Three centuries ago, the novelist and sometime tradesman Daniel Defoe described what happened when credit collapses: “If private Credit falls off, the Stock, the Trade, and, by Consequence, the Wealth of the Nation decays.” Modern economists tend to be more sanguine. As long as prices remain stable and the financial system continues to function, they see little lasting damage to the economy from a credit bust. This belief is likely to be tested as the current credit crunch continues into 2008.
Few people have thought as long and hard about the subject of credit as Albert Wojnilower. In the late 1970s the then–chief economist of First Boston Corp. was known on Wall Street as “Dr. Gloom.” (His Salomon Brothers counterpart, Henry Kaufman, was known as Dr. Doom.) Yet today Wojnilower, who advises a hedge fund on a part-time basis, is a beacon of hope among the many doomsayers thrown up by recent turbulence in the financial markets.
In a recent note to clients, Wojnilower argues that when past credit bubbles have burst, their “repercussions on aggregate economic activity have usually been small. The fears currently voiced of a ‘credit crunch’ do not take sufficient account of the fact that, to make a living, lenders must lend. Bursting bubbles cause some lenders to fail, but others take their place. In the process credit terms toughen in reaction to the undue ease previously, but lenders remain, as they are today, generally willing to finance — at a price — the purchase of capital or capital goods.”
Wojnilower believes that damaging credit crunches tend to be the consequence of ill-conceived government actions that end up paralyzing the lending industry. The current problems, however, “were spawned by global credit conditions that have been easy rather than restrictive.” These conditions are still in place and are actually getting easier as the Federal Reserve Board cuts rates. “Whatever may be happening to the world’s weather climate, its credit climate has not changed . . . it is merely undergoing a passing storm.”
There is plenty of evidence to support this view. During the second half of 2007, the securitized credit system started to implode. Investors lost confidence in the alphabet soup of structured finance. Debt issued by CDOs, CPDOs, SIVs and so forth fell to sharp discounts, and ratings downgrades followed. In the third quarter the market for structured finance securities expanded at an annualized rate of $50 billion, less than 10 percent of 2006’s growth rate. Since last summer outstanding asset-backed commercial paper has contracted by more than a third.
Wall Street firms have lost tens of billions of dollars playing with securitized debts — Morgan Stanley even succeeded in blowing nearly $8 billion on a supposedly hedged trade on mortgage securities. Although each day brings new revelations of further losses and mishaps, the credit system continues sputtering on. In fact, total U.S. credit actually accelerated in the third quarter of last year, according to the Federal Reserve’s latest Flow of Funds report.
During this period total credit market borrowings increased by a record seasonally adjusted figure of nearly $5 trillion, according to Doug Noland, editor of the online “Credit Bubble Bulletin.” Even total mortgage debt outstanding grew by 8 percent in the third quarter, outpacing GDP growth.
After the securitized credit system froze last summer, old-fashioned banks stepped into the breach. Total bank assets expanded by a seasonally adjusted $1.6 trillion (16 percent year-on-year) in the three months through September. Government-sponsored enterprises have rapidly grown their balance sheets in recent months. The Federal Home Loan Banks increased advances by an astounding 112 percent in the third quarter, says Noland.
Foreigners continue to provide liquidity to the U.S. financial system. Holdings of U.S. financial assets by the rest of the world increased by more than $1.1 trillion in the third quarter. Foreigners are also filling in the holes — the recent decision by Singapore’s Temasek Holdings to invest up to $4.4 billion in Merrill Lynch & Co. brings to nearly $40 billion the amount of money raised outside the U.S. to recapitalize Wall Street firms.
Consumer confidence appeared to be holding up toward the end of the year. Speaking on the first shopping day after Christmas from his Manhattan office overlooking Fifth Avenue, Wojnilower observed that the sidewalks were jammed with eager shoppers braving a nasty drizzle. “There is no sign of a credit crunch out there,” he said.
Nor are small businesses being cut off from access to capital. The latest poll from the National Federation of Independent Business, published in early December, reports that “on Main Street, credit conditions continue to look normal.” The net percentage of business owners finding loans harder to get was unchanged at the latest reading and is in line with readings over the past decade. “It would appear that all the hype about ‘credit crunches’ and tighter credit standards,” the NFIB report concludes, “has not impacted owners’ views about future credit conditions. All the angst appears to be confined to Wall Street and its observers.”
According to Wojnilower, serious credit problems arise only when the authorities intervene ineptly during a credit crunch. He blames regulators for aggravating Japanese banking problems in the early 1990s, when they forced banks to write off bad loans and shrink their balance sheets. Nothing like that is happening today. Wojnilower believes many well-capitalized U.S. commercial banks have escaped the subprime debacle and are currently both able and willing to lend. The only serious constraint to future growth, he envisages, comes not from lack of credit availability but from the fact that the U.S. economy is currently operating at near full employment.
And yet I find it hard to swallow this depiction of the credit crunch as just another overhyped Wall Street phenomenon. After all, American households depend on cheap mortgages to finance a level of spending that far exceeds their incomes. Consumers already apportion a record amount of their income toward servicing their debts. As underwriting standards tighten and loans become more expensive (despite Fed rate cuts), they are likely to feel the strain.
Furthermore, the value of collateral against which most consumer loans are made continues to decline. All 20 cities in the S&P/Case-Shiller home price index registered price declines in October, as the index fell 6 percent from its level a year earlier. With home prices still far above their long-term average relative to incomes and inventories of unsold houses at multiyear highs, it’s reasonable to assume that prices will continue sinking and mortgage delinquencies will keep rising for some time to come.
All bubbles are financed with credit. When they burst, some painful adjustment is unavoidable. During the technology bubble, U.S. companies borrowed massively to finance a capital expenditure boom. After the stock market crashed, they moved rapidly to get their finances in order, sparking a corporate credit crunch. The Fed was so worried that it slashed interest rates, which solved the immediate problem but inadvertently inflated a nationwide real estate bubble.
Today the excess spending by U.S. households above their incomes is equivalent to about 7 percent of GDP. Only when consumers are forced by circumstances to close this deficit will the full impact of the credit crunch finally be felt on Main Street. The faster home prices fall, the sooner we will arrive at that point.
Edward Chancellor, an editor at Breakingviews.com, is the author of Devil Take the Hindmost, a history of financial speculation.
