The Curse of Cheap Credit?

By Robert J. Samuelson
Thursday, June 2, 2005

Call it cheap credit's revenge. We seem to have arrived at the curious juncture where the low interest rates that rescued us from the last recession might be the cause of the next -- or, at any rate, might be the cause of some serious economic or financial unpleasantness. It turns out (not surprisingly) that cheap credit, when continued too long, inspires suspect and speculative borrowing. It becomes a formula for its own undoing.

William Rhodes, senior vice chairman of Citigroup, puts it this way: "The speculation here is more evident than people seem to realize. . . . I've seen this movie." The script is familiar. Too much cheap credit induces overborrowing. During the borrowing phase, the economy seems to do fine. But sooner or later the prices of things bought on credit rise to artificially high levels. Prices stop rising -- and perhaps crash. Lenders and borrowers suffer losses. Their spending slows or declines, dragging down the economy.

The present recovery is built largely on cheap credit. Striving to prevent a punishing recession after the 1990s' stock "bubble," the Federal Reserve lowered interest rates. The federal funds rate (the rate on overnight loans between banks) dropped to 1 percent. That policy worked. Americans borrowed heavily, particularly for housing. The result was a construction boom and a helpful rise in home prices. The higher housing values fortified confidence and provided -- through the refinancing of mortgages at lower rates -- huge cash windfalls that fueled consumer spending.

Now the Fed wants to preempt the perils of cheap credit, starting with old-fashioned inflation. The problem is that the Fed directly influences only the obscure federal funds rate, which isn't used by ordinary borrowers. It's risen to 3 percent and may go higher. But the more important rates are those on long-term bonds and mortgages -- and, contrary to expectations, they haven't risen. To take one example: Rates on 30-year fixed-rate mortgages averaged 5.8 percent in 2003 (down from 8 percent in 2000). In 2004, after the Fed began raising rates, they still averaged 5.8 percent. What are they now? Well, they're 5.7 percent.

No one quite understands why. It was expected that, as the Fed squeezed the total supply of credit, all rates would rise. Theories abound to explain what's happened: The Chinese (and others) are buying U.S. Treasury bonds, keeping down long-term rates; a better inflation outlook causes lenders to accept much lower long-term rates (lenders don't want their money eroded by inflation -- thus, prospects for low inflation reduce rates); the economy is actually weaker than it seems; the Fed hasn't yet offset its oversupply of cheap credit. Who knows? Even Fed Chairman Alan Greenspan calls the low rates on bonds and mortgages a "conundrum."

Whatever their cause, they pose twin dangers. One is that more loans may turn out to be stinkers. Borrowers may miss payments or default. The second is that cheap credit is pushing some prices to speculative (that is, unrealistic) levels. "Bubbles," as we've learned, do ultimately pop. Consider:

· Housing: In the past year, median home prices have risen 15 percent, to $206,000, reports the National Association of Realtors. Since 2002 they're up 32 percent nationally. Credit standards appear to have declined. Despite low fixed-rate mortgages, almost half of new home loans in the past year are adjustable-rate mortgages with even lower rates, says Mark Zandi of Economy.com. That's a record; in 2001 the ARM share was 20 percent. Zandi estimates that 20 percent of new mortgages are "interest-only" ARMs (monthly payments don't include principal), which barely existed a few years ago.

· Emerging markets: The Institute of International Finance Inc., a research group for banks and other financial institutions, warned last week that low interest rates may have led to overlending to poorer countries. In 2004 they borrowed $127 billion, up from a mere $1.6 billion in 2002, estimates the IIF. For some countries, interest rates are so low that they're barely above rates on U.S. Treasury bonds, says Charles Dallara of the IIF.

· Junk bonds: In the past year, they've become "dramatically junkier," Steven Rattner, a well-known investment banker, warned last week in the Financial Times. In 2004 companies issued a record $147 billion of these bonds, which have low credit ratings. About 42.5 percent of these bonds had a credit rate of B-minus or below, the poorest record ever, he said.

· Hedge funds: These are sophisticated investment vehicles for wealthy individuals, corporations, pensions and endowment funds. Since 2000 the number of U.S. hedge funds has doubled, to 8,000, and the amount they control has tripled, to $1 trillion, says the Hennessee Group, a consulting company. Many hedge funds finance their investments with short-term loans at low rates. As these rates rise, funds may make riskier investments to maintain profitability, says Andrew Lo, a finance professor at the Massachusetts Institute of Technology. More hedge funds may fail, he says.

The U.S. economy is doing well. The withdrawal of cheap credit would be less worrisome if the rest of the world were doing as well. Any weakness would be offset by higher demand for U.S. exports. But much of the world is struggling. If something goes wrong in the United States, it could spread globally. Everything is interconnected. Hedge funds own mortgages, junk bonds and emerging-market bonds. Losses in one market can cause losses in others. Of course, that's normal. But will the normal trigger something more threatening? Cheap credit, once a blessing, could become a curse.


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