This post first appeared on February 18, 2007
Mirable dictu, a Wall Street Journal editorial, “How Expansions Die,” that, for the most part, has a solid foundation in reality. Although the WSJ’s news pages have been reporting on the meltdown in the subprime mortgage market (admittedly somewhat less intently than the Financial Times), both the news and editorial pages have treated it as a localized phenomenon, and have not seen it as a sign that excessive liquidity, reflected in tight credit spreads, the use of leverage on leverage in hedge fund of funds, and generally very liberal borrowing terms, might be on the verge of correction.
The editorial still steers clear of acknowledging that the world is awash in funds (a situation that lends itself to speculative excesses that eventually leave some lenders holding the bag), but does fess up that the subprime free fall could be the beginning of a credit crunch. Of course, the Journal being the Journal, the editorial still has to work in attacks on “populists” whenever possible. The story inveighs against proposed curbs on predatory lending, and the possibility of tax increases or trade restrictions (beware of the ghost of Smoot Hawley!)
Now let’s consider each of these. I have yet to see a single bit of analysis on how many people would be affected by a restriction on predatory lending and what the impact might be (in fairness, there are many proposals being bandied about, so we may not see a rigorous assessment until a bill is drafted). But at this stage, all we have is a values-ridden, fact-free assertion that weak borrowers will be denied credit. Narrowly speaking, that may not even be true. First, we are entering a contractionary phase anyhow, so credit to weak borrowers is drying up. The marginal impact of tightening terms may be close to nil. Second, some lenders will likely persist under a new regime that restricts how much banks can charge, and they will do so by, among other things, getting better information about their borrowers and monitoring their credit usage more closely.
Moreover, banks have a proud history of overextending themselves and lending money to parties in retrospect, they really shouldn’t have. In the 1970s, it was sovereign credits. In the 1980s, we had the S&L crisis and the collapse of loans to highly leveraged transactions, to the point where the entire banking industry was inadequately capitalized, and it took years to rebuild their balance sheets. Now banks haven’t gotten themselves in trouble in quite a long time, which is a good thing. But having themselves priced out of a marginal market which had the potential to produce a lot of defaults in a weak economy isn’t entirely bad (although it does smack of paternalism). And the banks have been disintermediated to a great degree by Wall Street. We have the additional risk of Wall Street firms being damaged by losses from loans to hedge funds gone bad. Again, the firms have repeatedly reassured the Fed that they have stress tested their positions and all will be well. Let’s just hope they are right.
As for trade policy, yes, it is quite possible that the Democrats will do things that are unhelpful. It is equally possible that they will do things that are merely symbolic or (heaven forbid) useful on some axis. William Greider pointed out in a New York Times op-ed piece, “America’s Truth Deficit,” that the world economy is operating in a regime, not of free trade, but managed trade. Most of our trading partners seek to play the game so as to support their labor markets and generate trade surpluses. We seek to promote the interests of major multinationals. So what the Journal would like to depict as restraints on trade may not actually be that as much as redefining America’s interests away from blindly supporting large corporate interests to crafting agreements that serve a broader base of constituencies. But anything that reduces the profits of large corporations is ipso facto bad, in the eyes of the WSJ.
There are a couple of other odd threads in this piece. One is the Journal’s portrayal of the economy as strong. We’ve discussed the fact that there is distress not captured in the official statistics. And the characterization of the consumer as “resilient” when they have in aggregate outspent their income for two years running is daft.
The other is the notion that a contraction is someone’s fault. The piece takes aim at the Fed for having been too liberal with credit (a bit late to make that observation) and those pesky Democrats per above. But Joseph Schumpeter, the champion of the entrepreneur, believed that slumps were not only inevitable but desirable (his term was creative destruction, a sort of a business thinning of the herd). Many argue that the reason Japan’s recovery has been so anemic is that too many companies that should have failed have instead been kept on life support by their bank.
To the Journal:
….we finally have a threat that really does bear watching — namely, a potential credit crunch precipitated by the housing downturn and rising default rates. As Federal Reserve Chairman Ben Bernanke noted in his Senate testimony this week, the economic damage from the real-estate slide has so far been contained to housing. But in addition to the pain that homebuilders have experienced, banks and mortgage brokers are increasingly feeling the pinch, especially in the sub-prime sector. And in a perverse sort of populism, lawmakers are making noises about reducing access to credit for the riskiest borrowers, which would only exacerbate the crunch and could help take the economy down into recession.
The delinquency rate on sub-prime mortgages, now above 10%, is near record levels. Banks that bought up those loans for securitization are now demanding to be repaid, meaning that smaller institutions who thought they’d sold off their exposure are finding themselves on the hook, in some cases forcing them into bankruptcy.
This accumulation of bad loans represents a crack in the foundations of the recovery. Typically, a housing downturn and the credit problems that accompany it are a result of underlying economic weakness, rather than their cause. The economy slows, people lose their jobs and are forced to sell under duress lest they default. The distressed selling drives prices down. But in this case, it may work the other way around.
The Fed’s remarkably easy monetary policy helped goose house prices over several years. In turn, a large number of first-time buyers took advantage of low mortgage rates, especially on adjustable-rate loans, to stretch their buying power in the hopes of leveraging their way up the home-buying ladder. But someone finally blew the dog whistle in late 2005, and the buying dried up.
Now the housing market is flat to down across most of the country and loans with adjustable rates are adjusting upward. So even with unemployment low and the economy still humming, marginal buyers can suddenly find themselves forced to sell. And if they had little equity to begin with, they may not have much money left after they sell — if they can sell at all. If they can’t, they fall behind on their payments and the banks have to book the loans as delinquent.
Thus does a virtuous circle caused by easy money turn vicious, and interest rates aren’t even all that high — at least not yet. The Fed’s concern over housing’s potential effect on the broader economy is no doubt one reason it has kept short-term rates at 5.25% for several months, despite signs that inflation risks remain. Notwithstanding yesterday’s monthly inflation statistics (a function mainly of energy prices), gold has climbed back up to $665 an ounce, the dollar is weak, and “core” inflation remains above the Fed’s 2% upper limit.
The unknown is how far the credit contagion will spread. While rising, overall delinquency rates are still fairly low. But if banks continue to be hit by defaults, it may constrain their lending in other areas. Credit spreads, which have remained remarkably narrow, could widen. Meanwhile, Congress’s newfound preoccupation with “predatory lending” could, if it leads to changes in the law or in tough lending standards, increase the credit squeeze currently beginning to be felt. Decreasing consumer access to credit would in turn cast a pall over consumer spending and add another drag on the economy.
We aren’t joining the partisans at certain newspapers who have predicted recession each of the last four years. The labor market remains healthy, the consumer resilient, business investment robust and equity markets buoyant. But this certainly is no time for Congress to add to the risks of a credit crunch by committing such policy blunders as raising taxes, imposing trade barriers or punishing foreign investment in the U.S. Secretary Hank Paulson has prudently been adding financial plumbing capacity at Treasury, and he will need it to limit any credit fallout.
As for the Fed, we hope the tale Mr. Bernanke told Congress this week about perfect “soft landings” was right. But we also suspect that the Fed chief has his fingers crossed that the rest of the economy, at home and abroad, is strong enough to withstand the housing credit woes that the Fed did more than its share to inspire.