We love debt. We must, because we are utterly awash in it. Government debt is 9.5 trillion dollars and counting. Household debt in 2007 was 13.8 trillion dollars, up a full trillion dollars from 2006. How about the business sector, those clear-eyed unsentimental scrutinizers of the bottom line? 26 trillion dollars, more than the government and household debts combined. Why are we so addicted to debt?
First, a disclaimer: I am not an economist, or a banker, or a hedge fund manager, or even (definitely not) a wannabe. This post is a response to Stranded Wind calling me out when I suggested a series on economic literacy. A century ago popular discussion of economic policy was commonplace. Town meetings, pamphlets, discussions were held about monetary policy, inflation, bimetallism, etc that bespoke a much higher level of everyday economic literacy than we see today.
Today we are potentially facing a crash of epic proportions. The U.S. government has taken over mortgage giants Fannie Mae and Freddie Mac. Unemployment is up, credit is gone, mortgage defaults are up, and one presidential candidate seems to be speaking for his party when he says that "the fundamentals of the economy are strong". We need to understand how we got into this, and what might work to get us out and what definitely will not. The idea, then, is to provide a "synoptic overview", as weather weenies might say, not specific details (if you're looking for analyses of the Fan and Fred takeover, try here, here, here and many other places.)
Second, a callout. Anyone and everyone is free, nay, encouraged, to contribute. Just use the same tag (if you don't like "Money Matters" contribute something better). Alternatively, someone in the finance field might want to take over. My only other request is that you don't use jargon (eg, "Discount window", "comparative advantage", "conduit", "M3", etc) unless you're going to explain it. Oh, and keep it easy to understand. With that out of the way ...
Debt
There are many reasons to go into debt. Unexpected events can do it, like a medical emergency or loss of job. We may work for a living and find that wages are at best flat while costs are rising. We may wish to purchase big-ticket items we can't pay for all at once: a house, a college education, a new factory, next year's crop. We may be lazy or intimidated for lack of information and invest badly (perhaps on the advice of "professionals"). We may be irresponsible or dishonest and buy SUVs and plasma TVs on credit we can't afford, or worse do something like invade Iraq. There are yet other reasons, and the one I want to look at today is this: debt makes money. What follows really only talks about corporate debt, but we've seen that when corporate debt goes pear-shaped, it inflates government debt as well.
Money
If you go to a bank and get a loan for, say, $10000, the bank (on approval) credits your account that amount. The bank has just created $10000. When you pay back the loan, that $10000 is destroyed. That is, by issuing debt, the bank has created money; when the debt is destroyed (paid back) so too is the money. In our system, money is debt.
Debts (loans) are assets to a bank, deposits are liabilities. Banks cannot just issue debt as they see fit: they need a certain amount of cash on hand or deposited at a Federal Reserve bank (the so called reserve requirement) if they're holding more than $9.3M in loans in case there is a spike in withdrawals or in case some loans go bad. For banks with at least $49M in loans, they must hold at least 10% of the total loan value in reserve (that is, they can lend out up to 10 times their reserves).
Now if debt is money, clearly there is enormous temptation to invest in debt rather than in farming or manufacturing or whatever. Economists would say that debt has the lowest "opportunity cost", which is the cost of the next-best alternative one would have to forego to get something. Obviously one has to have stringent oversight if one isn't to binge on debt. The Dutch discovered this in the 17th century, the British would rediscover this in the 18th, we would rediscover this in the 1920s, and now again (with the British) today. If this sounds like the Einsteinian definition of insanity, each time a debt bubble arose we said: "it won't happen this time, we know better now". Each time we were wrong. Actually, we did know better, passing such laws as the Glass-Steagall Act and the 1956 Bank Holding Company Act. But under persistent lobbying from the finance industry the regulatory framework has been dismantled, and we are once again proving Einstein right. In fact, we started binging on debt (again) in the mid-80's and haven't let up (figure from Kevin Phillips' Bad Money)
The interest rate is really just the cost of money: this is the price you pay for the use of the money you borrow, the price you charge when someone borrows money from you (eg, you buy a bond). Low interest rates mean easy lending, high interest rates dry up lending. Federal Reserve Chair Alan Greenspan kept the federal funds rate (basically the rate at which banks lend to each other) very low since the dot com bust of 2001, reaching as low as 1% in 2003-04 (it is now 2% -- the trend in the discount rate, which is the rate at which banks borrow directly from the Fed, is similar) in an effort to goose the economy. He kept it too low for too long, and all that cheap debt (= cheap money) inflated into a huge bubble which has yet to finish collapsing.
Leverage
Let's say you have $1000 which you invest in something that pays you 10% interest. Investment comes due, you get back $1100, and you've made $100. Not bad. Someone has just borrowed (gone into debt) $1000 and is willing to pay $100 for the use of that money. (Clearly the borrower is expecting to make over $1100 worth by the use of that money.)
Now let's say you find a bank who'll lend you $9000 at 5% interest. You borrow 9K, you invest $10K and you get back $11000. You owe the bank $9000 + $450 (5% interest), but you're still left with $1550, for a 55% return on investment. Way better than 10%. By going into debt (borrowing money) you've just leveraged your investment. Clearly the greater the interest rate spread, and the more you borrow, the better your ROI. More debt = more money. The catch of course is that leverage works both ways: if the investment doesn't pay off you're still on the hook for $9450. That's why banks do risk assessments and demand collateral. What we do today is take an income stream -- credit card receivables, car loans, student loans, but mostly mortgage payments -- and lever it up into a huge inverted pyramid that amounts to a giant Ponzi scheme.
The simplest measure of leverage is also known as gearing, which is the ratio of assets to equity, which is equal to the ratio of (debt + equity) to equity. When Bear Stearns collapsed, they were leveraged to the tune of 35:1 (or more): that is, they had less than 3 cents of equity for every dollar of "assets". This is insane, but not unusual: Lehman Brothers earlier this year was leveraged 32:1 (by massive sell offs they're down to about 25:1 -- they're still in deep trouble.) For context, Morgan Stanley is ~31, Citigroup 19, BoA 12, Merrill Lynch 46 (?!?), etc. Leverage by itself should not be taken as a measure of the health of a financial institution. It is fair to say, however, that high leverage ratios leave an institution vulnerable in the event of a downturn: if you have all of $1 backing up $20 or $30 or more of debt even a small shortfall of income can spell Serious Trouble. And if others are relying on your debt to back up theirs ....
Deleveraging
If you are badly leveraged it doesn't take much of a default in income or collateral to leave you unable to pay your debts. Nearly every major financial institution these days is deeply leveraged, and with collateral increasingly in default (mortgages and their derivatives, mostly), there is a massive rush to deleverage that's been going on for a year already. To reduce your leverage you either need to sell off assets or build up equity. But if the reason you need to deleverage is that your assets have lost value (assets collateralized, say, by subprime mortgages) and everybody knows this you are either screwed a la IndyMac or you have to sell things off at fire-sale prices -- and hope there are vultures who buy. This is what happened to Merrill Lynch, when they sold off $22B of CDOs (collateralized debt obligations -- exotic securities backed by debt) for 5.5 cents on the dollar (if everything goes well they might get as much as 22 cents on the dollar). If everyone is holding the same type of assets and everyone knows everyone else is holding debt of dubious quality, nobody is willing to buy or lend, and the system locks up. As the money stops flowing, it becomes increasingly difficult to service existing debt and it becomes increasingly difficult to avert disaster. The Federal Reserve will first reduce interest rates, in the hope that cheap money will get things going. But if the problem is not the cost of money but what that money will buy (debt of dubious value) then this is as effective as "pushing on a string". That is, reducing interest rates helps during a credit crisis (money is too expensive) but is ineffective in an insolvency crisis (too much bad debt nobody wants to buy), which is what we have now. When reducing interest rates doesn't work, the taxpayer steps in. This is lose-lose for the taxpayer: bailing out the banks increases taxes (or more likely defers them to be paid with interest, since the government is also racking up huge debts) and the lack of accountability leads to moral hazard issues. OTOH, not bailing them out could lead to a massive crash even more expensive than a bailout.
Other deleveraging tricks may involve selling a stake of yourself to someone else: Citigroup did this and sold off a stake to Abu Dhabi. Lehman Bros is currently trying to sell off a 50% stake to the Korea Development Bank (not to worry, if that falls through rumor has it they've found a buyer in the Tooth Fairy.)
You can try to attract more depositors by increasing yields on bank CDs. For instance, Washington Mutual is offering 5% APY on a 6 month CD, where most other banks are offering 3-4%. This approach is often too little too late, and besides is frequently an indicator that a bank is struggling to raise cash.
And there is always selling mortgage debt to the government via Fannie Mae and Freddie Mac. Fannie and Freddie had more than enough accounting and management issues of their own not to act as a backstop, but the government couldn't resist, directing them to buy more corporate debt last December and again this May -- that's levering up twice in 6 months when everyone else was trying to deleverage and sell off debt. Here's the typical justification:
"The lowering of the prudential cushion was appropriate in line with the company’s progress and with the need to maintain safe and sound operations": OFHEO Director James Lockhart said on May 6.
OFHEO is the Office of Federal Housing Enterprise Oversight, the agency that oversees Fannie and Freddie, and "prudential cushion" refers to the reserve requirement. Obviously they're not even trying to make sense anymore. Leverage at Fannie and Freddie is estimated at a ridiculous 78:1 (some estimates are higher). Now the taxpayer is on the hook, but even if we hadn't bailed them out they've already done their part bailing out the banks.
It's easy to get lost in detail and fail to see the forest for the trees. There are many technical reasons for the current crisis, including lack of transparency, conflict of interest, valuation of unknown products pretty much by wishful thinking (aka "mark to model" or Level III assets), etc, etc. But ultimately the reason we're in the mess we're in is that we've incentivized debt at the expense of the productive economy, that part of the economy where we actually produce things instead of shuffle numbers around. Here are profits from finance vs manufacturing (figure taken from Kevin Phillips' Bad Money again)
We have invested in money, not in capital, not in the human resource. But money is just a chit, a claim on goods and services, on capital and infrastructure, on human labor (actually, all of these ultimately come down to human labor) and without these things money is just a number. Investing in the chit and not the underlying assets that give the chit value is myopic: it is a demonstrable lock to fail in the not very long run, but in the short run it makes money hand over fist, and the market selects for myopia. Oversight to prevent binging has been eliminated, and it doesn't take a genius to understand what happens as a result. Here are just a couple of examples:
This is a figure from the NY Times showing the growth of the credit default swap market.
Credit default swaps (CDSs) look a lot like insurance, in which party A, holding debt from party C, makes periodic payments to party B. If party C defaults on debt, party B pays party A. This removes the risk of party C securities, at least on paper, which allows party A to take on yet more debt. But it's not just insurance: party A does not have to have a stake in party C or incur any loss from C to get a payoff, so this aspect of it is really a betting parlor, where people bet on how well or ill party C will do. The value of this insurance cum casino has rocketed in recent years and is now twice the value of the stock market, and three times that of US GDP. Mind-boggling quantities of money are involved and nothing actually gets produced.
Not just CDSs but also mortgage backed securities have boomed, though far less dramatically than CDSs. But $7.1 trillion is still half of US GDP.
One more example, if that is necessary. Here are new issuances of asset-backed securities (securities ultimately derived from credit card debt, car loan debt, student loan debt, etc)
It is the same pattern with all debt-derived securities (so called derivatives) -- MBSs, ABSs, CDOs, CMOs (collateralized debt and mortgage obligations), CDSs, etc all really took off in the early 2000s, shortly after deregulation. Until last August or so there was a race on to find new ways to lever on more debt and yet more debt, because debt is money -- right up until the bubble bursts, and everyone is left holding the bag (except of course for some CEOs who get generous packages irrespective of performance, and some vulture capitalists, who can pick up assets for pennies on the dollar). Right now we have no realistic way of gracefully unwinding, and it will likely end in synchronized cliff-diving. On to cement.
So how does this affect you and me? Our economy runs on debt, though that's usually spelled "credit". If manufacturers cannot get credit, new products and product improvements don't happen, and for many if not most production in general shuts down. Innovation and advances in technology go into hibernation. If agriculture cannot get credit, crops don't get planted. If retailers cannot get credit, they cannot buy and have nothing to sell. The economy contracts and unemployment goes up. This leads to further debt defaults, as the unemployed cannot pay mortgages or school loans or car payments, and this is the income stream that supports so much corporate debt. We go into a positive feedback loop of the bad kind (death spiral) and it is really really hard to pull out.
One last thing: the next round of mortgage resets should play out by 2011. We have a ways to go yet before the great deleveraging is over. But it is not too early to call for increased transparency, increased oversight, increased margin requirements, and reduced conflict of interest. It is not too early to call for accountability. If anything it is too late -- but late is better than never.