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Bubbling Credit
September 7, 2006 (American Enterprise Institute)
Lon Witter (Barron's "The No-Money-Down Disaster," August 21) does an excellent job of making us focus on the insidious recursiveness of credit-inflated bubbles: the flow of credit makes asset prices rise, the higher asset prices attract more credit, the prices rise more, the experience of a lengthy period of rising prices induces happy confidence among both lenders and borrowers, while calling forth greater supply of the asset to meet what becomes speculative demand. In the last stage, lenders cheerfully make new loans to pay the interest on the old ones, which is what "negative amortization" really means. Of course, this whole interaction finally goes into reverse, cycle after cycle.
Jesse Jones, the head of the Reconstruction Finance Corporation in the 1930s, vividly summed up the results in his day:
Here's more on the topic from Joseph A. Schumpeter's Business Cycles, 1939:
We had the Reconstruction Finance Corporation, formed in 1932 after the US banking system collapsed and the Resolution Trust Corporation, formed in 1989 after the S&L collapse.
We propose that the Bush administration get ahead of the collapse of many US banks, large and small, as this massive and idiotic housing bubble ends and charter the Greenspan Bubbles Reconstruction Trust Corporation now.
September 7, 2006 (American Enterprise Institute)
Lon Witter (Barron's "The No-Money-Down Disaster," August 21) does an excellent job of making us focus on the insidious recursiveness of credit-inflated bubbles: the flow of credit makes asset prices rise, the higher asset prices attract more credit, the prices rise more, the experience of a lengthy period of rising prices induces happy confidence among both lenders and borrowers, while calling forth greater supply of the asset to meet what becomes speculative demand. In the last stage, lenders cheerfully make new loans to pay the interest on the old ones, which is what "negative amortization" really means. Of course, this whole interaction finally goes into reverse, cycle after cycle.
Jesse Jones, the head of the Reconstruction Finance Corporation in the 1930s, vividly summed up the results in his day:
"Strewn all over was the wreckage of the banks which had become entangled in the financing of real estate promotions and had died of exposure to optimism."
AntiSpin: This Letter to the Editor from Alex J. Pollock, a resident fellow at AEI, to Barron's contains an excellent quotation from Jesse Jones of the Reconstruction Finance Corporation. Here's more on the topic from Joseph A. Schumpeter's Business Cycles, 1939:
"Consumers' borrowing is one of the most conspicuous danger points in the secondary phenomena of prosperity, and consumers' debts are among the most conspicuous weak spots in recession and depression.
"In other words, we shall readily understand why the load of debt thus light heartedly incurred by people who foresaw nothing but booms should become a serious matter whenever incomes fell, and that construction would then contribute, directly and through the effects on the credit structure of impaired values of real estate, as much to a depression as it had contributed to the preceding booms. Nothing is so likely to produce cumulative depressive processes as such commitments of a vast number of households to an overhead financed to a great extent by commercial banks."
In the face of ovewhelming evidence that the US banking system is heading into an iceburg of defaults, what we get from the Fed is this lengthy What Me Worry? paper (Sep/Oct 2006) from David C. Wheelock of the Federal Reserve Bank of St. Louis, What Happens to Banks When House Prices Fall? U.S. Regional Housing Busts of the 1980s and 1990s (pdf). In a nutshell, this ass-covering document says that US banks appear to be in better shape than they were in before the last two housing busts in the 1980s and 1990s, all without ever actually admitting that a speculative boom ever occurred. The paper lacks conviction and is filled with assertions that are later negated by counterpoints, such as:"In other words, we shall readily understand why the load of debt thus light heartedly incurred by people who foresaw nothing but booms should become a serious matter whenever incomes fell, and that construction would then contribute, directly and through the effects on the credit structure of impaired values of real estate, as much to a depression as it had contributed to the preceding booms. Nothing is so likely to produce cumulative depressive processes as such commitments of a vast number of households to an overhead financed to a great extent by commercial banks."
"These simple exposure measures indicate little, however, about whether banks have become more vulnerable to a decline in house prices. Without information about the risks of specific assets held by banks, one cannot determine definitively how vulnerable banks are to a decline in house prices. However, alongside the large increase in the size of bank residential real estate portfolios has been a substantial increase in bank equity capital relative to total bank assets. The greater a bank’s capital, the larger the amount of loan defaults and other declines in asset value it can withstand before becoming insolvent. Because capital serves as a cushion against loan and security losses, the increase in real estate loans and securities as a share of bank assets is probably less worrisome than it otherwise would have been."
We all know who the banks are counting on for capital, the same folks who always bail them out: US tax payers. Unfortunately, this time around, most of them don't have much in the way of savings, unlike during previous housing bust periods. Paradoxically, the reason households have so little saved to help them ride out a housing bust based recession is their misplaced confidence in their home as a store of value. This according to another recent St. Louis Fed report (our emphasis in italics):"Between 2001 and 2004, the median value of total financial assets for families that reported holding any kind of financial asset fell by 23 percent, to $23,000. This decline followed a 15 percent increase from 1998 to 2001. Since the surge in financial assets between 1998 and 2001 happened against the backdrop of the U.S. stock market boom, it is reasonable to conclude that the stock market bust that began in early 2000 was one reason for this decline in the real value of household financial assets.
"A second reason for the decline in median family assets may directly reflect a reduced willingness to save. Between 2001 and 2004, the percentage of families that saved any of their income declined by 5.2 percent to 56.1 percent. From a longer-term perspective, this response was broadly consistent with the responses noted before 2001, and it suggests that nearly half the population might be financially ill-equipped for retirement. It also is possible that many families view the sharp appreciation in home prices as a substitute for saving.4 Families also are borrowing on their home equity to make discretionary purchases." Thus, many families apparently look at their increased home equity as permanent saving and spend a greater percentage of their after-tax income.
In other words, households reduced their savings during the housing bubble because they believed that housing prices never go down, a fallacy that the Fed could have discouraged with a few words of wisdom from Big Al. Instead, he was pushing ARMs. Because they saved less, they will be less able to fund expenses, such as mortgage payments, out of savings should household income decline, such as if the primary wage earner in the household loses their job in the coming recession."A second reason for the decline in median family assets may directly reflect a reduced willingness to save. Between 2001 and 2004, the percentage of families that saved any of their income declined by 5.2 percent to 56.1 percent. From a longer-term perspective, this response was broadly consistent with the responses noted before 2001, and it suggests that nearly half the population might be financially ill-equipped for retirement. It also is possible that many families view the sharp appreciation in home prices as a substitute for saving.4 Families also are borrowing on their home equity to make discretionary purchases." Thus, many families apparently look at their increased home equity as permanent saving and spend a greater percentage of their after-tax income.
We had the Reconstruction Finance Corporation, formed in 1932 after the US banking system collapsed and the Resolution Trust Corporation, formed in 1989 after the S&L collapse.
We propose that the Bush administration get ahead of the collapse of many US banks, large and small, as this massive and idiotic housing bubble ends and charter the Greenspan Bubbles Reconstruction Trust Corporation now.
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