Tuesday, August 07, 2007

How We Got Where We Are

The Wall Street Journal front-pages a fine explanation of how and why Alan Greenspan created housing and debt bubbles to save the U.S. economy from a long recession after the bursting of the tech bubble in 2000-2001 and what the creation of those bubbles has meant for both the U.S. and world economies. Since the article is behind a pay wall, here it is in full:

How Credit Got So Easy
And Why It's Tightening
August 7, 2007; Page A1

An extraordinary credit boom that created many first-time homeowners and financed a wave of corporate takeovers seems to be waning. Home buyers with poor credit are having trouble borrowing. Institutional investors from Milwaukee to Düsseldorf to Sydney are reporting losses. Banks are stuck with corporate debt that investors won't buy. Stocks are on a roller coaster, with financial powerhouses like Bear Stearns Cos. and Blackstone Group coming under intense pressure.

The origins of the boom and this unfolding reversal predate last year's mistakes. They trace to changes in the banking system provoked by the collapse of the savings-and-loan industry in the 1980s, the reaction of governments to the Asian financial crisis of the late 1990s, and the Federal Reserve's response to the 2000-01 bursting of the tech-stock bubble.

When the Fed cut interest rates to the lowest level in a generation to avoid a severe downturn, then-Chairman Alan Greenspan anticipated that making short-term credit so cheap would have unintended consequences. "I don't know what it is, but we're doing some damage because this is not the way credit markets should operate," he and a colleague recall him saying at the time.

Now the consequences of moves the Fed and others made are becoming clearer.

Low interest rates engineered by central banks and reinforced by a tidal wave of overseas savings fueled home prices and leveraged buyouts. Pension funds and endowments, unhappy with skimpy returns, shoved cash at hedge funds and private-equity firms, which borrowed heavily to make big bets. The investments of choice were opaque financial instruments that shifted default risk from lenders to global investors. The question now: When the dust settles, will the world be better off?

"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," Mr. Greenspan says today. 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.

So far. But credit problems once seen as isolated to a few subprime-mortgage lenders are beginning to propagate across markets and borders in unpredicted ways and degrees. A system designed to distribute and absorb risk might, instead, have bred it, by making it so easy for investors to buy complex securities they didn't fully understand. And the interconnectedness of markets could mean that a sudden change in sentiment by investors in all sorts of markets could destabilize the financial system and hurt economic growth.

Side Effects of Deflation Fight

When a technology stock and investment plunge and the Sept. 11 terrorist attacks pushed the economy into recession in 2001, the Fed slashed interest rates. But even by mid-2003, job creation and business investment were still anemic, and the inflation rate was slipping toward 1%. The Fed began to study Japan's unhappy bout with deflation -- generally declining prices -- which made it harder to repay debts and left the central bank seemingly powerless to stimulate growth.

"Even though we perceive the risks [of deflation] as minor, the potential consequences are very substantial and could be quite negative," Mr. Greenspan said in May 2003. A month later, the Fed cut the target for its key federal-funds interest rate, a benchmark for all short-term rates, to 1%. It said the rate would stay there as long as necessary, figuring low rates would bolster housing and consumer spending until business investment and exports recovered. The rate stayed at 1% for a year.

Mr. Greenspan raised vague fears with colleagues over the possibility this policy could create distortions in the economy, but he says today that such risks were an acceptable price for insuring against deflation. "Central banks cannot avoid taking risks. Such trade-offs are an integral part of policy. We were always confronted with choices."

Fed officials who were there at the time generally maintain their policy was right, even in hindsight. The economy has grown steadily, avoiding both deflation and serious inflation. Yet some say they may have planted seeds of excess in the housing and subprime-loan markets.

Robert Eisenbeis, retired research director at the Federal Reserve Bank of Atlanta, says the Fed overreacted to the threat of deflation and kept rates low for too long. As a result, it "overstimulated the housing market, and now we're dealing with the consequences."

Edward Gramlich, a Fed governor in Washington from 1997 to 2005, says he failed to realize at the time that low rates were making it so easy for lenders to market subprime mortgages with low introductory rates. The Fed and other regulators could have prevented some of the resulting pain with more rigorous supervision of mortgage lenders besides banks, he says. "We didn't have that, and we're paying for it now."

In June 2004, the Fed began to raise the short-term target rate, eventually taking it to 5.25%, where it has been for the past year. Such a boost usually leads to a rise, as well, in long-term rates, which are important to rates on 30-year conventional mortgages and corporate bonds. This time, it didn't. Mr. Greenspan expressed concern that investors were willing to accept low returns for taking on risk. "What they perceive as newly abundant liquidity can readily disappear," he said in August 2005, six months before retiring. "History has not dealt kindly with the aftermath of protracted periods of low risk premiums."

Looking back, he 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."

Something besides Fed policy was at work. Both Mr. Greenspan and his successor, Ben Bernanke, point to an unanticipated surge in capital pouring into the U.S. from overseas.

'Global Saving Glut'

In June 1998, U.S. Treasury officials made a plea to China that they would be reminded of repeatedly in the following years. Thailand had devalued its currency in 1997, touching off a crisis in the region that led other countries to devalue and in some cases default on foreign debt. The yen was sliding. Chinese officials, who pegged their currency to the U.S. dollar, "let it be known...that if things kept going this way they'd have no choice but to devalue," recalls Ted Truman, a Treasury official at the time. The U.S., fearing such a move would trigger another round of devaluations, urged the Chinese to hold their peg, and praised them when they did so.

But times changed. As recessions and depressed currencies held down imports and goosed exports in other Asian countries, the countries ran trade surpluses that replenished foreign-exchange reserves. Determined never to be so tied to the onerous conditions of the International Monetary Fund, they have kept those policies in place. Thai reserves, effectively exhausted in 1997, now stand at $73 billion.

Long after the crisis passed, China's economic fundamentals suggested its currency should rise against the dollar. China let it rise only slowly, continuing to juice exports and produce trade surpluses that pushed China's foreign-exchange reserves above $1 trillion. When the U.S. pressed China to let its currency float, China reminded the U.S. of the fixed exchange rate's stabilizing role in 1998. China put much of its cash -- part of what Mr. Bernanke has called a "global saving glut" -- into U.S. Treasurys, helping hold down long-term U.S. interest rates. Chinese government entities also recently poured $3 billion into U.S. private-equity firm Blackstone.

Mortgages for All

Lou Barnes, co-owner of a small Colorado mortgage bank called Boulder West Inc., has been in the mortgage business since the late 1970s. For most of that time, a borrower had to fully document his income. Lenders offered the first no-documentation loans in the mid-1990s, but for no more than 70% of the value of the house being purchased. A few years back, he says, that began to change as Wall Street investment banks and wholesalers demanded ever more mortgages from even the least creditworthy -- or "subprime" -- customers.

"All of us felt the suction from Wall Street. One day you would get an email saying, 'We will buy no-doc loans at 95% loan-to-value,' and an old-timer like me had never seen one," says Mr. Barnes. "It wasn't long before the no-doc emails said 100%."

Until the late 1990s, the subprime market was dominated by home-equity lines used by borrowers to consolidate debt and by loans on mobile homes. But when the Fed held rates down after 2001, lenders could offer borrowers with sketchy credit histories adjustable-rate mortgages with introductory rates that seemed affordable. Mr. Barnes says customers were asking about "2/28" subprime loans. These offered a low starter rate for two years, then adjusted for the remaining 28 to a rate that was often three percentage points higher than a prime customer normally paid. Customers, he says, seldom appreciated how high that rate could be once the Fed returned rates to normal levels.

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 rose to $600 billion or more in both 2005 and 2006 from $160 billion in 2001, according to Inside Mortgage Finance, an industry publication.

At first, delinquencies were surprisingly low. As a result, the credit ratings for bonds backed by the mortgages assumed a modest default rate. Standards for getting a mortgage fell. About 45% of all subprime loans in 2006 went to borrowers who didn't fully document their income, making it easier for them to overstate their creditworthiness.

The delinquency rate was a mirage: It was low mainly because home prices were rising so much that borrowers who fell behind could easily refinance. When home prices stopped rising in 2006, and fell in some regions, that game ended. Borrowers with subprime loans made in 2006 fell behind on monthly payments much more quickly than mortgages made a year or two earlier.

When banks get in trouble, federal deposit insurance encourages depositors not to flee, and in extreme circumstances, banks can borrow directly from the Fed. But banks are no longer the dominant lenders. After the S&L crisis in the 1980s and early 1990s, regulators insisted banks and thrifts hold more capital against risky loans. This tipped the playing field in favor of unregulated lenders. They financed themselves not by deposits but by Wall Street credit lines and by "securitization" of their loans -- in effect, the sale of the loans to investors.

The consequences proved painful. New Century Financial Corp., founded in 1995 by three former S&L executives, was the nation's second largest subprime lender 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. New Century couldn't fall back on deposit insurance or the Fed. It filed for bankruptcy protection in April, wiping out shareholders and triggering market-wide fears about the health of the subprime business.

LBO Boom

Home buyers were not alone. In August 2002, Qwest Communications International Inc. -- heavily indebted, beaten down by the telecom bust and under investigation by the Securities and Exchange Commission -- decided to sell its Yellow Pages business. Private-equity firms Carlyle Group and Welsh, Carson, Anderson & Stowe agreed to buy it for $7 billion, about $5.5 billion of it borrowed. The business produced steady cash flow that could be used to pay down the debt.

The buyers were worried they might not be able to borrow as much as they needed. "We were coming out of a pretty bad credit cycle," says Daniel Toscano, managing director at Deutsche Bank, which helped to manage the fund-raising. Instead, they tapped into a gusher. Within a year, Dex Media Inc., as the business became known, was back in the market. It borrowed $889 million to pay a dividend to Carlyle and Welsh Carson, and then $250 million more to pay another dividend. In just 15 months, the private-equity buyers made back most of their investment and still owned the company.

By 2006, the volume of such leveraged buyouts was smashing records from the 1980s. Generous credit markets enabled private-equity firms to do larger deals and pay themselves bigger dividends. They boosted returns -- and attracted more investors, which enabled even bigger deals.

As in subprime mortgages, lenders began to ease borrowing requirements. They agreed, for instance, to "covenant-lite debt," which dropped once-standard performance requirements, and "PIK-toggle" notes, which allowed borrowers to toggle interest payments on and off like a faucet.

Bankers began marketing debt deals for companies that, unlike Yellow Pages, didn't have comfortable cash flow. There was Chrysler, burning cash rather than producing it. And there was First Data Corp., whose post-takeover cash flow would barely cover interest payments and capital spending, according to Standard & Poor's LCD, a unit of S&P which tracks the high-yield market.

Last month, investors began to balk. Now many banks find themselves having committed to lend about $200 billion that they had intended to turn over to investors, but can't.

Let's All Look Like Yale

The subprime and LBO booms required willing lenders. The stock-market collapse and low interest rates of 2001 to 2004 nurtured a class of investors and products to fill that role. Managers of pension and endowment funds long had divided their assets among domestic stocks, bonds and cash. The funds saw their performance suffer when the stock market and then bond yields tumbled.

A few endowments, most notably at Yale and Harvard, had for years been spreading their investments more broadly, going into hedge funds, real estate, foreign stocks, even timberland. The goal was holdings that wouldn't suffer in sync with stocks in a bear market. Sure enough, in 2000 and 2001, even as stocks tumbled, Harvard Management Co. earned returns of 32.2% and -2.7% respectively. Yale's returns were 41% and 9.2%.

Other institutions wanted their money managed the same way, seeding a flood of hedge funds that bought other untraditional investments such as credit derivatives. University endowments poured roughly $40 billion into hedge funds between 2000 and 2006, according to Hedge Fund Intelligence, a newsletter. "I call it the 'Let's all look like Yale effect,'" says Jeremy Grantham, chairman of Boston money manager GMO LLC.

Low interest rates made many investors willing to buy exotic securities in an effort to boost returns. Wall Street had just the vehicle: securitization, or turning loans that once sat quietly on banks' books into securities that can be sold in global markets.

Securitization, long common in conventional mortgages, had been supercharged in the early 1990s when the federal Resolution Trust Corp. took over S&Ls that held more than $400 billion of assets. Though some thought it would take the RTC a century to unload them, it took only a few years. The agency successfully securitized new classes of assets, such as delinquent home loans or commercial loans.

In the late 1990s, Wall Street went a step further, packaging bigger pools of securities into collateralized debt obligations, or CDOs, and carving them into "tranches," each with a different level of risk and return. Riskier tranches suffered the first losses if some underlying loans defaulted. Other tranches offered lower returns because riskier tranches would take the first hits if the business went sour.

Because of the way they were structured, some CDO tranches got triple-A ratings from Moody's Investors Service and Standard & Poor's even though they contained subprime loans. That lured traditionally conservative investors such as commercial banks, insurance companies and pension funds.

The upside was evident: Many borrowers got loans they wouldn't otherwise have had. The taxpayer-backed deposit fund was less likely to bear the cost of sloppy lending practices. Banks shifted risks to investors more willing to bear them -- leaving the banks able to make more loans. Investors could pick either more-risky or less-risky slices. And Wall Street middlemen made handsome profits.

Now the downside, too, is painfully evident. Final investors were so many steps removed from the original loans that it became hard for them to know the true value and risk of securities they bought. Some were satisfied with a triple-A rating on a CDO -- seemingly as safe as a U.S. Treasury bond but with more yield. Yet as defaults ate through the cushion of lower-rated tranches with unexpected speed, rating agencies were forced to rethink their models -- and lower the ratings on many of these investments.

Some structures were so opaque that markets couldn't value them. But ratings cuts sometimes forced an acknowledgment that securities owned weren't worth as much as thought. In May, Swiss bank UBS AG shut down a hedge fund after a $124 million loss. In June, two Bear Stearns hedge funds saw as much as $1.6 billion of investor capital wiped out by bad mortgage bets and pulled credit lines. The trouble spread to hedge funds in Sydney, Australia, a mortgage insurer in Milwaukee and a bank in Düsseldorf, Germany.

Even Harvard has been hit. The university lost about $350 million through an investment in Sowood Capital Management, a hedge-fund firm founded by one of the university's former in-house money managers.

Casino Night

Recent events show that financial innovations meant to distribute risk can end up multiplying it instead, in ways neither regulators nor investors fully understand. Mr. Grantham, the Boston money manager, says his portfolios are behaving in ways he hadn't expected.

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. Of course, that assumes the current problems don't culminate in a recession.

Market veterans predict the most egregious underwriting practices and products will disappear, but the benefits of innovation will continue.

Lessons have been learned -- the hard way. "The structures are here to stay," says Glenn Reynolds, chief executive of research firm CreditSights. "But you have to run it like a prudent risk-taking venture, not like it's casino night and you're on a bender."

The article was the fourth in a series on the subprime mortgage mess. The others are here:

Mortgage Mess Shines Light on Brokers' Role

How Wall Street Stoked The Mortgage Meltdown

DAY OF RECKONING 'Subprime' Aftermath:
Losing the Family Home

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