The Paper Economy: Credit Crunch of 2007

New inventions are not limited to physical things such as machines and electronics. Clever fellows in the financial world invent new forms of paper that give direction to the physical world of goods and services. The latest include zero down payment and adjustable rate mortgages (ARMs) and securitization of mortgages (mortgage bundles) called “collateralized debt obligations” (CDOs). Previously, home buyers obtained a mortgage from a local bank or mortgage company who evaluated the borrower’s ability to repay the loan and held the debt on the bank’s books. Now, these local firms resell the mortgages to brokers who package large numbers of loans to be sold to large national and international financial firms such as hedge funds and private equity buyout firms. In 2006, brokers accounted for 80 percent of all mortgage originations, more than twice the amount 10 years previously. The mortgage broker does not hold the debt, but is paid a commission. The more loans made, the higher the commission. This is an incentive for quantity, not quality. To obtain volume, home buyers with little savings and uncertain jobs were attracted to zero down payment ARMs. The institutional system of mortgage brokers and securitization is supposed to shift risk from local banks to those best able to evaluate and bear it. However, information is a problem. The risk of these mortgage bundles is evaluated by credit-rating firms who know that they will not get their fees if they are too critical.
Credit is at the heart of our paper economy. Hedge funds borrow money to buy these bundles of mortgages. Borrowed money is used to buy borrowed money. At the same time, borrowed money is behind a lot of the action in the stock market—private equity takeovers, leveraged buyouts and corporate stock buybacks.
One of the inventors of this new world of paper is Satyajit Das who estimates that one dollar of “real” capital supports $20 to $30 of loans. Derivatives (including CDOs) amounted to $485 trillion early this year, which is eight times the total global domestic product. In a period of rapid financial innovation and expansion, many firms profit from being highly leveraged, recently however, subprime loan default rates have doubled. Whole communities of non-maintained houses in receivership have appeared. In June, two hedge funds run by Bear Stearns went bankrupt with a loss of $20 billion. Countrywide Financial, the nation’s largest mortgage lender, is in trouble and its stock dropped 50%. Still, it makes little effort to restructure mortgages in default as it can make money on foreclosure fees.
The structure of incentives created by contemporary formal and informal institutions seems all wrong. Originators of mortgages have no incentive to seek quality, mortgage companies make money in foreclosures, and bond rating firms and real estate appraisers make fees by optimistic evaluations. Institutions structure the relationships among participants in the economy. New paper and new symbols organize production of goods and services. We know from past depressions and recessions that the physical components of the economy did not suddenly rust or freeze up causing massive unemployment and destitution. The problem lay in the institutional relationships. Institutional economists are skeptical of claims that markets automatically reach equilibrium. Rather they observe evolution and cycles. The contemporary practice of borrowed money being used to buy borrowed money is reminiscent of the stock market crash of 1929 when stock purchase on margin and purchase of the stock of holding companies was rampant. Satyajit Das sees hard times ahead as the economy deflates. I have no prediction. I certainly can’t claim to be better than Alan Greenspan who emphasizes that investment is based on expectations—a psychological phenomenon, not simply a matter of production functions. No one can really know when consumers and investors will lose confidence and withdraw. We only know that it can be quite sudden and tipped by unforeseen events of various kinds.
(Material and insights for this blog were collected from Charles Whalen, James Shaffer, Warren Samuels, Jon D. Markman, and David Ignatius.)