Friday, August 17, 2007

An End to the Debt Bubble?

Credit Crunch
Run on the Bank

Sub-Prime Meltdown

Housing Bubble

Central Banks Inject Liquidity

These terms are being thrown around left and right these days and I’ve read and talked so much about it that my brain is about to explode from serious information overload. Here’s my attempt to present the big-picture synopsis of what’s been happening.

Part I: How We Got Here:

Low Interest Rates:
Starting in 2001, after the dot-com crash and 9-11, the economy was teetering on the edge of recession. To stimulate economic activity, the Fed began to lower interest rates. From the corresponding chart (, we can see that interest rates across the whole economy fell dramatically.

Along with lower interest rates -- beginning with those set by the Federal Reserve -- there was also a dramatic increase in the money supply.

Since interest rates are lower, demand for money will be higher. The Fed sees to it that money will be available through its “open market operations.” Most often, the Fed will engage in repurchase agreements (repos) with the money center banks (Citibank, JPMorgan, Bank of America, etc.). Essentially a repo transaction is when a bank deposits collateral (loans) at the Fed and receives cash in exchange. This cash is then lent to the bank’s customers who are eager to borrow money at low interest rates.

The other option is for the Fed to buy Treasuries from the banks (outright purchases). The Fed buys Treasuries with freshly printed currency, thus dramatically increasing the money supply. As I understand it, the Fed rarely does this because it is considered more permanent and it can be highly inflationary.

Over the past few years, the Fed was not buying US Treasuries but our foreign trading partners certainly were!

In 2006, the US trade deficit was nearly $764 billion: the US bought $764 billion more stuff from the rest of the world than the rest of the world bought from us.

What happened to all of those dollar bills sent to our trading partners? A great deal of them found their way right back into the USA through the purchase of US Treasuries and T-Bills. Consider the massive foreign currency reserves held by the Chinese government: as of June, 2007 they stood at nearly $1.4 trilion. Of this amount, it is estimated that the vast majority is held US Treasuries and other USD debt instruments.

And let's not forget that the US was not the only country with a stimulative interest rate environment. Interest rates and availability of loans from Japan was another hugely stimulative factor.

Increased Risk Appetite:
With so much money available at such low interest rates, the collective risk appetite of market participants across the globe increased. All of this newly created money had to flow somewhere. Because of China’s willingness to produce consumer goods at such low prices, the increased money did not, by and large, slosh into the prices of consumer goods. Instead it sloshed into asset prices: bonds, stocks, commodities, wine, art, and especially REAL ESTATE.

The new money certainly helped to push home prices higher. The other major factor was the increased risk tolerance and demand for risky loans. Wall Street banks created new “structured products” which were sold to investors all over the world. Leveraged products such as CDO’s & CMO’s were created and promised increased yield with low risk to investors. These products contained lots of subprime and Alt-A mortgages yet they managed to receive AAA ratings from S&P, Moody’s & Fitch.

Typically, banks are very careful about who they lend money to because they want to get paid back. In this latest cycle, the borrower’s ability to repay was irrelevant because the mortgage brokers immediately sold the loans to Wall Street. Because of these new products and the strong market to sell them into, Wall Street had a voracious appetite for risky home loans.

Yesterday’s WSJ has a must-read free article about a family in California who bought a $567,000 house with a combined income of $90,000, and NO-MONEY DOWN. Their mortgage was an interest-only, adjustable rate mortgage. At the start, their yearly payments on the loan were $38,400. After a reset which is coming shortly, the mortgage will cost them $50,000 per year. It doesn’t take a financially sophisticated person to realize that this mortgage is totally unaffordable!

But it’s OK because housing prices only go up, right? Wrong – the price appreciation in many neighborhoods was driven by the hysteria and availability of easy loans. Without that, prices must fall.

To be continued...


Dave said...

Nice assessment, totally agree with you.

Not sure what you are to be continuing, but my prediction is that we are in for a serious free for all of everything.

I contend that consumer spending is what has increased profits for companies over the past several years, and people have managed to spend this much because their houses have increased in value so dramatically over the past several years. Now that housing prices are falling, people will no longer be able to leverage their homes value to create personal liquidity, and will not be able to spend. Additionally as the market decreases people will be seeing dramatic losses in their 401ks and I don't think consumer confidence is going to be very high.

Here is my thought and question for you, how far can homes decrease in value?

Home prices are driven by the same economic forces as anything else, simple supply and demand. As more people default on their homes, (creating an increase in supply) and credit standards tightening (decreasing demand) how low can they go? I struggle with this, because the fact of the matter is that you need to live how low can they go?

Will said...

Hi Dave, thanks for the comment.

You're essentially asking: what is the fair value of the houses?

How far they fall is probably a function of how high they went during the bubble.

The real estate crash in Tokyo in the early 1990's sent prices down more than 80% in some cases! But the bubble there was way larger than our real estate bubble.

I'd have to confirm this figure, but I think a "normal" price for houses is 2x the median income in the neighborhood. In overheated real estate markets like California, home prices are more like 4-5x median incomes.

The other metric that I like is rental yields. Historically, the yield (annual rent received divided by cost of the property), should be somewhere around the rate of the 10-year Treasury. Rental yields in many markets are WAY below their historical norms and many landlords have severely negative cash flow. I'm sure the CA family profiled in the WSJ article could have rented that house for about $1500 per month. Instead, they own it and will pay more than $4,000 per month. Clearly, renting is WAY cheaper in that market.

Like you said: "people have to live somewhere." Prices have to come back down to Earth to reflect economic realities. This is what happens at the end of every speculative bubble.

Dave said...

Hi Will - Another dave here ...

Agree with you but I'd probably argue that the housing boom in the west since 1995 is worse than Japan. See graph 3 in this economist article where they overlay the 2 markets (one with a delay of 10 years) ...

The other comment I'd make is that housing markets are not textbook 'perfect competition' markets so I'd disagree somewhat with the other dave where he says it is simply supply and demand. It gets complicated. Markets are heavily distorted particularly on the supply side where government involvement is necessary (infrustructure, regulation etc).

Anyway. despite these distortions when prices get to a level where the median income person can't even afford an entry level house then something is going to give - it will come crashing down.

My prediction is it will bottom out at 2002 prices (a roll back of 5 years of capital growth).