Borrowers, Beware

By James Grant
Sunday, March 18, 2007

The top man at the Treasury Department urged calm last week in the face of losses on Wall Street brought on by fears of defaults on the riskier kinds of mortgages. Really, he said, the damage is easily containable.

But of all people, Henry M. Paulson Jr., former head of the New York investment banking house of Goldman Sachs, should know just how reasonable this near-panic was. Easy credit has long been the American financial lifeblood. Anything resembling stringency on the part of our formerly carefree lenders would tend to set the economy on its ear.

Easy credit financed the bull market in houses and the flood of home refinancings. Americans felt richer and spent as though they were. It stands to reason that the withdrawal of this manna will lead them to spend less -- with substantial collateral damage to the housing-centered U.S. consumer economy, and, perhaps, well beyond. Our captains of industry owe as much to their lenders' leniency as does any subprime, or high-risk, home buyer. They, too, have been able to raise money on terms unimaginable only four years ago.

All this sounds scary enough, and it is. But financial history offers some solace. The U.S. economy excels in the art of facing up to error -- of identifying it, reappraising it and then repricing it. Loans, especially the risky kind, have been mispriced. They were, and are, too cheap. They will be repriced -- as they were, for example, in the aftermath of the junk-bond and real-estate troubles of the late 1980s and early 1990s. Borrowing costs will go up, and the value of the things that debt financed will tend to go down. In an attempt to ease the pain, the Federal Reserve will print more money.

A sign of the times was the announcement the other day by the top U.S. mortgage lender, Countrywide Financial, that it will no longer help the average Joe or Jane buy a house with not one dollar down. The era of lending home buyers 100 percent of the purchase price is over, it said. The other surviving mortgage originators have been forced to adopt similar policies -- not as stringent as in Grandfather's day, but a radical departure from the free-and-easy ways of the recent past.

It wouldn't matter so much if the new sobriety affected only a narrow segment of the home-buying population. But no less than 40 percent of the residential real estate market faces a much higher borrowing bar, according to a new report from Credit Suisse. About one in five of last year's mortgage originations could not have been booked if 2007 standards had applied, the banking firm estimates.

But the ripples from this cold bath go even further than the $8 trillion mortgage market. The truth is that the no-down-payment, no-documentation, interest-only mortgage loan has its counterparts in most branches of American finance.

The date of the last ceremonial burning of an American mortgage is lost in the mists of time. Outright, unencumbered ownership of a house, a building or a corporation is no longer an ideal that most Americans embrace. The new goal is to borrow as much as possible, as soon as possible, against any asset that could be financed. And these days -- thanks to Wall Street's ingenuity --all manner of assets pass as good collateral for a loan.

Up until just the other day, nearly every home buyer could qualify for a little more house than he or she could decently afford. The same holds true, with no interruption to date, for the billionaire buyers of businesses. On Wall Street, as on Main Street, borrowers have had to beat the lenders away with a stick. The question before the house is whether Wall Street's lenders will catch Main Street's jitters.

Many are the wellsprings of credit in this age of financial invention. The Federal Reserve, for example, pushed down the interest rate it alone controls to just 1 percent in 2003 (and held it there for 12 months). But the Fed is only one central bank. Interest rates are low the world over. You can borrow in Japan for about 1 percent today -- and many hedge funds do.

Lenders are herding creatures. They tend to think the same thoughts at the same time. In consequence, credit ebbs and flows in cycles. Imagine a bankers' migration between point A, which we may call "No way," and point B, which we will designate "Come and get it." Just such a movement got underway in 2002-03. At the start of this journey, risky credit instruments -- junk bonds, for example -- were virtually unmarketable. Lenders feared the fallout from the burst stock-market bubble. Before long, however, lenders and borrowers regained their courage. But now, having long tarried at "Come and get it," they are reversing course for "No way." The migration has only just begun.

Free-and-easy lending not only financed the run-up in house prices (and the attendant massive drawdown of homeowners' equity). It also spawned the upsurge in corporate-acquisition activity. Business borrowing costs in relation to the Treasury's borrowing costs are at near-record lows. Exotic borrowing terms designed to enable investors to pay higher and higher prices for businesses are still freely available. The standard fine print once demanded by lenders in loan documents to protect against wayward borrowers is increasingly being waived. Last week, Stephen A. Schwarzman, chairman and chief executive of the Blackstone Group, a leader in the private-equity field, informed a New York audience that he could raise $20 billion with only a few phone calls -- and without the inhibiting fine print, of course.

Lenders read the newspapers, too. All but the greenest understand the risks of overdoing it. What, then, could they possibly be thinking about? For many, it is the serenity of the recent past. It seemed that nothing could go wrong in American finance. Stocks went up (or, at least, not down). Inflation was contained. Defaults were few and far between. Until the tiny Metropolitan Savings Bank of Pittsburgh bit the dust last month, no federally insured bank had failed for 2 1/2 years, the longest such streak since the Federal Deposit Insurance Corp. opened its doors in 1934. And when a company did file for bankruptcy protection, more lenders rushed to its aid.

Last Tuesday brought word that delinquencies among subprime mortgage borrowers had hit a four-year high. Few had expected it. Housing will be fine as long as the economy is upright, standard Wall Street thinking had it. But the optimists failed to reckon with the lenders. The sheer recklessness of recent mortgage underwriting practices has done the kind of damage to the creditworthiness of the American homeowner that only recessions used to inflict.

Always, the knee bone is connected to the thigh bone. Especially in this age of global markets, the two are tightly joined. Nowadays, loans rarely rest on the balance sheets of the lenders who make them. Rather, they are scooped up and fashioned into securities -- "asset-backed securities." And these are gathered up and refashioned into still other securities -- "collateralized debt obligations." And the CDOs, many of them dizzyingly complex, are sold to investors the world over. No bank regulator watches over these financial sausage-making operations. As the Federal Reserve has receded in importance in this worldwide financial system of ours, so has the U.S. banking system. A parallel kind of banking system has come into existence. Wall Street calls it the "CDO machine."

The CDO machine is a component of the infernal engine of international finance. This nation is privileged to be able to consume much more than it produces. We buy foreign goods, paying with dollars. The foreigners most generously consent to invest these dollars in U.S. stocks, bonds, CDOs and the like. Many of these CDOs are packed with mortgages, including the subprime, or low-grade, variety.

In a speech two years ago, Federal Reserve Chairman Ben S. Bernanke pointed to a curious coincidence: Growth in U.S. mortgage debt tracks closely with the growth in the trade deficit -- that is, the difference between what we consume and what we produce. "Over the past two decades," he said, "major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures."

If I were the head of state of one of our trading partners, I would be asking myself if these "major innovations" were as wholesome as they used to seem. Deciding not, I would command my minister of investments to unload U.S. mortgage holdings. And I would imagine that I would not be the only head of state to whom this thought had occurred.

Naturally, Congress will want to know whom to blame for this reckless lending and borrowing. The usual suspects come to mind: the Fed for pushing interest rates down to half-century lows, the bond-rating agencies for sugarcoating the risk on mortgage-backed securities and the lenders who competed with one another to see who could operate in defiance of the greatest number of canons of prudent credit practice. It was Congress itself that eliminated tax deductions on interest for nearly all consumer debt -- but let them stand for residential mortgages.

But our lawmakers should not forget to call human nature to account. In 1886, 40 years before the birth of former Fed chief Alan Greenspan, the Great Plains was the scene of a terrific real-estate boom, financed by the most reckless kind of lending. There was no Fed, and there were no rating agencies, just lenders and borrowers taking leave of their senses. They returned to them, eventually. They always do.

James Grant is the editor of Grant's Interest Rate Observer.

© 2007 The Washington Post Company