• Stuart Fowler

Drowning in debt: the American way

America’s insecurity after 9/11 showed in a desperate attempt to prevent recession by cheap and easy credit. Now the chickens are coming home to roost. An unprecedented house price boom was in large measure fuelled by this monetary expansion but it was also aided by lax lending standards from mortgage bankers and by new sources of liquidity from hedge fund investors – now as big as banks. In recent weeks we have seen the first signs of this foolhardy liquidity drying up, with several lenders to the dodgiest borrowers going bust and others shutting up shop.

Two weeks ago I wrote about UK consumer debt. In America, the position is even worse: US consumers are overstretched and overconfident. But it is not just credit card debt that looks vulnerable: over-extended mortgage debt is the bigger problem. There is a significant risk of contagion spreading from dodgy mortgages to Wall Street investors via debt-based hedge-fund strategies. This is scary stuff – and not just for holders of American investments. The American authorities may have bought growth but only at the expense of a much deeper recession later.

The American dream turns sour The States shares with us an unhappy distinction: after a prolonged phase of economic growth, the people at the bottom of the pile are barely any better off in terms of real income and in many cases are already substantially over-borrowed. Whereas the UK’s economic underclass can get easy access to credit-card debt yet has little hope of owning a home, in the US the American dream has taken the form not just of credit-card debt but the spreading down of home ownership, thanks to easy access to ‘junk mortgages’.

A necessary condition, as for much of the booming global markets, was the excessive monetary expansion engineered by Fed Chairman Greenspan to avert a major recession in the early 2000s. It was not sufficient to cause a mortgage boom without the accompaniment of lax lending standards – as bad, by the look of it, in the US housing market as in the UK credit card business. To quote economistNouriel Roubini’s blog:

“Suppose you were a poor African American or Hispanic or a white poor with low income and no assets who wanted to pursue the American Dream of home ownership and you did not qualify for a regular mortgage because of your low income. No problem – told you the mortgage broker – we will give you a NINJA (no income, no job and assets) or liar loan, i.e. a loan with no documentation of your income and assets. You did not afford any down-payment because of little assets? No problem as we will let you to put zero down-payment so that you start with zero equity in your home. You could not afford principal payments? No problem as we will give you an interest only loan. You could not afford a fixed rate mortgage? We will give you a 2-28 ARM [adjustable rate mortgage] where the rate is fixed at low level for two years and then you move to much higher market rates. You did afford even that? We will give you a teaser rate for a little while. You could not afford even that? We will let you capitalize interest on a higher face value of the mortgage for a while so that you will have negative amortization and you pile up negative equity on your home from the very beginning. And the poor, hapless and clueless borrowers said yes to all of this as the lender never told him that after two years its debt servicing rate would balloon by 500% once he/she had to start paying high market rates and principal on an ever increasing –not decreasing – stock of mortgage debt.”

In the brief period of monetary reflation post 9/11, US house prices rose in real terms by nearly 80%. As I wrote in September 2006 this was an entirely unprecedented boom in most American’s experience. Prices in real terms had been flat since the last boom, caused by returning GIs at the end of WWII. With building costs rising in line with general inflation for 50 years and readily available land, there was no reason for land prices or house prices to appreciate in real terms, not even in line (as in the UK) with real incomes. Money, lots of it at stupid rates, was the only factor that changed.

One result is that the consumer balance sheet is in bad shape. As a percentage of GDP, US household debt has increased from nearly 60% to nearly 100% in just 20 years. As personal incomes growth has lagged the economy, the debt burden relative to personal incomes has grown even more. Debt service is nudging 20% of household incomes – and that is without particularly high real interest rates. This ratio has previously cycled between 15 and 18%. The US personal savings rate, which averaged about 6% through the ‘60s. ‘70s and ‘80s, dropped below zero nearly two year ago and has not yet begun to recover.

We are not economists but being around financial markets for over thirty years is enough to know that this is going to go into reverse. The house price boom is not sustainable. With lower prices will come increasing risk aversion by bankers, a return to normality which not even the Fed can prevent. Without access to the credit drug, consumers will have to rein in spending. Weaker final demand leads to job losses or wage cuts. And those are the two killers for over-borrowed households. At that point, the vicious cycle really bites.

What have the financial engineers done?

This much is relatively ‘predictable’ in terms of past bank-credit cycles. However, there is another twist this time that might lead to an acceleration of the process, triggering the general liquidity reversal that ‘contagion’ is all about. So far we have encountered two major sources of human error: central bank laxity and commercial (and mortgage) bank laxity. To these we can in all probability add a third: excesses in the use of financial engineering, involving collateralised debt obligations and credit default swaps. You will be hearing quite a lot about these, the investment bankers who package and sell them, the funds that hold them and create leveraged structures around them, and the investors who ended up with them in their portfolios.

Asset backed securities and credit derivatives have removed the traditional cap on the expansion of money and credit that banks’ own equity capital growth had historically provided. Bank capital both shaped and limited the credit cycle in much the same way as small increments to the stock of gold from new discoveries limited money supply under a gold standard. Credit derivatives have been the equivalent of the discovery of the New World’s gold stock: allowing credit to grow without limit by bank capital and banking prudence, as long as there were individuals or institutions in the wider investment community to put up the capital to buy loans (or their derivatives) from the banks that originated them.

This new El Dorado has been viewed by the monetary authorities as a good thing, worth encouraging and not to be hamstrung by heavy regulation. Since banking prudence has not been particularly reliable (remember First Pennsylvania, the S&Ls), the idea that Wall Street might do a better job of creating new products and techniques for managing and spreading financial risk was appealing. This was itself part of a much bigger political ‘Big Idea’: governments are not the universal fixer, ‘free markets’ are.

Nice idea, but free markets are not above forgetting prudence either – including, when complex engineering is involved, prudent assumptions about ‘tail risks’: events with a small probability but very big consequences.

These are typically complex instruments. A simple loan (such as a mortgage) gets sliced and diced into different tranches with different payoffs and credit risks, as a function of its own expected default and recovery probabilities. These tranches can then be packaged to create portfolios of exposures with a targeted risk profile. Portfolios can be more or less leveraged and combined with swaps either to lay off risks or take on additional risks. By this stage the true payoff probabilities may have been blinded by the science. Add the usual agency biases of high fees, profit incentives and other rewards to asset gathering and appropriate standards of judgement in managing (and selling) these products can also be blinded.

Valuation processes are also of questionable use in this area. Some of the popular credit-based hedge-fund strategies, for instance, book higher returns when risk premiums on the riskier slices of debt increase even though the market is implicitly pricing in a greater probability of loss. These may be losses on a scale a bank could survive but not a leveraged hedge fund with concentrated exposures to the higher risk tranches, and possibly unseen multiplication of the same underlying bad debts.

Not being as clever as the product engineers, we are again driven to experience of human nature in financial markets to guide expectations about outcomes. We think there is every reason to be extremely cautious and we will be watching events in the US mortgage market closely for the first signs of spreading illiquidity. e ABI has an agenda. It just is not ours.



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