When Fools Rush In, The Joke's on ThemDissecting the Henny Youngman Economy.
Posted Saturday, Aug. 11, 2007, at 8:17 AM ETAn idea for a morality play: Capture the madness of an era when investors—entranced by new technology, a novel set of economic assumptions, and an all-powerful Federal Reserve—lost their heads, blew an exuberant bubble, and suffered a painful bust.
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StumbleUponSure, it may be late for a chronicle of the zany dot-com 1990s. But this template can be adapted easily to the financial trend that has defined this decade—and that may have come to a close this week. It is, in a way, the Henny Youngman Economy. Lenders pleaded: "Take my money ... please!"
In recent months, harbingers of the end of the credit bubble have been popping up like shoots of yellow forsythia. The spring brought rising subprime delinquency rates and the ensuing failures of subprime lenders. In July, leveraged hedge funds tanked, and several massive corporate-debt offerings were shelved. This month, mortgage rates for borrowers with good credit have spiked, and credit-card giant Capital One Financial jacked up interest rates, citing "business and economic factors." The coup de grâce came Tuesday, when Federal Reserve Chairman Ben Bernanke dryly declared that he was in no mood to cut interest rates.
In the past six years, since Alan Greenspan's Federal Reserve slashed short-term interest rates after 9/11, and U.S. auto companies rolled out zero-percent financing, cheap money evolved from a privilege extended only to the ultrarich into a near-constitutional right.
Credit derives from the Latin root credo, meaning "I believe." (Subprime comes from the Latin root sub primo, meaning "foreclosures in southern California.") And this credit boom rested on the staunch belief in three pillars of faith, all of which, coincidentally, underlay the 1990s boom.
Pillar No. 1. Technology, by ironing risk out of the system, obviates the business cycle and makes it safe to invest or lend at any level. In the new lending economy, the technology was securitization—the process through which loans are packaged and sold to investors.
Pillar No. 2. Asset prices continually rise. Banks were willing to lend 100 percent of the purchase price (and customers were willing to take on adjustable-rate mortgages that reset at higher rates after two years) because they knew a perpetually rising real-estate market would bail out even the most leveraged borrowers.
Pillar No. 3. In a pinch, the Federal Reserve would step in with a well-timed interest-rate cut, just as it did after various 1990s crises, flooding the system with cheap money.
Cue Mr. Youngman. As low rates proliferated, lenders fell over themselves to stuff cash in customers' pockets. And, ultimately, the lenders jumped the shark. Ninety-five-percent loans gave way to no-money-down mortgages to buy preconstruction condos in Miami. Subprime loans morphed into low-doc loans, no-doc loans and, the ne plus ultra, NINJA loans: no income, no job, no assets. In this age of promiscuous credit, the overriding sentiment was "trust, but don't verify."
Bankers proved similarly accommodating to corporations, especially to private-equity firms. Historically, most bank loans came loaded with covenants—early-warning systems that stipulate that the borrower has to keep spending to a certain level. But starting in 2005, Wall Street banks, eager to supply credit to hungry private-equity firms, began extending "covenant-lite" loans—debt blissfully free of such requirements. In May 2007, according to Goldman Sachs, such loans accounted for 15 percent of bank debt.
It all worked fantastically well—borrowers got their money, bankers collected their fees, investors harvested interest payments. But this year, one by one, the pillars underlying the Henny Youngman Economy crumbled. The securitization of subprime mortgages had the perverse effect of tethering more investors around the globe to the same crumbling assets. Home prices fell nationwide for the first time in a generation, down 2 percent between June 2006 and March 2007, according to the Case-Shiller Index. And Alan Greenspan's replacement, Bernanke, revealed himself to be more concerned with the prospects of inflation than with the prospect of unemployment among hedge-fund managers.
Chagrined lenders have been gripped by the sudden realization that debt can, and does, go bad. So, just as rapidly as they rushed to lower standards, mortgage companies—the ones that remain solvent—and lenders of all types are rushing to tighten them. Credit, the fuel that powers the economy, is becoming more scarce and expensive. Somewhere, in the great borscht belt in the sky, Henny Youngman is hoisting his violin.
This column also appears in Newsweek.
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Remarks from the Fray:
Credit expands the money supply, but does not create wealth. The real fuel is farming, mining, and production- that which adds value.
Credit allows people to buy that which is produced sooner than otherwise, but does not increase *longterm* consumption.
When people have large debt service burdens, they can't consume as much. Instead, they help enrich moneylenders, who may or may not consume the profits.
So why do people use credit? Two reasons: 1. Stupidity and 2. Inflation.
Unfortunately, most of the time it is #1 instead of #2. Sadly, attempting to explain this to someone with debt won't cure them of stupidity most of the time. It will only make them mad, and then they will go buy therapy (on credit) to cheer themselves up.
--Madai
(To reply, click here.)
There are many real estate investment schemes which IMHO are modified Ponzie schemes. Buy an old house, splash some paint on it and flip it. Buy a property, hire a property manager, and rent the property. Use the equity to buy more property.
The problem with both these schemes is they are based on a boom housing market. If the market keeps going up, you can make big money. However, if the market hiccups, you are stuck with unsalable properties and ongoing expenses. In the second scheme you are constantly up to your eyeballs in debt since you constantly reinvest equity as you get it. Like a Ponzie scheme, if you are in at the inevitable end crash, you lose big time.
Why should anyone stupid enough to invest in such a scheme be bailed out? Are there lucky ones in these schemes? Of course, a Ponzie scheme wouldn't work if the first level lost money.
--TheRanger
(To reply, click here.)
There was overlending to allow people to buy houses. Some people are not able to pay the loans back and the financial markets have to correct. But there are a number of good things.
1. Many of the borrowers are able to service their loans so those folks get to own houses and build equity, the building block of middle class life. If the lending had not gotten looser, these folks would not have gotten loans at all. So, the majority of borrowers are benefiting. The lending is something a populist should support because otherwise only wealthier people could ever get loans and build equity.
2. Houses do revalue down and people who held their assets back or could not afford houses during the boom can now buy up the houses are lower rates and put them to productive use at a lower cost basis. Again, a populist effect.
So, volatility in pricing whether it be stocks or other assets provides a benefit. A straight-line growth curve in prices would squeeze a lot of people out of the market. Government control of markets results in very low private investment rates which means primarily the rich benefit because they already have their money and can play the influence game with government officials.
Markets work.
--Dan_O
(To reply, click here.)
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