The Myth of the Credit Market 'Push'

The other night on CNBC my friend Barry Ritholtz told a good story. He said that for the time in credit market history loans between 2002 and 2006 were made on the basis of the ability to cut up and syndicate the debt, as opposed to lenders' ability to pay.

It's a good story. But is it true? No, other than in the most superficial sense. I'm assuming Barry was really saying that it was the first time loans were made because there was an external appetite for the loans as byproducts, instead of lender concern about prudently putting out money that could be paid off. (If instead Barry meant that it was the first time in history loans had been syndicated, then that's a trivial point, like saying this was the first time Countrywide had failed.)

So, was it the first time that credit market push created a problem in debt markets? Of course not. Almost every banking crisis back almost 200 years has had much of its roots in the sudden explosion of credit availability, without regard for people's ability to likely pay off the loan in any reasonable risk-adjusted scenario.

Look at the crisis in the 1870s. It was driven almost entirely by a flood of European capital into U.S. banks without regard for the wild and uneconomic overbuilding of railroads that ensued. Lenders were under pressure from European institutions to put the money out, and so they put more money out.

Sound familiar? It should, because it ended very similarly to the current crisis.

Comments

[ritholtz:]

I cant find any prior examples from history. Can you show me something specifically that proves this statement is false:

"During a 5 year period from 2002-07, the basis for mortgage lending was NOT the borrowers ability to pay -- it was the lender's ability to securitize and repackage a mortgage. This has never happened before . . . "

2008 Sep 27 04:15 AM

[venividivici:]

I am very disappointed with you Paul. The grotesque excesses that created this latest bubble would rival anything in the financial history of the human race and so soon after the dot com dementia. Apparently you think, judging by a previous posting of your's, which I now can't find, that the answer lies in borrowing another $700 billion of other people's money and gifting it to the thieving low lifes who created this problem in the first place. When you are hoplessly in debt, going deeper in debt will only make the problem worse. That applies to America as much as it applies to an individual.

2008 Sep 27 05:59 AM

[CaptBob:]

If you think this is about the lender putting a couple of fibs on the application or being a few bucks short on due date--you've got a big surprise coming.

Wait till Macys Thanksgiving Parade and they trot out the balloon of all time--The Hedge Funds and Big Banks Leveraged Debt Derivatives Special--The bang from that Turkey will make this 700B pop look like a 1" firecracker against a 100's of Trillions$$ Hydrogen Bomb.

Just throw in the towel without all this fanfare---then execute the Bums.

2008 Sep 27 11:00 AM

[flow5:]

This is my viewpoint but I'm not sure if I got everything right:

When the proxy for the rates-of-change in monetary flows (MVt) exceeds the the proxy for rates-of-change in real-gdp (i.e, in excess of 2-3 percentage points) we have chronic inflation.

Chronic inflation breeds all types of speculation. I would narrow the period of contention to 2002-2005 (the beginning of the tight monetary policy initiated by Bernanke).

Collosal money flows (loan-funds) were channeled into a narrow and important, segment of the economy (housing). This was accomplised by the willingness of domestic and foreign financial institutions, to support a secondary market, that consisted of "negotiable instruments", having variable degrees of risk (i.e., Barry's right).

This, plus brokered loans, (68% of residential mortgages) overstimulated, commercial and residential construction. And the construction industry has long leads and lags. It cannot be quikly turned around.

I.e., the instrumentality created by securitization, initially had many of the marketability and liqudity qualties of Treasury bills. And the use of securitization enabled these institutions to draw funds out of investors from all over the country, and indeed the world. I.e., this created more market participants and speculators in the housing sector, than ever before.

This unequal distribution of loan-funds was promoted by the FED's low interest rate policy. But as interest rates began to rise, interest expenses increased, with no concomitant rise in income (from borrowers & for lenders). Participants slowly found that they could not pay the rising rates of interes, in the market conditions that prevailed.

Banks used to store their liquidity, but now they buy their liquidity, (which, e.g., gives the reference importance of the LIBOR inter-bank rate). Thus, there became both a lack of funds from lenders (generating both illiquidity and insolvency) and the increasing cost of funds for borrowers (resulting in bankruptcy), that precipated this credit crisis.

2008 Sep 27 12:19 PM

[Buddy M'Kee:]

I believe that what Barry must have been referring to was the ability of securitization to "turn dross into gold"... more specifically, by grouping geographically dispersed and or otherwise economically divergent source mortgage originations into large pools and than securitizing the pools into a variety of different tranches with distinctly different characteristics, it became possible to raise the weighted average investment rating for nearly all of the pool.

Such that --- if much of the component mortgages, or other assets, rolled into the pool had been sub-prime, and thus on a stand-alone basis would have implied a 'below-investment grade' financial rating --- by the financial alchemy of pooling them from many different locales the resulting slices of financial paper were *assumed* by the ratings models to have a much higher overall quality... a more dependable expected rate of return, because the dispersed nature of the component parts mitigated the odds of any one regional slowdown seriously impacting the expected returns from the new whole.

So... perhaps what Barry was saying was not that "it was the first time loans were made because there was an external appetite for the loans as byproducts" but rather that there was vastly increased demand as a result of the syndications (and the ratings models) themselves... which created a significant increase in the amounts of product available to sell that carried higher implied financial ratings?

2008 Sep 28 04:25 AM