Too Much Borrowing Vs. Not Enough Borrowing
October 26, 2008
If you look at the present situation, at some level it was a problem of “too much borrowing.” Consumers, real estate investors, private equity, levered speculators etc. etc. simply borrowed too much money, to buy marginal assets, on terms that were way too lax. Or, on the consumer side, they just fluffed it away on junk and high living, leaving big debts. Now, sometimes in a recession it seems like there was too much borrowing, but actually, the preceding borrowing was sensible given the conditions and expectations. For example, if you bought a house at 3x income and 10x annual rent with a 30yr fixed mortgage — sensible guidelines — and then tripped into the Great Depression two or five years later, then you might have a problem anyway. That doesn’t mean the original purchase or loan conditions were flawed, but that economic conditions changed. However, if you bought a house at 8x income and 35x annual rent with a neg-am option ARM, then obviously you were a disaster waiting to happen, until you didn’t have to wait anymore. There were commercial versions of the same thing, like private equity buying companies at 10x EV/EBITDA with 80% debt using payment-in-kind financing (this is investment-banker talk for a neg-am loan), promptly followed by a big cash-out dividend (this is the private-equity version of the 80/20 HELOC piggyback loan), or REITs (General Growth hmmmm?) buying shopping centers at a 3.5% cap rate.
Eventually people wise up, and stop making these kinds of loans. This is not a bad thing, it is a return to a good thing. And, when they wise up, they find that there are very few people who either want to borrow, and who qualify using conservative guidelines. The gamblers from the past are going kablooey. The careful and prudent investors are usually allergic to debt in all cases, and that conviction is reinforced as they see the debt-gamblers going BK all around them. Plus, the economic situation is typically not very inspiring, which translates into apparent “surplus capacity” in every industry. Not too many reasons to borrow money.
In those times where there wasn’t sloppy lending previously, but an economic problem emerges (due to rising taxes or monetary instability for example), it is normal for lending to decline simply because the more difficult economic environment offers fewer situations in which businessmen can reasonably expect to make debt payments and a profit on top of that. However, in those times where there was indeed a lending boom (on extremely lax terms), not only do you have the difficulties of the first example, you have the fact that pretty much everything that one could lend money for has already been funded, and probably all the assets backing those loans are coming back on the market in the form of foreclosure and bankruptcy. The point is, excessive lending is typically followed by a reaction toward very little lending, for perfectly good reasons and not some sort of fear of fear itself.
Nevertheless, there are certain theories, which are really variants of a sort of credit-manipulation thesis that has been around since at least the 17th century, if not earlier. They are that 1) the decline in lending itself is causing the recession, instead of being a natural result of sensible people reacting to existing conditions. This can be a reasonable diagnosis if there was a “credit bubble” (as there most certainly was recently). However, the solution to the bubble is not to keep the bubble going! Or, there is 2) that the recession just is, for whatever reason (typically very little investigation is done into what that reason may be), but maybe we can do something about it by gunning credit. Goverments have a persistent fantasy that, if they do this or that, all of the actors in the economy are going to start jumping up and down like puppets on strings. Typically, they believe the primary strings to pull are base money, or M1 or M2, or reserve requirements or something like that. (Oddly enough, it may be the case that the Bushies did coordinate a somewhat artificial lending boom in the 2002-2003 period, which is now blowing up. If so, it would be another rather exceptional case.) Alas, economic actors are not given to doing this or that because of M1 or M2. Talk to a dozen bankers. See if you can find one that said: “I have to make this loan because of M1” or “I can’t make this loan because of M1.” With a few rare exceptions (systemic situations like the present), bankers never have to make loans if they don’t want to (like today), and always seem to have the money to make loans that they want to make.
It is possible to have an expanding economy without an unsustainable credit boom. Indeed, the healthiest economies typically show this pattern. We saw this graph a few weeks ago:
By the way, this figure is up to about 350% as of 1Q08, and that doesn’t include the government’s recent efforts, all of which could total another 25% or so of GDP!
The spike in the 1930s, as I explained, was caused by the decline in nominal GDP by 46%, not excessive lending. That means the present multi-decade credit binge is really unprecedented. Notice that the healthy and happy 1950s and 1960s show no great credit expansion, at least as a percentage of GDP. Certainly the great expansion of the U.S. economy during the 19th century was achieved without the “financial innovation” that we have today. All of this really amounted to a scam. Capital users and capital providers have been perfectly capable of joining together and funding projects using techniques — debt, equity, preferred equity — that have been around for centuries. The only ultimate reason for the recent monkey business has been a) higher fees for investment bankers, and b) making things so confusing that you can slap on an AAA rating and it is hard to dispute.
Nevertheless, the decline in lending activity during a recession is typically thought to be a big problem. There could be problems, when the withdrawal of credit is “irrational.” For example, working capital for healthy companies, or the recent trade finance issues. These probably fall into the category of “systemic” issues which should be avoided. For the most part, however, it may surprise some to learn that bankers are often quite anxious to make loans in a recession — loans to good borrowers on proper terms, which will result in profits instead of losses. This is because bankers need to make loans to make money, in much the same way as automakers need to make cars. Second, the availability of such quality (and willing) borrowers is normally quite low, so there is actually more supply of credit than demand.
Thus, I tend to conclude, “systemic” issues aside, that the government should just let bankers do what they do best. Alas, manipulation of credit has long been an avenue by which a government attempts to affect economic outcomes. Unfortunately, this often does not work very well. It may result in making still more low-quality loans. It seems the newly nationalized Freddie and Fannie are going down this path. The government is the only entity that can continue such a loss-making strategy. The other method, typically, is “lowering interest rates.”
The “Lowering Interest Rates” Boondoggle
As I mentioned in that piece, interest rates typically decline in a recession, without manipulation. This is because, as I just noted, there tends to be a surplus of capital to invest relative to high-quality uses for capital, which is sort of the opposite of a “credit crunch” isn’t it? The ones getting crunched are normally the lower-quality borrowers. Alas, neither the low interest rates that naturally occur in an unmanipulated gold-standard environment, or the low interest rates that may appear as the result of central bank manipulation, typically incentivize a lender to make a poor-quality loan to a borrower. (It may increase the net-interest margin on existing loans, which does help profitability of banks.) Sometimes the focus is not on interest rates, but some other monetary statistic, like the Ms, bank capital, bank excess reserves, or what have you. It doesn’t really matter. In the end, it comes down to the lender and the borrower. So, interest rate targets are lowered/Ms increased/capital or reserves increased, and there typically isn’t much effect on lending. At this point, all the “pushing on a string” and “broken transmission mechanism” metaphors are rediscovered, and academics act like they’ve discovered some sort of Black Swan, when in fact they’ve discovered a White Swan — the way things normally happen, which is contrary to the various make-believe fictions they’ve told themselves.
All of these theories often work as a cover story for the real story, which is currency devaluation. Currency devaluation can indeed produce results. In general, a higher nominal GDP would mean debt service burdens are lighter, and currency devalution can produce a higher nominal GDP than would otherwise be the case. (You can imagine what the 46% decline in nominal GDP during the Great Depression meant for debt service.) Also, you can sometimes induce or help along a lending boom via currency devaluation, as people latch on to the idea that you can borrow today and pay back loans in cheaper dollars tomorrow. There was quite a housing boom in the 1977-1980 period, for much this reason, although the inflation was terrible for the economy in general. It probably had something to do with the 2002-2006 housing bubble, although it was not the only factor.
Indeed, this is exactly what I argued with regard to Japan for many years. The purpose of the BOJ’s various “easy” actions (culminating in their “quantitative easing” policy) was never to expand lending through some sort of “transmission mechanism” that was soon declared “broken,” but to correct the value of the currency. When the currency’s value was corrected, businesspeople would sense that one of the economy’s problems had been solved, and they would start to knock on their bankers’ door with new business ideas. Thus, lending would increase naturally.
Thus, I tend to agree with the “just let things work themselves out” thesis, because a) attempting to artificially increase lending doesn’t really accomplish much, and b) you can’t do it anyway, and c) you often end up with a currency devaluation if you try. This doesn’t mean that a government should do nothing. It could take some of the actions I enumerated previously:
A major tax cut would allow more economic activity, new business plans would emerge, and banks would start getting calls for financing. In practice, tax cuts — in an environment of excessive taxes, as is universally the case today — do not lead to a reduction in revenue, for many reasons I described in my book. But, let’s just say they did. “Ohhhhhh, we can’t do that because it would be toooo expeeeensive” is the refrain. OK, so is all the other doodah that is likely to lead to $3 trillion of new debt issuance up ahead, if not more. That’s about 21% of GDP! It’s also about equal to the Federal government’s entire annual tax revenue (which was $2,407 billion in 2006). Kinda makes you think, doesn’t it.
As for consumer lending — I used to have a more laissez-faire attitude toward consumer lending, but that is evolving somewhat. I’m starting to think that low-quality consumer lending (basically for “consumption” instead of “investment” such as houses or education) results in an overall economic negative. It is not hard to see that misuse of consumer credit can lead to many problems on an individual basis, and in aggregate these are problems on an aggregate basis. Maybe if we had the consumer credit availability and standards of the 1950s and 1960s, which despite recent drama are still considered laughably quaint, we would have an economy more like the economy of that period.
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Pravda.ru published a little op-ed of mine: Making Currencies that Last
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If you want to understand why Hanky Panky’s latest “bank recapitalization” plan didn’t seem to get much positive reaction in the market, take a look at Morgan Stanley’s balance sheet. Morgan Stanley got $10 billion from the Feds. As of 1Q08 (a little dated admittedly), Morgan Stanley had $1,091 billion in total assets, with $29.2 billion of capital. MS also had “level 2” assets of $226 billion, and “level 3” assets of $76 billion. The “level 2” and “level 3” stuff is of course a junkpile of asset-securitization crapola. Plus, of course, Morgan has all sorts of derivatives and other off-balance sheet liabilities, which probably nobody including MS’s CFO knows for sure.
Naturally, all this makes one a bit nervous having MS as a counterparty or borrower. Because, what if that Level 2 garbage was not really worth $226 billion … what if it was worth $200 billion. That is not a real big markdown, considering that it is probably unsaleable junk, the tag ends of a bunch of mortgages or private equity loans that are also crap. That means Morgan Stanley just got a $26 billion capital deficiency. Which is a lot more than the $10 billion it got from the Feds. (Look at what happened to Lehman in liquidation. $0.08!) Thus, if you spend five minutes at it, you can see that $10 billion doesn’t really change Morgan Stanley’s situation one way or another. If you were a Morgan Stanley counterparty or creditor, you would be just as sweaty-palmed as before. Also, we can see that the government stepped up to the plate, with some big cash, and apparently didn’t achieve anything at all. Thus, we have an additional negative. The Feds are just trying to paint the newspaper headlines like they’re painting the tape. “We’re saaaaving the banks!” That might keep Joe Plumber from cashing out his bank CD, but it won’t fool the Wall Street sharpies. (It would have fooled them a year ago, but not today.)
That’s why a government needs to actually solve the problem rather than just trying to paint headlines that sound like someone is solving a problem. I suggested a bank recap plan.
October 5, 2008: Effective Bank Recapitalization
October 12, 2008: Effective Bank Recapitalization 2: Three Examples
January 27, 2008: Crisis Management
Do I think they will do something like this? The evidence to the contrary grows every day.
