It IS Different This Time!
by Edmund M. McCarthyThis old curmudgeon never expected to write the phrase above. More and more, however, it is apparent that the credit expansion which has financed the unparalleled boom rapidly approaching a decade in duration in the United States is different this time.
WHAT IS DIFFERENT TO SOMEONE WITH MANY YEARS OF CREDIT EXPERIENCE IS THE COMPLETE LACK OF OR DISAPPEARANCE OF THE PRINCIPLES OF CREDIT WHICH WE AND EVERY OTHER CREDIT GRANTOR IN YEARS GONE BY WERE TAUGHT BEFORE EVER PENNING APPROVAL!
THE PRINCIPLES WERE KNOWN AS THE "C's" OF CREDIT! WE LOOK IN VAIN INCURRENT CREDIT GRANTING METHODOLOGY FOR SUCH PRINCIPLES AS "CHARACTER", "CAPITAL" ETC.
We said in a prior missive that the players had learned that it made sense to "engineer" credit so that it required no lender capital, reserves or regulatory scrutiny. To this we now add that it is "engineered" without any of the principles above being observed and utilized.
Instead of these time-honored principles, Wall Street has enshrined a new one "Cession". This term emanates from the insurance industry; the notion being to cede risk to another entity or, in common parlance, a "Reinsurer". Nothing new; just an adaptation.
THE ONLY PROBLEM IS THAT THIS ADAPTION HAS RESULTED IN MULTI-TRILLIONS OF DOLLARS OF ORGINATED DEBT IN THE LAST DECADE HAVING BEEN "CEDED". THE DEBT SO TURNED INTO "JETSAM" IS OWNED BY HOLDERS IN DUE COURSE WHO HAVE NO POSSIBILITY OF EXERCISING ANY OF THE PRINCIPLES, IT WOULD TAKE A FAR GREATER OPTIMIST THAN THE WRITER TO THINK THAT THE ORIGINATORS EXERCISED SUCH PRINCIPLES!
The debt so ceded ranges across the entire spectrum of capital/liquidity applicants. It also ranges from the simple to mind twistingly complex in the extent of the engineering. Much of the more complex could not have been accomplished without the other miracle of engineering of the last decade "derivatives".
It would be possible to bore the reader with all kinds of statistics on kinds of debt, totals of such kinds etc. There are better sources than this writer. What we will try to do hereafter is to look at the Wonderful World of Cession in amplitude or risk and disregard to the aforementioned "Principles".
1.Securities of Government Sponsored Enterprises
The most plain vanilla is the now multi-trillion in debt and guarantees of the two major Government Sponsored enterprises; Fannie and Freddie. (Fascinating that the writer can assume that ever reader will recognize the two acronyms without further explanation. It's not too long ago that "Dubya" had less public recognition). We start with these two on the assumption, valid or not that they have the lowest probability of holders confronting default and loss. (The Pax Congressional recently announced may even diminish for a while the possibility of market loss.) The measurement of the two entities as having a low level of default risk is on the assumption, valid or otherwise, that they are the epitome of "TOO Big to Fail". This couples with the conclusion that the universal belief in spite of protestations to the contrary that they are Government Guaranteed will occasion whatever bailout is necessary, "Ginnie" IS guaranteed.
On the other hand, they are splendid examples of the abandonment of virtually all principles of credit extension. Increasingly, they buy from "Anyone". (It used to be a lot more difficult to become a seller to them.) And "anyone" clearly has little interest in the multiplicity of anyone's it originates from. We do these things mathematically, you know. You don't? You think that an originator might know more than the credit score about a borrower? How quaintly Dickensian! What is the CHARACTER of the borrower? Define character! If it's not the credit score, what is it. It's fascinating to visit one of the relics which portfolios mortgages and see their equally quaint adherence to such a principle. Of course their low delinquency and default ratios are due to either luck or geography!
Trying to find CAPITAL in any part of this chain of multi-hundred billion originations annually is becoming increasingly difficult. Down payments (Capital of the borrower), have gone from low to none. There is virtually no recourse to intermediary capital. The GSE's themselves, even if they adhere to the Pax Congressional, will have capital levels far below those of the failed S&L's of the 80's. .CAPACITY was shorthand for a convincing evaluation of the borrower to service the debt in an ongoing fashion. In antediluvian credit circles, it was even annually reevaluated! What we now have is a static credit score and after we get all these hummers into a pile with a GSE imprimatur, it's up to the OFHEO to worry.
2. Other Mortgage Credit Securities.
We have used a fairly catchall description for this sector in spite of it's being comprised of nearly endless variations and permutations coupled with similar complexity on the part of the derivatives used to engineer quite a large percentage of the enormous aggregate amount outstanding due to the underlying credit risk having the basic similarity in being title to a residence. We actually think that the owner of a primary residence with a real credit score at the outset may be a reasonable risk! Later stages of mutation in this sector into no or low down payment, marginal credit risks, developer engendered concentration into large projects and other unsavory variables provides for a fringe element with much greater risk. Generally, however, this oldest and longest established form of credit done with full or partial abandonment of the Principles is subject to less risk of default and loss with growing exceptions. An imponderable risk is in the derivatives which cling like lampreys to much of the engineered credit. Issue by issue; thee "enhancements" are held beneficial. Our problem lies in their general opacity.
AS HAS BEEN STATED TO TEDIUM PREVIOUSLY, DERIVATIVES, IN GENERAL ARE NOW NOT SUBJECT TO ANALYSIS AS A CLASS. THE SOLE REPORTING ENTITY AFTER THE DERIVATIVE ISSUER'S UION ABANDONED RESPONSIBILITY FOR SUCH REPORTING BY THE ISDA IS THE BANK FOR INTERNATIONAL SETTLEMENTS. THEIR ANNUAL REPORT WAS CANCELLED AND HAS BECOME A 3- YEAR LOOK. THE ANALYSIS OF DERIVATIVES BY INDIVIDUAL ISSUER IS POSSIBLE BUT OF LIMITED VALUE AND CLOUDED BY NETTING. OUR CONCERN IS THAT EACH DERIVATIVE MUST HAVE A COUNTERPARTY! THEY APPEAR, IN THE ONLY RECENT STUDY AVAILABLE: A MOODY'S EFFORT ON ASSET BACKED COMMERCIAL PAPER, TO INCREASINGLY BEING CONCENTRATE AS TOWRITER IN A SMALL GROUP OF EXTREMELY LARGE FINANCIAL INSTITUTIONS. THE RISK OF CONCENTRATION WAS AN OLD CREDIT "PRINCIPLE".
The mortgage credit arena suffers from the same avoidance of principles as that related in the GSE ranting above. Additionally, there is the derivative and counterparty risk. Lastly, both areas of housing credit are increasingly suspect on the basis of statistical magnitude of growth. The increase in aggregate credit in the sector is astonishingly larger than the growth in units in the housing sector. This leads to a simple conclusion. There are two reasons for the anomaly. One: Housing prices are climbing at levels far above the "inflation" reported in the CPI. This is confirmed by the OFHEO report, which had prices rising nationally at 6.8% in the year to year June 2000. In some areas, the OFHEO admitted 8-10%. Anecdotal evidence yields a multitude of areas with 20-50% annual increases. No matter what the Loan to Value, and in many cases that has increased towards or to 100%, the credit being written in increasingly suspect as to further price appreciation and at risk for significant price depreciation in any type of turndown. Ion the 1980's, in the old S&L crisis, the default levels of increase in prices will aggravate this phenomenon this time around. IT IS NOT DIFFERENT IN THIS RESPECT.
Two: A saving grace for this multi-trillion area of risk has always been the "seasoned credits" on the books which have a low LTV based on long periods of payments. The curmudgeons recollection is that, in the sector, LTV was in the 45-50% area. I have not seen a recent statistic on this total housing portfolio LTV but suspect that the value portion has decreased significantly. Refinancing is the other reason for the ridiculously high levels of issue creation in this most securitized of markets. In a recent study published in Grant's Interest Rate Observer, done by the inestimable Charles Peabody of Mitchell Securities; the proportion of mortgage refinancings have at least a 5% higher loan amount had risen from as low as 40% in 1998 to over 80% in recent months. What this implies is that the borrowers are taking out the value as quickly as it is built! We wonder if the computer models predicting default risk on which this whole financial sector is built and rated are looking at this?
Three: Holders in due course. In a totally securitized world, it is impossible to understand where this paper resides. FDIC statistics indicate that an awful lot is in the Investment portfolios in the banks in the system. With Insurance still regulated by the fifty states no such information is available on that industry but it can be inferred... The mutual fund industry has also created a fair number of vehicles. This aggregate of the three, however, seems insufficient to have absorbed the startling growth in the outstandings in this sector. It is our contention, largely backed by anecdotal evidence, that a significant pile of this paper has been purchased by overseas holders; particularly the GSE part of the issuance. Statistics on the massive inflow of foreign capital in the last three years are readily available. It has been a great ride for the European buyers: Wide spreads to U.S. Treasuries and, if bought at the euro's start, 30% exchange appreciation! In a downturn, there is appreciable risk of wholesale liquidation by these holders! These holders ARE EXCHANGE RISK SENSITIVE! It is an economic downturn, they are not going to wait for the dollar to slip. The added risk is that these instruments are largely in "held for sale" portfolios in the U.S. commercial banking system. This means mark to market. Is it not possible to hypothesize that the holders are going to seek to avoid the type of hit that might occur with foreign liquidation as the starting precipitator?
So, in the end, the safest of the engineered instruments and portfolios in this era of abandonment of credit principles seem to have quite a bit of risk. Let's proceed DOWN the risk ladder.
3. Consumer credit in it's many forms.
With the exception of some "high net worth" lending and some dinosaur personal lines of credit in the local and regional banks; virtually all consumer credit is now originated, scored and securitized. We have already demonstrated in the housing arena, how such credit lacks adherence to traditional principles and will not reiterate. What is now generally acknowledged statistically is that the consumer debt burden in relation to income is at the highest level recorded. It continues to grow apace. Why? We suspect that the same game is being played as in prior credit expansions. If growth is sufficiently large; the emerging delinquencies in percentage terms always look "manageable".
CREDIT FOR THE PURCHASE OF AUTOMOBILES/TRANSPORT is one of the oldest forms of consumer credit. Originally. The principles made it one of the safer forms. It has migrated considerably. Concentration in recent years has contributed to a growing opacity. Many in the commercial banking arena have exited left. A number of independent providers have disappeared or been swallowed up. Except for that portion being granted by Credit Unions (Fierce competitors and the subject of whole report on the incrementing risk to these idols of the public), the bulk is securitized. Increasingly the terms of credit are going further and further out. Leasing is also a little analyzed phenomena with increasing risk as residuals have been used as a competitive weapon. Leasing, by and large (now a very significant part of the auto credit market) is a 90's product with little data on default in difficult times. It could be a wildcard in an economic downturn, weighing heavily on the ability to resell repo's if sufficient numbers simply turn in their keys. Let's face it; litigating massive defaults of this nature it is not cost effective! After all of the foregoing is said, however, the auto credits are probably the safest of these forms of consumer credit. They will, however, have to take cognizance of the NR 2000-76, The Regulatory agencies proposed revision of capital rules for the treatment of residual interests. The greatest risk in auto credit is to the captive's.
CREDIT CARD DEBT has also experienced tremendous concentration in recent years. The principles of credit have completely disappeared. Origination is pure marketing with growth (other than switching between the players) virtually confined to expansion down tier. This trend has occasioned many a cavil over the last few years that a blow-up was imminent. To this writer, there have been two factors mitigating against such an eventuality. The first has been the ability of the consumer to refinance the home at higher levels and find the cash to take care of the increasing problem with cards. The second is that, in fact, cardholders as a group are becoming subprime and that the marketing to the sup prime segment is actually, in many cases, an expansion of card credit available to cardholders in aggregate! Looking at the growth rates in cardholders and card debt outstanding for the Providians, Capital One's and other such entities; the inescapable conclusion is that they are adding cards to the customers of the more conservative grantors. Let's face it, the holder of a card with Wells IS NOT periodically resurveyed as a credit as long as delinquency does not intervene. If in trouble, take out a new card from one of the myriad offerings from the lower tier providers. This theorem accounts for both the unexplainable growth in outstandings and the lack of delinquencies!
In the world of securitization, these issues are ALWAYS ENGINEERED to be high investment grade if not AAA. The Agencies aforementioned tightening on residuals could wreak havoc on the securitizer's world. If, adopted, some of these players ratings might be threatened. Card debt, because of its ratings has also become a portfolio holding in the Investment held for sale in a broad segment of investors. The commercial banking sector is deeply involved and the mark to market would be very painful in the event of a downgrade. Derivatives and the relative short duration of these issues have provided suitability for money market funds to enter the arena. While we will warn against the potential for "breaking the buck" from the explosive growth in holdings of asset backed commercial paper in these funds later; there is another threat from a flight from credit card paper for the reasons enumerated here which cannot be ignored.
HOME EQUITY DEBT is, by any analysis, the most perilous of this genre! The past decade has seen this hybrid of the old second mortgage grow exponentially. An aside, the only state to hold in check, Texas, was the poster child for the proof of the fact that lending on residences can be less than safe in 1980's. The writer will never forget transferring a needed staff member from Houston to Dallas after the employer had adopted a maximum equity loss policy of 5%. The $80,000 Condo the employer recompensed the employee $78,000 went at auction for $6300. DOES ANYBODY REMEMBER THAT THE ONLY WAY TO GET THE HOUSE IF YOU ARE A HOME EQUITY LENDER IS TO PAY OUT THE FIRST MORTGAGE? In an age of discontinuity and the aftermath of credit bubbles always is, by the time home equity lender has title, the market will guarantee that, after legal fees, commissions and assorted costs, the resulting proceeds of sale will be nil! We have been watching the activities of the former DITECH, now firmly embedded in General Motors. When you are used to selling cars and repossessing, it is easy to think that home equity is the same game. The portfolio the auto giant is accumulating in sub prime home equity must be in total ignorance of the first mortgages they are going to have to confront! If one could desegregate the mighty GECC, there might be a similar story. Where are the principles? This whole market is a complete aberration in that respect. Who are the holders? We suspect that the relatively long duration means that a considerable amount of this stuff is in Insurance company portfolios. The Agencies proposed revisions could result in downgrades. You can't keep that kind of lower rated stuff in Insurance portfolios usually. Risk to be remembered. (On the other hand, have you seen the horrifying proposal to permit insurers to begin to stuff pension portfolios with low grade stuff! End of cycle, anyone? ) This form of credit still demands due diligence plays a large part. The biggest problem will undoubtedly turn out to be the Loan to Value situation. The credits being granted as this form of credit still grows at an extremely rapid pace are at end of cycle appraisals. The collection process makes all the difficulties aforementioned for mortgage credit much greater. Additionally, since virtually all of it is securitized, there is, in the absence of default, no periodic or annual resurvey in accord with the principles. These holders have no idea whether the hypothesis of the writer (That home equity borrowers use proceeds as found in their marketing not only to consolidate bothersome debt but as a re-entry vehicle into the selfsame debt) is true. What looks like a reasonable debt to income or cash flow at the writing is likely a ridiculously untenable one in many cases thereafter.
4. Corporate Debt in it's many forms.
Corporate debt, in this morning's WSJ is at 83% of net worth, still below it's early 1990's high but worrisome. More worrisome is the mix and the uses of corporate debt in recent years. Also to be remembered is that a lot of "worth" is suspect in the player's who have used pooling in the ongoing mania. We will refer to a recent interview with the manager of one of the largest bond mutual fund aggregations around in which be basically advised staying away from "spread product" a euphemism for corporate's to set the stage. Spreads themselves are an endorsement to this viewpoint as they continuously widen.
TERM DEBT for corporate's (including financial corporate's) used to be the true citadel of the Principles. Relationship lending predominated and the lender was close enough to exercize the principles in an ongoing basis. This still applies in some community and a few regional commercial bank lenders. THE AREA OF HUGE GROWTH IN THIS ARENA, HOWEVER, IS IN "SYNDICATED LENDING". This game is the antithesis of lending by the principles. The writer had extensive experience with this form of lending in the late 80's/early 90's with one of the largest players. The writer's constituency was financial institutions and they were the target of the syndicators. The mandate to these worthies was "book ‘em and sell ‘em! The due diligence, such as it was, limited to running impressive sets of numerical projections and flogging the output. I labeled their favorite off takers "tourists banks" since their acquaintance with what they were buying was about the same as the average tourist has with the Statue of Liberty. Since the writer had to take the risk that the buying banks would fund for the life of the deal 5-years; there were fights aplenty as the writer turned down "future funding risk"! Fortunately in that era, the Japanese banks were open all night and much of the junk being ped lled was absorbed there before things got too hot. In those days, the game was funding "buyouts" i.e. compete with Milken. The results were disastrous. These days, it's not to finance fiber optic for every kid in outer Nebraska and Kyrghistan and buy back the stock of the borrower. It will end as badly or worse! That the OCC has a team travelling the nation to look at the dreck that has been purchased says enough as they, like the agencies which rate bonds, are lagging indicator. A difference from prior era's is the inclusion of Wall Street firms in the game. Last time they had to compete with "junk bonds"; this time they are in the thick of the syndicated lending fray. Since every analyst rates banks on fees not interest differential, they have to maintain position in syndicated. Is this not a perfect scenario for complete abandonment of the principles? The other wild card this time around is the number of foreign (primarily European not Japanese) banks in this game both on the loans themselves as well as on the frequently accompanying derivatives. So far, the expansion of the balance sheets in dollars of their U.S. entities has been extremely beneficial when translated into euro's at home. If the dollar ever does plateau, could there be a drought as these worthies exit; presumably at a time of increased stress and increased demand for liquidity. Lastly, as long as whatever remains of this stuff (what they couldn't even find a stupid buyer for) is on the books as a loan; all they have to do is frustrate the regulator. If it is ever forced into mark to market mode as it should be, trouble ahead. The other imponderable is where all the money to complete that telecom build out is coming from.
COMMERCIAL PAPER AND ASSET BACKED COMMERCIAL PAPER is an area of increasing concern. The growth in this arena is accelerating. Such acceleration in the face of high short-term rates and an allegedly slowing economy is a sign of strain not growth. Naked commercial paper (the kind that isn't asset backed) is a fascinating reversions to the days when banks issued their own notes. Some of the larger bank holding company's are in this game. A suspension of disbelief on the part of the buyer is a necessary ingredient. What is truly fascinating in the last decade is how the issuance is financed. Remember. The writer's aphorism for the new era of "unprincipled" credit is to do the stuff without capital, reserves or regulatory supervision. Commercial paper takes it a step further. The explosion of money market funds as buyers makes it possible to create the funds necessary to buy unlimited amounts of the stuff. The game can be played entirely outside the traditional money system. Wall St. (including the large banks) can do this on a self-perpetuating basis. For standard commercial paper there is the requirement to get a complaint rating agency to come up with a Prime 1 or equivalent. To any rational person, the fees charged for lines to get such ratings borders on the ridiculous; from 6 or 7 BASIS points for the AA to 10-15 for the BBB. The grasping for fees for the analysts has brought this to a perilous level. Do the arithmetic. How much do you have to have to recover one loss. Can't be done.
More fascinating is the absolute reversing of the principles in the relatively new asset backed marked. In this arena, parlous credits are packaged, enhanced, shrouded with derivatives, rated Prime and then sold to the money market funds. This is where we think the buck will be broken. By the time this dance has been completed, the holders in due course; i.e. the lenders, have no idea who the borrower is much less what the character of the borrower might be. The borrowers capacity to repay is also unknown but suspect given all the enhancements required. Capital is limited to the enhancements and they are computer generated. Essentially the lender is lending on a rating. In the last few months the writer has asked numerous holders of "money market" accounts if they have any idea of what proportion of their funds are backed by this paper. I have yet to meet one who had the first clue and the usual reply was that the writer had a screw loose to worry about it. Greenspan won't let them take a loss! This area is also the one I would posit as having the greatest divergence from the fundamental principles of credit. The underlying borrowers represent a mongrel mix of subprime cards, autos and home equity, a variety of leasing deals of dubious capital and capacity and also missing as are the aforementioned consumer items of any question of character. Some stuff that otherwise might be syndicated is also to be found. It seems as if this is the new device or vehicle for credit, which is difficult to otherwise find a home. Here in money market land, virtually anything can be financially engineered into a rated piece of paper. The fund manager, in search of the last basis point to outperform competitors is the last bastion. Guess how vigilant the due diligence is. I haven't had the opportunity to deposition on of these managers but have no doubt some plaintiff's attorney eventually will have. My guess is that they have no more idea of what is in their portfolio than the poor ultimate lender, the public owner of the money market account. This toxic waste is as $600 billion and growing apace. From what I have read, it is flying below virtually all radars. Think of it, a perpetual money machine throwing off vast fee income, usable for virtually any form of credit and susceptible to finance at prime short-term rate. Nothing else comes close except General Electronic Capital AAA and Prime1+.
THE INESCAPABLE CONCLUSION TO ALL OF THE ABOVE IS THAT CREDIT IS DIFFERENT THIS TIME. THERE ARE LITERALLY TRILLIONS IN CREDIT WHICH HAVE BEEN ORIGINATED AND SOLD ON PARAMETERS DERIVED FROM COMPUTER DRIVEN FORMULAS TO END LENDERS UNABLE TO UNDERSTAND, ANALYZE AND TRACK WHAT THEY HAVE BOUGHT. NO REGULATORY ENTITY CAN AGGREGATE AND EXAMINE THE SITUATION MUCH LESS THE PUBLIC.
There is tremendous incentive for all players to keep the game going. One of the other PRINCIPLES we were taught was that if credit grew fast enough; the delinquencies would not catch up. BUT THERE IS ALWAYS A LIMIT. Are we at or near it? Impossible to predict.
The signs of approach to a limit are multiplying in yield spreads, default rates, particularly in the corporate sector and illiquidity for some forms of issuance. The whole subject of credit outside the United States could take up a book. Nevertheless, it is apparent that there are growing strains in the 1998 rescued Asia and Latin America. At the first quarter rate of $150 billion for the quarter in net change in foreign-owned assets in the United States, we are absorbing the lion's share of global credit creation. The telecom build out to come is in the hundreds of billions. The writer will go out on a limb and say that we are certainly more than 75% through this credit bubble creation. I do NOT underestimate the ability of the financial engineers to find the next instrument for the next few hundred billion but would definitely say we are much nearer the end than the popular conception. With the belief in the Greenspan Universal Put, the end will be prolonged, THE FINALFALLOUT WILL NOT BE PRETTY, WILL SPARE NO CREDIT SECTOR AND WILL PROBABLY BE UNPRECEDENTED IN FEROCITY. CREDIT BUBBLES NEVER AND GENTLY!
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company