When will the so called Credit Crisis end?

A risk professional I respect asked me this question last week. On the way home, I thought about his clarifier “so called”. He well knows we are experiencing a shortage of the availability of credit. If professionals can disagree what to call what is happening, how can the public understand what is hurting home prices? Is this a Credit Crisis or some other kind of market failure?

The current credit shortage is different from classic credit crisises of the past. Credit professionals are comfortable with how Credit Crises work. They know what causes them and how the economy, with the help of the Federal Reserve, work them out, even if we are forced to suffer a recession in the process. We may not like living through them, but we can see into the future when they will end.

A Credit Crisis occurs when lenders sharply cut back on new lending and renewal of existing credit. Remember, banks borrow short term and lend long term. When lenders make loan origination decisions, they do not know the profitability of the loan for many years as the loan is paid back. Besides the financial and market risk calculations, professional judgment introduces emotional influences into the decision process. As lenders look far into the future for their returns, they can become skittish when circumstances change. Bankers are no different from the rest of us.

To make a loan decision, lenders need to convince themselves that the opportunity of their expected margin over the life of the loan is greater than the risk of not being paid back. The margin is the difference between the interest rate lenders charge the borrower and the lender’s cost of funds. Lenders cut back on extending credit when their analysis shows they may loose on the loan. The shift from aggressive lending to greatly tightened credit standards can happen abruptly. The cause is usually an external factor, such as an increase in short-term interest rates causing a narrowing of the interest margin they can command. Another example is an inflation shock caused by, say, a sharp increase in energy prices. The trigger is always different but it is something that causes a change in the interest rate view by bankers.

This time the crisis did not begin with banks curtailing their mortgage lending. It began when the funds the banks and mortgage brokers depended upon dried up. How this happened is because, this time around, there are many new players involved in the mortgage, and other lending markets. In the past banks made loans, either directly or indirectly through mortgage brokers. Banks would either keep mortgages and fund them internally or bundle and sell them to investors. The market they used to sell their mortgages was the CMO or Collateral Mortgage Obligation. CMOs have been around for a long time. Buyers of CMOs thoroughly understand the risks and obligations they create. CMOs still exist and are still a major source of mortgage funds. In this market cycle, new types of securities including CDO or Collateral Debt Obligation were created to give lenders a wider source of funds. An innovate feature of them laid the seeds of this crisis. The risk of a mortgage's default is split up into tiers and separated from the cash flows from borrower's payments and from, most significantly, individual mortgages themselves. The details are unimportant to this discussion, but suffice it to say, there are now multiple investors involved in each mortgage. The problem is how to get everyone together to make reasonable decisions on how to deal with loans where the borrower has trouble making payments.

A simple example of slicing up an asset is the time-share condominium. There might be 52 owners, one for each week in the year. Management decisions are made by a firm who runs the complex, sometimes not in the best interest of the true owners. At least in this case, a manager manages the facility that can prevent things from spinning out of control. Time-shares had serious growing pains of their own when first introduced. This market is stable now but, in the early years, many investors lost money.

In the end, buyers of these new securities did not fully appreciate the risks of investing in them. The proximate cause of this credit crisis was the discovery by the market that sub prime loans had been mis-priced. The web of players was so convoluted that buyers, to a greater extent than they should have, relied upon the valuation / risk opinion of others. Securitization encouraged new players to indirectly enter the mortgage market. When buyers realized their loss risk was likely to be much higher than they were told, the securitized funding stopped cold. Security holders are in the mode of disposing of risk, rather than purchasing more. Fears about counter party risk have adversely affected other credit markets where banks obtain funds. There is no short-term fix to these investors’ woes.

This crisis will end when the risk reward evaluation by lenders tips again toward reward. This can happen when their cost of funds decline, thereby increasing lender’s interest margin. Only time will allow the excesses that have built up in the market since the last Credit Crisis work themselves out. Do not expect a quick bounce back of the residential real estate market. The purchasing power CDOs gave homeowners to bid up home prices over the last few years will not return. Prices will need to seek a level where home buyers can afford them with traditional bank financing.

There are bright spots on the horizon. Banks will return to the market. They are not short of liquidity and short-term rates are low and moving lower. They are short of capital but have moved quickly to shore themselves up. Banks have all the tools to jump back into making residential loans as home prices stabilize. With all the help the Federal Reserve and congressional legislation is providing, banks will move before the home market completely bottoms out. This will help soften the blow. An unintended consequence of this is likely a very long period of stagnant home prices. However, that will have to be a discussion for another time.

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