April 2008 Quarterly Forecast > The Credit Markets

Special Section: The Credit Recession ¹

David Shulman

For about a year, the U.S. economy has become enveloped in an ever widening and deepening credit recession, as distinguished from an economic recession, that is working to constrict financing to all but the most credit worthy borrowers. We have the specter of once proud financial institutions such as Citicorp, Merrill Lynch and UBS going hat in hand seeking cash from Sovereign Wealth Funds to replenish their loan loss depleted capital.

Credit Losses Multiply

Leveraged loans that were once thought to be readily marketable now sit on the books of both the investment and commercial banks at valuations well below par. All told reported credit losses in the system are now in excess of $150 billion and growing. As a result, the credit spread for high-yield bonds have widened out from record lows last spring and to levels not seen since the end of the last recession.

The credit recession started in the subprime mortgage sector just over a year ago when HSBC and New Century Mortgage announced a significant increase in nonperforming assets and it soon spread to Alt-A, jumbo mortgages and home equity lines of credit. By August, LIBOR became a household word as the interbank loan market seized up. It then moved on to asset backed commercial paper that was issued by bank affiliated entities called “SIVs”. Because the bond insurance companies both insured and invested in Collateralized Debt Obligations (CDOs) that were backed by the now defaulting subprime mortgages, the Triple–A credit ratings of the once staid insurers were now called into question.

The giant government sponsored mortgage lenders, Fannie Mae and Freddie Mac just reported multi-billion dollar losses stemming from the weak housing market. Sitting just below the iceberg is the precarious position of the two major mortgage insurers, MGIC and PMI. Both of these companies are suffering huge losses and their survival is essential for Freddie Mac and Fannie Mae.

Thus far, the bulk of the pain has been concentrated in the financial sector, but should the current economic slowdown develop into a real recession it is likely that stocks will experience another leg down. Unlike the 2001 recession, where only stock prices declined, we now run the risk of a double-barreled hit to wealth coming from both the stock and housing markets.

Of Course, The Fed Has Not Sat Idly By

Over this period, the Fed cut the discount rate several times and made the most aggressive moves in cutting the Federal Funds rate since 1982. The Federal Funds rate has been cut from 5¼% last summer to 3%. We expect another 1% cut to 2% by the middle of the second quarter. However, as noted above, the easier monetary policy is being offset by wider credit spreads. Thus the full benefits of the rate cuts are not being felt by both consumers and businesses.

What is at work here is the concept of the “financial accelerator”, a term first coined by Fed Chairman Bernanke when he was a distinguished academic.²  Put simply, the financial accelerator enhances or dampens economic conditions through the actions of financial institutions in making credit more or less available to the public. For example, when times are good, loans are easier to get and with lenders being optimistic about repayment, credit spreads contract. When times are difficult the accelerator works in reverse as fearful lenders protect their balance sheets and become reluctant to make loans. This pretty much explains lending behavior from 2004 to the present and why money remains very expensive despite successive rate reductions by the Fed.

The real reason why housing will be in a rut for quite some time is that lenders as well as homeowners are in shock that house prices can go down absent significant declines in employment. There is no magic wand available for the Fed or fiscal policy to solve the crisis in housing market. As a result, the era of minimal or zero down payment home finance is over. Put bluntly, after years of easy credit, the American housing consumer is not ready for the more stringent mortgage terms of yesteryear and the shock of that will be severe. Although we are officially not calling for a recession, it will not take much to put the U.S. economy into recession. Should that occur, a two quarter decline in real GDP on the order of 1% a quarter would trigger absolute job declines this year and an unemployment rate of 6% by the end of the year. Indeed, if history and global experience is any guide, the hangover from the mid-decade credit boom could last for quite some time.³

Endnotes

1 We are indebted to Jack Malvey of Lehman Brothers for this concept.

2 See Bernanke, Benjamin S., The Financial Accelerator and the Credit Chanel, June 15, 2007.

3 See Reinhart, Carmen and Keneth Rogoff, Is the 2007 Sub-Prime Crisis so Different? An International Historical Comparison, AEA Meetings, January 8, 2008.

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