The historic credit bust, in review:

JoeyDVivre Wrote: ------------------------------------------------------- > So what’s really historic about this in my view > are: > 1) Excessive monetary intervention is really f-ing > dangerous. > … the Fed decided that they could circumvent all > that by handing people money. Duh. It created > many of the problems we have now… > > 2) Bad risk transference can destroy wealth at > amazing rates. > The convergence of the low interest rates with the > idea that all risk can be transferred and thus > made irrelevant was especially dangerous. So > there is lots of bad debt out there because it was > extended to people in silly ways. It’s just not > at all clear what wealth has been directly > destroyed by that. … Ultimately, though, > that shouldn’t affect the inherent value of the > house or the human capital of the person who owes > the money. Unfortunately, we are finding that it > wipes out a bunch of the institutions we need to > keep things running (like home equity loans and > banks) and has caused a huge dead weight loss. > The key for govt is to figure out how to fix these > institutions so that we ameliorate that loss and > stop the bleeding. Does anybody think that > handing out tax credits for people to blow on > stupid stuff and dropping interest rates > precipitously are even mildly constructive steps > toward that? The real historical value of this > will be in how we save those institutions and how > long it takes. Joey, I really like this analysis. I was struck by this part: “Ultimately, though, that shouldn’t affect the inherent value of the house or the human capital of the person who owes the money” I guess the problem is that cheap credit made housing (and other asset) prices inflate so much that it became impossible to figure out what the inherent/intrinsic value of a house or a person is. Any analysis of historical intrinsic values came up with numbers so far below the value of recent home transactions that it was hard to see how you could price anything other than by adding a few percent to the last closed deal. And one can’t really short residential real estate, unless you’ve bought first (Bob Shiller’s housing index may start to change that, but not yet). By creating unrealistic lending terms that no one could understand, you now have a bunch of people with lousy credit ratings not because they are untrustworthy, but because some mortgage originator made 1% off of the deal and sold it to someone else to manage it. “Greater fool” theory indeed! Now, even if you could clear out the mess of badly-collateralized loans, you’d have a bunch of people who can’t get credit simply because some of their creditors successfully fooled them. But credit ratings are supposed to be about how responsible the debtor is, not how irresponsible their lenders are. How’s that for risk transference! I also think the real danger is that key institutions that make the financial system work are getting frozen up in the process, but am not sure how to do that effectively. I am sure that handing out money to consumers as a “tax rebate” isn’t going to do it. By the way, does the Bush administration have any economic policy other than cut taxes?

vitaminc Wrote: ------------------------------------------------------- > I would blame the credit bust on ridiculous > residential housing valuations methodology. > > Also, stock price should hit the inflection point > before the recession is officially over as the > stock market is a leading indicator of the > economy, IMO. What methodology? There was no discipline or methodology involved in the majority of the real estate transactions (South Florida in particular) during the housing bubble. Any valuation model, or common sense, would tell you the 2 bedroom shithole 20 miles from the Atlantic is probably not worth $400K and has little potential for rental income even if you have a temporary low cost of funds The credit market turmoil is due to a lack of prudence by the buyer and the lender - you can’t divorce the two. Similarly, collateralized debt transactions appears to have suffered from an eerily similar lack of discipline. I’m not sure how much research is possible when your are 4 or 5 times removed from the underlying but that’s why risk management departments exist.

I think “Similarly, collateralized debt transactions appears to have suffered from an eerily similar lack of discipline” isn’t quite true. I’ve been enjoying re-reading various papers and conference presentations from the last few years. There are some gem lines in there that recognize the possibility of debacle but then discount it. The problem is that those risk management departments: a) Relied on a level of due diligence in the underlying loans that existed prior to the development of these vehicles. b) Knew that the models for these were untested, unreliable, and complex but better than no model. c) Recognized that there was explosive growth in a sector that really does have promise (I still believe that this kind of tranched risk transference can change the world for the better if we can get past this). As you say, it’s not clear how they could have done better being 4 or 5 times removed from the underlying except say “we’re not going to be involved in this asset class”. I’ve never even heard of a risk manager with the authority to say that.

joekinde Wrote: ------------------------------------------------------- > there was a credit crisis in 1990. HY issuance > went from $30 billion in 1989 to $1 billion in > 1990. damn guiliani BTW - There are some lessons to learn from this. There was some stuff that got incredibly cheap during this period because of window-dressing “I’ll look like an idiot if I’m holding any of this stuff” concerns. What’s the comment about giuliani about?

The mess we are in has a parallel to the beginning of the Great Depression: Heavy speculation bets, discount on sound banking practices, criminal acts, exotic products, cheap money, bank runs. ***** Quote: --------- By the fourth quarter of 1930 the trouble with the Bank of United States gave occasion to grave concern. The Bank of United States was a bank which ought never to have existed, and which certainly ought never to have had the name it had. One leading banker of New York went personally to Albany to protest against the giving of such a name to that bank or to any other bank, and was told that there was a political debt to pay. In the period 1924 to 1929, with excess reserves and rapid bank expansion, it was easy for plungers and speculators to grow rapidly. There was a heavy discount on sound banking, and a high premium on reckless plunging. One watched it with apprehension, afraid not merely that bankers would lose their judgment but also that in many cases moral standards would crack. In many cases judgment went bad, and in more cases traditional practices, sound and tested, turned out to be bad practices in such an abnormal money markets as then existed. But the great majority of American bankers kept their integrity and tried to adhere to established and approved banking practices. However, it was an era in which the bold speculator and promoter could gain ground rapidly at the expense of the conservative banker, and it was a period in which departures from convention and approved banking practices would seem to be brilliant strokes of genius ¯ while the new era lasted. The Bank of United States grew very rapidly down to 1929. The name itself meant, as it was designed to mean, to many of the ignorant people of Europe, that this was the national bank, the state bank, the official bank of the United States. Deposits came to it from a great many of those people and from a great many of the ignorant poor on the East Side of New York. And a great deal of business was brought to it, too, by men engaging in speculative activities who could get the desired accommodation from this bank which other banks of New York would not give. Loans against mortgages were generally looked upon at askance by great New York banks. The first principle of commercial banking is to know “the difference between a bill of exchange and a mortgage”. Second mortgages and third mortgages were notoriously improper documents in a bank’s portfolio or as a collateral to its loans. But the Bank of United States went in heavily for these. It had an affiliate also ¯ the Bankus Corporation. This was engaged in many yet more questionable transactions, including manipulation of the stock of the bank and loans against the stock of the bank. In addition to the utterly unsound banking practices, there were definitely criminal acts for which the head of the bank subsequently went to prison ¯ not unaccompanied. When the first mortgages grew shaky, when the second and third mortgages had no market, and when the bank’s stock was crashing, the Bank of United States and its affiliate, the Bankus Corporation, were in grave peril. Depositors grew very uneasy and they made heavy withdrawals of funds. Unsuccessful efforts to save the Bank of United States. The great New York clearinghouse banks, the Federal Reserve bank, and the state superintendent of banking, Joseph A. Broderick (who had no part in giving the name to the bank and whose job was primarily salvage), made strenuous efforts to save the situation. The great clearinghouse banks were prepared, in the interest of preserving the good name of banking in New York, to stand part of the losses. On Monday, November 24, 1930, it was announced that there would be a merger of the Bank of United States with the Manufacturers Trust Company, the Public National Bank & Trust Company, and the Interstate Trust Company, with J. Herbert Case, Federal Reserve agent and chairman of the Board of Directors of the Federal Reserve Bank of New York, as the head of the merger. This looked like an admirable solution of the problem. The financial community breathed a great sigh of relief when it appeared that J. Herbert Case thought that the situation could be solved in this way. It appeared that the aggregate capital funds of all these banks would suffice to absorb the losses and still leave a strong institution. But the agreement was a contingent agreement, and the other banks were to have time to scrutinize the assets of the Bank of United States. As they did, the merger became impossible. The officials of the other banks and J. Herbert Case could not assume responsibility for such a mess. The problem remained. The clearinghouse continued to work hard upon it. A conference, lasting beyond midnight, of leading New York bankers sat with superintendent Broderick on the night of December 10 and the early morning of December 11. A plan was worked out by which a wholly new management, under the presidency of the head of one of the small but sound banks of the city, was to take over the Bank of United States with a guaranty of the great clearinghouse banks against loss. But after this able young president and his associates, accustomed to clean, sound banking, looked at the assets of the Bank of United States, looked at the second and third mortgages, looked at the tangled and involved transactions they would have to deal with, they declined. They just did not know how to do that kind of banking. No other New York bank knew how to do that kind of banking. And so it happened that, on Thursday morning, December 11, 1930, the Bank of United States was closed for good. Cheap money could not help in a situation like this. To ease the shock and to relieve the plight of the depositors of the bank, the other banks of the city agreed to make loans against deposit accounts in the Bank of United States up to fifty percent of their face value. With the announcement of the closing of the Bank of United States the stock market plunged still lower. Money remained extraordinarily cheap in this stock market crisis. Call- loan renewal rates ranged from 2 to 2.3 percent between December 13 and December 27. But cheap money could not help in a situation where it was not liquidity but confidence that was vanishing. The stock market reached a wide-open selling climax on Wednesday, December 17. Then, as is usual, it rallied, and the rally carried over through the early months of 1931. But, in the light of the developments of the next two years, the American banking system was mortally wounded. One rotten apple can make the entire pile of apples go bad. * 1886-1949, author of the posthumously published treatise Economics and the Public Welfare, A Financial and Economic History of the United States, 1914-46 (Princeton: D.Van Nostrand Co., Inc., 1949; second edition: Indianapolis: Liberty Press, 1979) from which this excerpt was taken, slightly edited by Antal E. Fekete of Gold Standard University. Editor’s comment. Professor Anderson was a distinguished scholar, historian, banker, financier, and economist. As a monetary historian he wrote about a period in which he was not only an astute observer but also a frequent participant. What lends extraordinary timeliness to his observations about the 1930 scene is the unfolding subprime mortgage crisis that already metastasized from the United States to the rest of the world. Needless to say, in 1930 the American banks were in a far better shape than they are today when the entire banking system is guilty of unsound practices with which only isolated banks, such as the Bank of United States and the Bankus Corporation, indulged themselves eighty years ago. Eighty years ago the fancy name of the bank was the lure to entice ignorant people to their doom. Today it is the fancy name of the product: “mortgage-backed securities”, “collaterized debt obligations”, “securitization of loans” and, most recently, “bond insurance” that is supposed to do the same trick. What makes the above reading so frightening is the fact that eighty years ago the credit of the United States was rock-solid. Today it is moth-eaten; the promises of the federal government are hardly worth the paper they on which they are printed, in view of its repeated defaults, and its embracing of the unconstitutional regime of the irredeemable dollar. Worse still, the credit of other countries is no better, given the fact that it is not backed by anything more solid than the credit of the United States. Eighty years ago American institutes of higher learning offered the very best available by way of economic and banking knowledge. Today they are a sorry shadow of their former self. They are subject to bribe and blackmail. They are stooges of the banks. There is a gigantic cover-up and distortion of truth, as a consequence of our way of financing higher education through grants from the banks with a hidden agenda to perpetuate the regime of the irredeemable dollar. If academia is the tamed lion of the banks, then financial journalism is their lapdog. Eighty years ago, in the words of Anderson, one was afraid that moral standards may crack. Today we know that they have. It is interesting to watch the Fed trying to meet the present crisis in the same way as it was in 1930: by administering liberal doses of cheap money. In 1930 the Fed made the crisis worse as it prepared the ground for the Great Depression. It certainly did not stop the decline in the stock market. Ruefully, one can say of the Fed the same what was once famously said of the Bourbons after the restoration of the monarchy in France: “they’ve learned nothing and forgotten nothing.”

While the 1990 credit crunch is partially attributed to the collapse of savings loan, it was also caused by a singular event. The inprisonment of Micheal Milken, an event in which Guiliani played a small role. Only kidding of course. But I agree, I think you are starting to see some really cheap valuations in corporate credit. Anything not going bankrupt is super cheap right now.

Wait…you think the imprisonment of Michael Milken was a cause of the 1990 crunch?

Re: busy_people’s post. Professor Anderson’s history = top-notch good stuff with lots of important lessons (but surely Prof Anderson’s view is nothing like the bad mortgages of the Bank of the US caused the Great Depression which collapsed well into the Depression not as a cause of it) Editor’s take on Professor Anderson’s history = huh? “the promises of the federal government are hardly worth the paper they on which they are printed, in view of its repeated defaults, and its embracing of the unconstitutional regime of the irredeemable dollar” Say what?

Hey, Great post, I am also belong from one of such areas where the situations is not controlled yet.