Feb252008

The Credit Crunch

The Credit Crunch

credit-crunchIn 2007, the financial markets were abuzz with talk of a “credit crunch.” It was portrayed as some unusual and unpredictable outside force like an asteroid impact or a cold winter storm. However, it was not unexpected, and it was not caused by any outside force. The credit crunch began because borrowers were unable to make payments on the loans they were given. When lenders started losing money, they stopped lending: a credit crunch.

New Century Financial is the poster child for The Great Housing Bubble. New Century Financial was founded in 1995 and headquartered in Irvine, California. New Century Financial Corporation was a real estate investment trust (REIT), providing first and second mortgage products to borrowers nationwide through its operating subsidiaries, New Century Mortgage Corporation and Home123 Corporation. The company was the second largest subprime loan originator by dollar volume in 2006. April 2, 2007, the company filed for chapter 11 bankruptcy protection. The date of their financial implosion will be regarded as the day the bubble popped. The death of New Century Financial has come to represent to death of loose lending standards and the beginning of the credit crunch. Subprime lending was widely regarded as the culprit in starting the cycle of credit tightening, and New Century has been linked to this problem, but the scale and scope of the disaster was much larger than subprime.

The massive credit crunch that facilitated the decline of The Great Housing Bubble was a crisis of cashflow insolvency. Basically, people did not have the income to consistently make their mortgage payment. This was caused by a combination of exotic loan programs with increasing payments, a deterioration of credit standards allowing debt-to-income ratios well above historic norms, and the systematic practice of fabricating loan applications with phantom income (stated-income or “liar” loans.) The problem of cashflow insolvency was very difficult to overcome as borrowing more money would not solve the problem. People needed greater incomes not greater debt loads.

When more money and debt was created than incomes could support, one of two things needed to happen: either the sum of money needed to shrink to supportable levels (A shrinking money supply is a condition known as deflation,) or the amount of money supported by the available cashflow needed to increase through lower interest rates. Given these two alternatives, the Federal Reserve chose to lower interest rates. The lower interest rates had two effects; first, it did help support the created debt, and second it created inflationary pressures which further counteracted the deflationary pressures of disappearing debt and declining collateral assets. None of this saved the housing market.

Credit availability moves in cycles of tightening and loosening. Lenders tend to loosen credit guidelines when times are good, and they tend to tighten them when times are bad. This tendency of lenders often exacerbates the growth and contraction of the business cycle. In the decline of The Great Housing Bubble, the contraction of credit certainly played a major role in the decline of house prices. Lenders continued to tighten their standards for extending credit for fear of losing even more money. This meant fewer and fewer people qualified for smaller and smaller loans. This crushed demand for housing and made home prices fall even further.

One of the biggest problems for the housing market was caused by tighter lending standards was the reinstatement of downpayment requirements. During the bubble rally, 100% financing was made widely available. This made it unnecessary for people to save money to get a house. People respond to incentives. This is basic economic theory. The availability of 100% financing removed the incentive to save for a downpayment. People responded; our national savings rate went negative. Potential homebuyers who ordinarily would have been saving money for a downpayment to get a house, stopped saving, borrowed money and went on a consumer spending spree. This created a situation in the aftermath of the bubble crash where very few potential entry-level buyers had any saved money for the newly required downpayments. This created very serious problems for a market already reeling from low affordability, excess inventory, and a large number of foreclosures.

delinquency_downpayment

100% Financing

Once 100% financing became widely available, it was enthusiastically embraced by all parties: the lenders suddenly had a huge source of new customers to generate high fees, the realtors and builders now had plenty of new customers to buy more homes, and many potential buyers who did not have savings were now able to enter the market. It seemed like a panacea; for two or three years, it was. There was a problem with 100% financing (which was masked by the rampant appreciation brought about by its introduction): high default rates. The more money people had to put in to the transaction, the less likely they were to default. It was that simple. The borrowers probably intended to repay the loan when they got it, they just did not feel much of a sense of responsibility to the loan when the going got tough. High loan-to-value loans had high default rates causing 100% financing to all but disappear, and it made other high LTV loans much more expensive, so much so as to render them practically useless. It was all part of the credit tightening cycle.

Besides stopping people from saving for downpayments, 100% financing harmed the market by depleting the buyer pool. In a normal real estate market, first-time buyers are saving their money waiting until they can make their first purchase. There is usually a steady stream of first-time buyers that enters the market each year as they saved enough for their downpayment. When 100% financing eliminated the downpayment requirement, it also eliminated any need to wait. Those who ordinarily would have bought 2-5 years in the future were able to buy immediately. This emptied the queue. This might not have been a problem if 100% financing would have been made available to everyone forever; however, once downpayments came back those who would have been saving were already homeowners, so there were few new buyers available, and any potential new buyers had to start over saving for their downpayment. What was worse was those late buyers who were “borrowed” from the future buyer pool overpaid and many lost their homes. This eliminated them from the buyer pool due to poor credit for several years. Everyone who thought 100% financing was a dream come true found it to be a nightmare instead.

Conclusion

Credit availability moves in cycles. During the Great Housing Bubble, credit was loosened to a degree not seen before, and it facilitated a price bubble of epic proportions. During periods of credit contraction, lenders seek to avoid risk and they make fewer loans. This causes inflated asset prices to drop precipitously. The last period of stability at the bottom of the credit cycle saw 20% downpayments, 28% DTI requirements, and high FICO scores. Is there any reason to believe credit will not tighten to those levels again given the losses the lenders are experiencing? This cycle of credit contraction leading to asset deflation feeds on itself until lending standards become too tight and overly cautious when asset prices are their lowest. Of course, this is when credit should be made available to purchase assets at bargain prices. As safety and sanity returns to a financial market, lenders see they became too conservative and loosen their standards allowing more money to flow into capital markets: the whole process starts all over again…