I named my blog “Credit Writedowns” because I anticipated an historic wave of credit writedowns in the global banking system which would lead to a wave of deleveraging, systemic risk, and bank failures — in short, a massive financial and economic bust to rival the Great Depression.
Up until now I have masked this dire view because, honestly, most people do not want to hear this sort of thing. I reckon they are watching “America’s Next Top Model” or “Grey’s Anatomy” to escape the grim reality out there (Those are two shows I like very much, thank you). So, I apologize in advance for the downbeat nature of this post.
This is probably the first time I am on record admitting the depth of my concern for the U.S. and global economy. But unfortunately, present events are now confirming my thesis and I want to step up the attack on our policy makers by highlighting the lurking dangers. Maybe that way we can get real solutions to our problems.
The largest equity bubble of all times spells economic pain?
Rewind back to 2001.
Soon after the tech bubble hit, it was obvious to me that the United States and the United Kingdom were two societies that had developed an unusual and excessive reliance on financial services as an engine for economic growth.
Back then, it was a foregone conclusion that the United States would be hard pressed to escape what was the largest stock market bubble in history with a garden variety recession. I felt that the United States, at minimum, faced a deep and protracted downturn similar to the 1973-1975 or 1980-1982 period, if not one of Japanese proportions.
All of the problems that felled the U.S. economic juggernaut in 2007 were evident in spades in 2001. And quite honestly, that would have been a healthy cleansing process for a global economy hooked on a savings-short, over-leveraged American economy as its growth engine. The problem was severe but manageable.
Reckless Fed policy
However, I was wrong. Alan Greenspan’s Federal Reserve resisted this necessary unwind by lowering interest rates to 1%, well below the rate of inflation. While U.S. businesses did reduce leverage from 2001-2003, low interest rates and poor bank and financial market regulation led to risk taking on a massive scale.
Because interest rates were low, lower-risk assets offered poor returns. The financial services industry was unable to make significant return on equity without increasing risk. Therefore, most players increased both leverage and risk. This includes banks, investment banks, mortgage lenders, asset managers, private equity companies, and hedge funds.
Asset classes included:
- Residential Property (Subprime, Alt-A, Payment Option, Negative Amortization Mortgages)
- Commercial Property (Commercial Real Estate and Construction Loans)
- Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
- Credit Card Receivables and Asset Backed Securities
- Auto Loan Receivables and Securitized Auto Loan Bonds
Alan Greenspan literally gambled with the world economy on a bet that low interest rates would allow the U.S. economy to recover before the magic elixir of leverage and risk became a systemic risk. Rather than fold his hand and accept a protracted period of weakness, Alan Greenspan decided to go all in. The result was not just a housing bubble but a credit bubble more generally, involving unsustainable price increases in all of the asset classes above and more. Trends in all of these asset classes suggest large credit writedowns to come from these assets as well.
When Greenspan went all in in 2003, the U.S. residential property market was arguably already in a bubble. The same was true in many parts of the UK as house price increases had already far outstripped the rise in inflation and house rent increases. So, had the Fed decided to follow a more hawkish and appropriate monetary policy in 2003, it is quite probable that house prices would have been pressured and none of the excesses since that time would have occurred.
However, the Fed allowed these excesses to occur and allowed the shadow banking system to become yet more leveraged in the process. All of the data pointed to excess: average debt per household, debt servicing costs as a percentage of income, debt to GDP, the savings rate, the value of housing stock as a percentage of GDP, the ratio of house prices to rent, the median/mean equity owned in homes, etc., etc., etc. Why could I rent a house for $2000 that would cost $4000 for 10% down on a 6% 30-year fixed mortgage? Why would I buy a house in that scenario?
I found this period — 2003-2006 — to be very, very frustrating because the data were all pointing to an unsustainable bubble. Yet, everyone seemed to be caught up in the tonic of paper wealth and excess consumption. The more house prices rose, the more they were taken as prima facie evidence of the sustainability of the previous increases. I felt like your classic Cassandra.
Systemic risk- credit writedowns
If the numbers looked bad in 2001 and we hadn’t unwound the excesses, but had simply papered over them with more debt, the problem in 2006 was obviously even bigger. That was my greatest concern in 2005-2006. But, more of concern to me was deleveraging and credit contraction. See, the Tech bubble was limited to shares and capital spending. The banking system was not as affected. So credit was not as restricted as a result of the popping of that bubble.
This is not the case in a housing bubble. Housing goes to the core of our credit system. When a housing bubble pops, loans go bad and credit losses must be recorded. These credit losses are called ‘Credit Writedowns.’
What is a credit writedown? It is a reduction in the value of an asset carried on a company’s balance sheet. As these losses must also be reflected on the income statement, credit writedowns result in massive losses. For example, a company may believe a number of mortgage-backed securities are permanently impaired and are carried on the balance sheet at values that do not reflect market prices. As a result, they may decide to take a writedown by reducing the valuation.
The bubble we have just experienced was the mother of all housing bubbles. It saw large and sustained price increases across a greater percentage of the developed world than any other housing bubble we have ever witnessed in history. The amount of credit writedowns that we should see from this period of credit excess will be much, much more than is currently anticipated by the mainstream media or the general public.
So, that is why this blog is named Credit Writedowns. My hope had been to draw attention to the systemic risk associated with the deleveraging process necessary to purge these excesses. Quite frankly, I was cautiously optimistic that our policy makers would avoid the worst of the potential policy mistakes which could worsen the situation. However, over the past month we have witnessed key policy mistakes, which I believe will likely lead to further downside risk going forward.
Realistic future assessment
I am not painting a particularly rosy picture here. And it pains me to not be able to do so. We have seen over $500 billion in credit writedowns at the world’s major financial institutions, the collapse of the largest mortgage lenders in the world in Fannie Mae and Freddie Mac, and the bankrupting of two of the largest investment banks in the world in Lehman Brothers and Bear Stearns. We have witnessed the end of the investment banking business model as Merrill Lynch was acquired and Goldman Sachs and Morgan Stanley became bank holding companies. And finally, we are now experiencing the largest series of bailouts and government market interventions since the Great Depression.
I would like to say that this thing is going to be over soon. However, the truth is that we are not even halfway through this. We have at least $500 billion more in writedowns to come. As a result credit will contract generally and many banks will fail. The knock on effects of this credit contraction will be higher unemployment, major commercial bankruptcies and a deep recession. The other bubble asset classes like commercial real estate will also fall. And the stock market will follow the real economy and probably bottom lower in inflation-adjusted terms than 2002 or 1998.
We need leadership
To deal with this crisis, we need policy makers who understand the gravity of the situation and its effect on people’s lives. None of the current proposed bailouts are addressing any of this. Do you think Paulson’s plan will help people find jobs? Do you think Barney Frank’s plan will help people from losing their homes. Will any of the market manipulations like banning short selling stop even good banks from falling prey to liquidity concerns? The answer to all of these questions is no.
So, my role at Credit Writedowns is to continue to point out where the minefields are, what we can do to avoid them, and what has historically been done before. I do not like to be the messenger of bad news. But, someone has to hold our policy makers’ feet to the fire. My hope is that I can play my small part in helping ensure the policy response we get going forward is better than the one we have had thus far.