Misreading charts...

Its amazing that people who are college economics professors can misread charts so badly. Mark Perry argues there is no credit crunch, which I imagine would be to the amazement of central bankers of the world, and one reason Mr. Perry won't become a Federal Reserve Board member any time soon.

First, lets look at his chart to the left, the original, which shows the total consumer credit outstanding in the US. At first glance, this looks pretty positive, a nice 45 degree slope up. But there are a couple things we are forgetting about this. First, consumer credit only counts credit that is not backed by real-estate, so forget about home loans and home-equity lines (HELOC's). Second, credit increased at an annual rate of 2% in July. That's actually not that good.

The second chart shows the year-to-year percentage change in the same data. You can see its rarely been negative, and generally the 0-2% area borders a recession. Right now, there's nothing really positive happening with consumer credit. Nothing that negative either, but that's not what this credit crunch, or even a credit crunch in general, is all about.

Banks, particularly the now dead institution called the Investment Bank, depend on borrowing money to make investments. Just like when you, a consumer, gets a loan, there is a cost to this borrowing, and that cost is primarily determined by the company's credit rating. So let's dispel one thing first off: talking about consumer credit in relation to the credit crunch makes no sense at all. After all, its not like banks are putting their investments on Discover card...

So lets look at what the total loans and leases of commercial banks are (at left). Notice something striking? Its basically flat over the last year.

Finally, we look at the bank credit of all commercial banks, % year-on-year change. Like chart #2, the striking thing is that it rarely dips below 5%, and when it does, its near a recession. Now look at the recent plunge we have had.. And this data is only updated through July!

So what these banks do is called leveraging, you've probably heard all about it now. The basic idea is that you borrow money at one rate, hopefully cheap because your company has a good credit rating, and then invest that money into something else with a better return. In today's case, that was Mortgage Backed Securities, and a lot of banks were highly leveraged, say 30 times its equity. Now the problem with this is that the debt you are using to finance this activity is often shorter in term, so you have to constantly get new debt to keep the operation going. And that works, except when your company's credit rating get's slashed. Suddenly the cost of your debt, or insuring your debt, goes up and it makes it much harder to do business. Counterparties (your trading partners) may ask you to post up some more capital to prove you are good for your debt, otherwise they'll come knocking for their money. This is the Credit Crunch.

Now some consumers have had their HELOC's reduced or frozen, but again, that's not part of the consumer credit in chart #1. Its all about the banks and their ability to get credit. When they can't get credit, or when their investments blow up on them, they tend to tighten up with any lending operations they did have going. Which is what's happening right now in the housing market; instead of subprime it's become SuperPrime. You have to be Mr.Perfect borrower to get a loan from many institutions; they have tightened standards considerably, and probably unreasonably so. But that's human nature, from one extreme to the other.

Governments DO Create Markets

Its amazing how strongly some people will cling to the idea that well-functioning markets are a natural result of mankind's activity on earth. While its true trade results inherently from human activities, a well-functioning market requires many things.

It requires a system of currency, which most economists would agree should be controlled by a central bank (the monetary supply). It requires an exchange to allow people to trade their goods in a way that is not cumbersome. No one really wants to drag their physical good to market, and we certainly want to be able to trade futures (and obviously no one has a 'future good' in physical form, unless you want to count seeds...), so this means an exchange.

So now you've got instruments that represent physical goods to be delivered, pieces of paper that represent value backed by the government, an exchange that enforces various rules upon the participants, such as clearing, credit, and margin obligations. And we're still only trading commodities...

Now our exchanges our private companies, but they are governed by a comprehensive set of regulations to allow transparency in the markets, as well as to ensure that the market functions right. You know, things like insider trading rules, etc, that make the market a fair and equal place to transact. After all, every capitalist should understand that markets work best when there is ample liquidity, and participants have confidence their deals will settle with their counterparties and that all participants have relatively equal knowledge of the market.

The government brings credibility to a currency, as its generally the most credit-worthy counterparty in any given country. Modern capitalism, as Fareed Zakaria so elegantly put it, depends on credit, and credit depends on confidence. The ultimate source of confidence is that ultimate counterparty, the big bad government, and when confidence falls apart, as in a Minsky Moment, that source of confidence can provide a steading hand.

Why CRA Is Not to Blame for the Housing Crisis

Today in The Gartman Letter, which I highly respect, I came across the following regarding the $700B government bailout and the housing crisis:

"Senator Dodd... upon whom we pin much of the blame for the current circumstances, for it was he and others on the Left who pushed the nation's banks, savings & Loans and mortgage brokers to expanding home lending operations into minority areas that were clearly incapable of handling large debt loads... seems intent upon adding various additions to the law as presented, sufficient to slow passage, and perhaps even to have it defeated." [Emphasis mine]

This isn't the first time I've seen this argument; it not exactly new. The basic idea is that back in the day, banks were sticking with lending to their bigger depositors, who were rather obviously middle and upper-class. CRA is the Community Reinvestment Act and it requires that FDIC institutions lend to all of the people in the community they serve without prejudice. In 1995, the Act was expanded to increase the number of loans being made to lower-income areas.

Now the argument goes that the banks were 'forced' by this regulation to loan money to people who really couldn't afford a house to begin with. Now I must clear something up right from the start: loans to low-income borrowers to meet CRA obligations and subprime lending are NOT the same things.

When the CRA requirement first started, banks did most of their lending to these lower-income borrowers through FHA (or VA) loans, which the government-sponsored entities, Fannie Mae and Freddie Mac, will buy off the originating bank. That off-loads the risk, and since the number of these borrowers was never that high, and the houses they were buying were cheap, the risk was reasonable. The loan terms were also very conventional; generally fixed rate 30-year products.

After 1995, CRA lending did indeed increase, and this marked in some ways the beginning of subprime, but not by FDIC banks! Instead, those institutions continued lending prime products to fufill their CRA obligations, or simply avoided opening branches in places where they felt uncomfortable lending.

So just looking at the chart, it becomes clear that FHA picked up after 1995, as did subprime, but then both cooled down in 2001. However, subprime then exploded in 2002 onwards while FHA loans slumped. Its backed up by data from the Treasury that the CRA-affected institutions continued meeting their obligations with prime loans during this period.

So what exactly *is* subprime? Well it can be a lot of things, but basically a 'prime' product is one that is considered either 'conforming', which means that the GSE's will buy it (which banks really like, because it allows them to get rid of the loan). Or it means the borrower is extremely well-qualified for the loan and is considered low-risk. Let me make a point here: banks hate to hold loans themselves; they'd much rather sell them off, either to the GSE's, or to private buyers in the secondary market who will package them up into Mortgage Backed Securities.

Some people don't seem to understand that fact, that banks don't actually loan their own (or depositors) money for mortgages; they originate the mortgage and sell it to an investor, usually to one of the GSE's, which off-loads the risk and free's up lots of capital while still collecting almost all of profit (and usually retaining the 'servicing' portion of the loan, which is the billing, etc).

The GSE's get to define what a 'conforming' product is, and there are certain things an originator must do to meet these guidelines. However, if you do, the GSE's guarantee they will buy the loan from you, which is great. So basically if it wasn't for the idea of a conforming product, most people would be considered too high of risk to lend to. Remember, before the GSE's, most mortgages from private banks were 5-year loans with a balloon (a really big) payment at the end.

Subprime was for borrowers that 1) didn't fit a Prime product and/or 2) couldn't get a FHA/VA loan (low-income). But subprime was more than that; it was all kinds of exotic loans; everything you could dream of beyond the 'conforming' standard.

As someone who worked in the mortgage industry for a number of years (before running away), I can tell you that the low-income type of borrower is one problem. But another, often much bigger problem, are the loans like NINJA's, Options ARM's, non-Amortizing ARM's, often of Jumbo size, often with 95% or greater LTV, sometimes with over 100% LTV! These loans did not go to the demographics targeted by CRA.

By the time sub-prime was at its height, institutions were over-originating 4-5 times their CRA requirements, in additions to all of these other toxic subprime loans that to not serve low-income borrowers. Remember, subprime was not just for low-income borrowers; it was offered as a solution for anyone who needed a unique, flexible, or unconventional product.

At the institution where I used to work, we used to do a loan called Stated Income Stated Asset, but we called it the Mobster loan, because there was really no reason to use the product unless you had no way to justify how you had come across a giant pile of money. Basically we said 'we won't ask questions, we'll loan you a ridiculous amount of money, secured at say 95% LTV, and we'll slap a pretty ridiculous rate on it, but as long as you keep paying, we'll never ask any questions about your personal details....' We even did loans to illegal immigrants. And this was an institution that did not get heavily involved in subprime.

So I think to blame CRA entirely is unfair at best. Yes, it made some contribution, but had HUD-type lending been constrained to a reasonable number of borrowers, the risk is entirely mitigatable, particularly if you keep those borrowers in non-toxic loan structures, ie. fixed-products with reasonable LTV's. I do not think 100% LTV's are completely unreasonable in all cases (I got my first house that way). But consider that NINJA loan for 800k. Its going to take a lot of HUD loans to add up to 1 of those, and that spreads out the default risk, and in general, those lower-priced loans probably have a better shot of being modified to something reasonable.

In case your wondering why I keep emphasizing fixed rates over ARM's, is that the ARM rates often reset to higher rates, but appear to be lower payments on paper when you ask "what's my monthly payment going to be?" Check out the default rates:

As you can see, the ARM's have not done well, and the interest-only loans will start to be even worse as those are really 'speculation' loans (originally meant as Prime products for really really rich people who could buy a house with cash, but have better investments they could do in the meantime).

Some people want to blame the GSE's for the mess, but this is also wrong. Yes, they were allowed to purchase some subprime loans, but the amount they could buy was very very small. Instead they lobbied for relaxed restrictions, the "Alt-A" loans, which are basically "less than prime" loans, but what's critical is that they are largely of non-toxic structures, meaning they have fixed rates, or they are fully amortizing ARM's. But for the most part, the GSE's could only buy conforming loans, which is why their market share shrank badly from 2002+ as the private sector expanded its operations.

So back to the original point, are low-income minorities at fault here? Well, the data seems to say otherwise. They benefited the most in terms of increasing home-ownership, but all groups really benefited quite comparably.

Finally, these last three charts have all been from Harvard's Joint Center for Housing Studies, and the last is the most depressing. Even college-educated people are losing income over the last several years.

But if you want to read a real treatise on the subject, you can go here. So hopefully I've dispelled the myth that CRA somehow 'forced' banks to make bad loans. No way, no how. And I'm not the only one making such an assertion.

There are always two sides to every transaction, and with subprime, there is no doubt that many borrowers got in over their heads, or speculated, or knowingly bought houses they couldn't afford. But at the same time, there was a party on the other side willing to lend them money against collateral (the house) that they assumed would always increase in value (and thus cover their losses), and that the risk could be diversified enough.

But without enough history of these exotic products, no one could correctly model the default rates, the risk, etc. And that was the real problem; everyone rushed for profits in what was a very opaque house-of-cards built on one assumption: that real-estate would always go up.