Bailout Nation (17 page)

Figure 8.5
GDP Growth: With and Without Mortgage Equity Withdrawal

SOURCE: Calculated Risk,
www.calculatedriskblog.com

Now factor that into family wealth: Increases in home price provided 70 percent of the gains in household net worth since 2001.

The wealth effect of home price appreciation is much more widely distributed than stocks. This made the generational-low interest rates the single largest factor that resuscitated the economy. Sure, tax cuts, deficit spending, increased money supply, war spending, and the like all played a role—but it was the ultralow rates and the mortgage equity withdrawal they allowed that dominated U.S. economic activity.

Even China's explosive growth was indirectly related to FOMC actions. Chinese apparel, electronics, and durable goods manufacturers were prime beneficiaries of America's debt-fueled spending binge. Beijing returned the favor, buying a trillion dollars' worth of U.S. Treasuries. This helped to keep rates relatively low, even as the Fed shifted into tightening mode, raising rates from 1 percent to over 5 percent. This “conundrum,” as Fed Chief Greenspan called it, reinforced the virtuous real estate cycle, extending it even further.

T
he first rule of economics is that there is no free lunch, and the massive ultralow rate stimulus came at a price: Cheap money led to inflation, fueled American's worst consumption habits, and added a ton to consumers' total debt.

But it was not just Main Street that binged on easy money. On Wall Street, cheap money would become even more addictive. Leverage (borrowing capital to invest) fueled investment banks, while liquidity powered hedge funds. Private equity gorged on cheap cash and used it to go on a buying spree. How else can one explain the ridiculous purchase of Chrysler in the spring of 2007 by the hedge fund Cerberus, if not for the nearly free cost of capital used to make this bone-headed investment? It wasn't the only dumb acquisition of the time; plenty of other ill-advised mergers and acquisitions (M&A) were funded via easy money.

Corporate America also rushed to grab cheap cash; many companies increased their dividend issuance, and quite a few borrowed heavily to do so. Others used the money to make stock buybacks as markets rallied higher. Most of these share repurchases have since proven to be horrific investments.

In the age of Sarbanes-Oxley, earnings manipulation via accounting trickery was out. What was in was the simple form of financial engineering enabled by easy money: reducing share count via stock repurchases.

TrimTabs Investment Research estimated that $456 billion worth of stock repurchases—nearly half a trillion dollars!—took place in 2005. A study by David Rosenberg, Merrill Lynch's chief economist, discovered that in Q3 2006, nearly a third of earnings gains were due to share repurchases.
⁵

With so much cheap money liquefying the system, the new mantra seemed to be to borrow freely. There was no need to worry about the debt or leverage—the day of reckoning was far, far off in the future.

Or so it seemed.

The great credit boom-and-bust cycle of the early twenty-first century was a typical bubble. It had its supporters and early detractors; there were the usual tortured rationales to explain what was unusual economic behavior; and there was a land rush to grab short-term profits despite increasingly obvious risks. As is often the case, it went on much longer than one would have reasonably expected.

One aspect of this credit boom, however, stands out as particularly unusual: the astonishing shift in the fundamental basis of credit transactions.

Throughout the history of human finance, the underlying premise of any lending, credit, or financing—indeed, all loans, mortgages, and debt instruments—has always been the borrower's ability to repay the loan. It is the most basic aspect of all finance.

This system of economic transactions goes as far back as when Og lent the guy in the next cave a dozen clamshells so he could purchase that newfangled wheel. If Og didn't have a reasonable basis to expect his neighbor would be able to service that debt—
Is he a good hunter? Is he trustworthy? Will he be able to repay those clamshells?
—he never would've entered into what was the first commercial loan.

From 1 million B.C. up until the present day, the ability to repay the debt has always been the dominant factor—except, however, for a brief five-year period starting around 2002. During that short era, the fundamental basis of all credit transactions was turned on its head. It was no longer the borrower's ability to repay the loan that was of paramount importance. Rather, the basis of lending money shifted to the lender's ability to sell the debt for securitization purposes.

As the world soon discovered, this was enormously important, and was the basis for what came afterward: credit bubble, housing boom and bust, derivatives explosion, economic chaos. It can all be traced back to that shift in making a lending decision.

Since the crisis began with real estate loans, let's use the typical mortgage as an example of how these earth-shattering changes occurred.

The basis for making a mortgage loan to a potential home buyer has relied on several simple factors: Banks looked at the home buyer's employment history and income, the size of the down payment, and the person's credit rating to determine the borrower's ability to service the debt. They also considered the loan-to-value ratio of the property, as well as other assets the borrower might own, to ensure that the loan was secured by the property.

Those factors went away during the early 2000s housing boom when the basis for mortgage lending was no longer the borrower's ability to pay—it was the lender's ability to securitize and repackage a mortgage.

This was a game changer. Any loan originators that could process the paperwork and quickly ship the loan off to Wall Street stood to make a lot of money from this process.

If we were to sum up the entire history of finance on a time line, it would look something like this, with the five-year period—the paradigm shift—as an unusual aberration relative to the prior million years:

It is the duty of the Federal Reserve to supervise credit and lending. We have since discovered that numerous people, including (now deceased) Fed Governor Ed Gramlich, tried to bring the problems of this lending to the attention of then Fed Chairman Alan Greenspan. You will be astonished to learn that the Federal Reserve of the United States did nothing about this shift. Indeed, the change in lending standards was praised by Greenspan as an important innovation.

I call this “nonfeasance”—failure to carry out an official charge or duty.

The so-called innovation turned out to be nothing of the sort. It was a deeply flawed lending process camouflaged, at first, by strongly rising home prices. Once prices peaked, the fault lines became clearly visible. Since late 2006, 306 major U.S. lending operations have imploded and over two million U.S. homes have been foreclosed (and rising).
³

Allowing banks to give money to people regardless of their ability to pay it back is at the heart of the current situation. That factor, combined with the ultralow interest rates created by the Fed to bail out the prior market crash, sent the credit market cascading toward disaster.

As we will see, this isn't the first time one crisis bailout led to another.

[
The option ARM is
]
like the neutron bomb. It's going to kill all the people but leave the houses standing.

—George McCarthy, housing economist, Ford Foundation

 

 

A
s we saw in prior chapters, Alan Greenspan's rate-cutting regime after the tech bubble burst was a radical departure from usual Federal Reserve policy. Starting in January 2001, the Fed began cutting rates—and kept cutting until they were at generational lows. The FOMC kept the federal fund rate at 1.75 percent or below from December 2001 to September 2004—nearly three years! This was unprecedented in FOMC history. Rates had never been kept so low for such an extended period of time.

Not only had this never happened before, it was previously unthinkable. And with good reason: Ultralow rates are an enormously irresponsible action on the part of a central bank. When money becomes that cheap, there are all manner of dire consequences. Rate cuts “reflated,” then inflated the economy. But it did so at a horrific cost: