the United States. 90 years ago, the US economy was expanding rapidly. New technological advances in automobile and telephone technology were erasing geographical distances within and outside of the United States. Rising productivity was increasing wealth and the signs of prosperity were evident in the stock market and the housing market.
The stock markets in the United States took off for most of the 1990s. Most of the rise was understandable; internet was revolutionising the distribution of knowledge. And modern economy is a knowledge based economy, not the traditional manufacturing based economy of the 20th century. Technology is a self perpetuating phenomenon. It builds on a wider base and increases exponentially. The equity market future expectations of higher revenue in the future due to higher revenues and profits down the road were probably justified.
But by how much; this was a question that was vexing serious investors and economic commentators. In 1998, Alan Greenspan, the US Federal Reserve Chairman called US economy in the best shape that he had ever seen in his lifetime. Yet he was also worried about the high expectations that investors were pricing into the equity markets. He called that behaviour irrational exuberance.
The wealth and higher liquidity was finding its way into one of the most fundamental assets that individual investors will ever own in their lifetimes; their houses. US house prices started appreciating around the middle of the decade. At first the rise was orderly. Yet by the beginning of the 21st century, housing market truly took off. In 2001, stock market bubble burst due to excessive valuations. Along with the bursting of the dot com bubble and the attacks of 9/11, US experienced a brief recession in 2002. With no inflation threat, Federal Reserve (Fed) quickly slashed rates to 1% from its prerecession levels of almost 6%. As banks could borrow at lower rate, they started offering mortgages at even cheaper rates. Banks or mortgage providers could in turn sell these mortgages to Fannie Mae and Freddie Mac. The United States had created these two financial behemoths in 1930s to fund the housing loans (mortgages) available to the individual home buyers. A mortgage provider would offer a mortgage to a new homeowner at a rate of say 5% fixed for 30 years. The mortgage provider would have the homeowner’s house as the collateral against the loan. This loan is an asset for the mortgage provider who would sell it to Fannie Mae or Freddie Mac. The flow of funds for a home owner to buy mortgages was never cheaper.
As the Fed was slashing the rates, the US economy picked up again. But what merely slowed during the recession was the US housing rate of appreciation. As the Fed slashed interest rates, US housing market shot upwards, increasing in some cases at more than 15-20% per year.
At the same time, the mortgage providers started targeting a section of the population that they termed the subprime borrowers. A subprime borrower has a weak personal balance sheet, a weak credit history and is not eligible for normal loan as his ability to pay back the loan is questionable. But with low interest rates, mortgage providers came up with a clever plan: If an investor cannot pay say a regular 1,500 dollars per month regular payment for his $200,000 home, they would offer him a loan with a teaser rate for the first two years. The teaser rates would be an extremely low rate that would allow this home owner to pay only $800 per month for the first two or three years. What was the catch? the payments would adjust upwards after three years, by a lot. Some owners who paid $800 per month for the first three years would see their payments rise to say $2,800 per month. For a blue collar worker making say $2,000 per month take home pay, the first payment was manageable. The second payment was not.
This was the first regulatory failure of the authorities. While providing housing to marginal segment of the society is a noble idea, the economics of the deals were untenable in most cases. The subprime loans were made in some cases at zero percent down payment, which means the owner has to put up none of his own capital to buy the house. Homeowner had literally no equity or stake in his own house. He was buying it off fully borrowed money. Homeowners were told that if they could not afford the house in three years time, they could always sell the house for a profit. The housing market is supposed to always go up they said. The questionable loans being made in the subprime and even regular mortgage markets were escaping the critical eyes of the regulators that were responsible for making sure that banks were not putting up bad assets on their balance sheets.
The second failure of the regulators was how these securities were securitized and sold to investors across the globe. Say a bank offered a homeowner ABC a mortgage/loan at a rate of 6.50% per year. This mortgage is a liability for the homeowner and an asset for the bank. Bank will repackage this asset into a security called Security ABC that will yield 6.25% per year (bank will keep 0.25% for itself). Financial institutions that can earn only say 4.5% by investing in a risk free 30 year US treasury will snap up a similar security yielding an extra 1.75% per year.
What’s more there were other securities that were being created that mimic the price of the Security ABC. These securities commonly referred as derivatives were adding risk to the bank’s balance sheets as financial institutions started playing another dangerous game. The short term interest rates were 1%. If banks could borrow short term at 1% and buy a long term security ABC at say 6.25% yield, they would make a lot of money on a lot less capital. The financial institutions were borrowing at short term at a low rate. But they were buying a long term asset with fixed higher yields.
Of course the investors and financials made two critical assumptions that were wrong from the beginning. First, the short term rates were not to remain at 1% forever. Second, for Security ABC to keep returning 6.25%, the homeowner ABC needed to keep paying his mortgage for the next 30 years.
In any case, the amount of leverage in the US financial system was rising dangerously under the regulators’ watch. And the quality of the underlying assets had begun deteriorating. The poor homeowner ABC was nervously looking at the ticking time bomb; the time when his interest rate was going to reset and his payment was going to increase almost two to three fold.
In 2004, US Fed started hiking the interest rates. The rate rise was orderly, and banks and financial institutions kept borrowing. As long as the short term rate does not rise above 6.25% per year, their profits were safe they reasoned. However for the home owner ABC new payment was tied to the Fed rate. As three year teaser rate period expired, subprime borrowers found themselves facing intolerable mortgage payments. Unable to pay off the mortgages, they left their homes. The houses were foreclosed, leaving bank or the mortgage provider holding the underlying collateral, the house.
The rise in subprime foreclosures put an end to the house price appreciation in 2006. The US Fed rate had reached almost 5.25% by that time. As more and more homeowners like Mr. ABC left their homes, the housing market started crashing and the assets on banks and financial institutions started dropping in values. As more and more homeowners defaulted on their mortgages, the assets on bank balance sheets started dropping precipitously in value. Banks stopped lending to each other and to private businesses as they were unsure of each other’s financial capability pay back loans. Financial institutions that had heavy mortgage related securities on their balance sheets stopped trusting each other. Credit flow between the institutions dried up. Many of the mortgage providers either failed or got bought out by bigger banks. Then bigger financial institutions started failing as well. Bear Sterns failed in March 2008 and barely got bought out by JP Morgan Bank with the help of US treasury and Federal Reserve. Yet the assets on financial institutions balance sheets kept on dropping in value. The high leverage in the system was working viciously the other way. Everyone had borrowed too much against too little. And they could not sell their assets fast enough. The more they sold, the more the assets dropped in value.
The Great Recession truly arrived in the US and around the world in one fateful weekend of September 2008. That weekend, Lehman Brothers with almost 650 Billion dollar assets failed. The United States government made a fateful decision of not bailing out Lehman Brothers. We are not a socialist state the US government reasoned. Lehman should pay for its transgressions. This is what risk taking entails right? They told Lehman dismissively.
Wrong; for starters Lehman had huge exposure to major financial institutions across the globe. Those institutions started suffering a lack of confidence as no one knew what assets they were holding, and how much exposure they had to Lehman. Interbank lending came to a complete halt.
The mass layoffs and the drop in equity market by almost 40% in the ensuing months was what the world came as close to the Great Depression of the 1930s. Yet fortunately for billions around the world, the Federal Reserve had studied the Great Depression well. Fed started buying tainted mortgage backed and other risky assets. Fed was assuring the markets. We are the buyers of last resort. We will buy the asset that is not as bad as you are thinking it is since no one is buying it right now. Fed also slashed the overnight rate to zero in a bid to increase liquidity in the system and allowing lending at almost zero rate. The only risk for the Fed was higher inflation. When no one spends, inflation ceases to become a threat. In fact the Fed was fighting an almost equally worse enemy; deflation. Deflation is a persistent drop in prices. This phenomenon causes individuals to hoard cash as they expect lower prices down the road. When no one spends, manufacturing suffers, joblessness increases and recession becomes a self fulfilling vicious downward loop.
As Federal Reserve, the central bank of the United States became a buyer and lender of last resort, its own balance sheets starts exponentially expanding. At the same time, US treasury started buying the stocks of the big banks who were failing the lack of investor confidence. The irrational exuberance of the 1990s had given way to the irrational pessimism of the 2008. Recession was raging, and the United States and the European government started borrowing heavily to fund infrastructure projects and helping keep the spending going. This was a lesson from the 1930s Great Depression. Supreme lack of confidence in the markets needed government intervention. When no one lends, government should cut the borrowing rates and start lending itself. When no one spends, government starts spending on major projects.
These actions by the major governments staved off the great depression. In fact the downward economic spiral was arrested by early 2009 and major economic indicators started stabilizing around the spring 2009. India and China resumed their massive economic growth, providing the industrialized nations with big markets where services and industrial products could be sold. Yet this was the same time that the sovereign governments were borrowing heavily. Unlike a private corporation, a government has taxation authority to fund its loans. Yet like everything else in this world, nothing is limitless. Even huge economies need good conditions for its population to make money and pay taxes. And this act requires another big assumption; better economies down the road.
Thursday: The European Fiscal Crisis