Consumer credit:
Isn't it still true that the average American family carries massive amounts of debt? Without question we do. Looking at figures from 1953 to the present the ratio of household liabilities to personal income has grown significantly. But this simply means that we spend now and save later. Our savings take the form of interest payments and payment of principal on the funds we have already borrowed. We save ex post (after the fact) not ex ante (before the fact). This debt is part of the price we pay for enjoying goods and services sooner rather than later and it does carry with it certain risks. Our ability to retire this debt is senstive to the rate of interest charged, the total amount we have borrowed, and what happens to our earnings. If I use my credit card to make major purchases, the more I charge to this card, the higher the interest rate attached to this credit and the lower my income is as I pay back this debt, the larger the share of my earnings I must commit to paying interest and the original amount charged if I am to retire this debt any time soon. The temptation to delay this final day of reckoning and the almost inevitable need to so as unexpected expenses come up means that for many individual families the burden can grow to be considerable. We may in fact long for the mythical days when to buy something one had to build up cash reserves over time. In this case, in the event of a broken windshield and $100 deductible to cover or hundreds of dollars in plumbing bills, one could draw on these balances and simply delay further the major purchase originally planned.
The moral virtues of delayed graitifaction aside, the real advantage of "saving-up" for something then is the flexibility is provides. The temptation of simply putting off payment, the risk of rising rate being charged on balances you still owe and the financially precarious position one faces having amassed such debt if their earnings decline are the real reaons to be concerned about consumer credit. The personal advanatges of controlling spending and using this money to make extra payments on the mortgage, on car loans, and on credit cards are very real. And a shift from the buy now/pay later mentality that easy access to consumer credit makes possible would provide the sort of freedom of manouevre already discussed. However, these actions will weaken the financial position of businesses accustomed to the trade of such familes. As their revenues fall, given costs, profits and cash flow will decline. It is this a very fundamental fallacy to reason from the individual advantages of higher savings that it will be socially advantageous. Reduced spending will free resources that could be used for more investment. However, since saving in the aggregate will not increase -increased personal saving leads to reduced business saving- the rate of interest will not fall. And the degree to which these businesses rely on cash flow to honr their debts, any belt tightening by households will simply push the burden on to the business sector. At any rate, although we obviously save today so that we will have the power to spend sometime in the future we have only the vaguest ideas of what form exactly this spending will takeor when it will take place. As a result, assuming they could somehow raise the funds to employ investible resources, businesses contemplating investment are left to themselves to decide what fraction of the resources available they should employ and in what direction they should employ them. Subprime mortgages: It is interesting to go back to comments made by Greenspan in 2004 regarding what we now refer to as the subprime market. He pointed to advances in computer technology that made it easier to identify good credit risks out of the pool of low income borrowers. In particular he was referring to the automated underwriting systems such as Freddie Mac's Loan Prospector (see a, b, c, d). These systems promised to make it possible to extend credit to many who otherwise might be denied mortgage credit under traditional underwriting. With automatic underwriting systems to screen applicants (and separate the wheat from the chaff high credit risk borrowers from lower risk ones) Freddie Mac claimed in 1996 to have reduced such costs by on average $350 to $600 per loan (a) (For claims made more recently that it is has been reduced by over $900 see b). As a result of such technologies, lenders- anxious to mine a previously untapped vein of borrowers and to tap a market where the rates charged typically were 2% points higher than a prime mortgage for the same amount would be- aggressively begain issuing mortgages to economically poorer families with less of an estiablished credit history in more depressed areas. Banks increasingly originated variable rate mortgages to low income families to purchase modest homes. According to one source, last year in 2006 20% of all mortgages granted were to subprime borrowers. The social benefits of subprime lending are that home ownership rates have risen from 65% of the population to 69% with 12 million new homeowners and approximaltely half from racial minorities (see a and b) Greater competition among banks for the business of higher income families with proven credit histories and buying expensive homes meant that potentially greater returns could be obtained by those moving into the subprime market. The securitization of such mortgages meant that there was money to be made through fees paid to the banks that originated these mortgages and the pooling of such loans into firms specializing in subprime mortgages meant that the risks could be spread out among a large number of investors. Lending to lower income families at variable rates of interest is one thing when jobs are relatively plentiful and market interest rates are low. It is quite another matter when higher interest rates are targetted and weakness in the overall economy (or specific sectors such as construction and the automobile industry) and the housing market caused in part by higher interest rates are coupled with competition from abroad, immigrant labor and computerization reduce employment opportunities and growth in earnings. Also, unlike prime mortgages, subprime mortgages more often than not carry substantial prepayment penaltie. Typically they were set up in such a way that they were more than viable in an economy with low interest rates, easy refinancing, and rising house prices but carried, as we can now see, a considerable amount of downside risk. Were lenders who originated these mortgages, the companies that bought them, and the borrowers blind to these risks? Probably in the case of many borrowers yes. Less financially savvy, eager to buy their own home, and trusting the authority of bankers and mortgage brokers they have workers with, they focused on the initial terms of the mortgage and were reassured that later on they had little to worry about. What is chilling is how little attention is being paid to 1 million plus families who are expected to go into default this year and therefore who will face foreclosure. Equally chilling is that the many families who were misled, given the complexities and layering of these securitized mortgages, have a far more daunting task if they wish to complain of consumer fraud than if this were a more traditional mortgage both issued and held by the bank that set up the mortgage(See Kiff and Mills). In the case of the bankers, mortgage brokers, and investors who provided the demand for subprime mortgages, rather than being blind to these downside risks they have rightly assumed that downside risks would be shared and, if lucky, the lion's share of the burden would be borne by others. Many involved in the formerly lucrative business of originating subprime mortgages are leaving both the families they lent money to and the investors who bought these mortgages from them to twist in the wind. That the focus has been on the latter group and the much more economically and financially significant repercussion of their difficulties is shameful. The real victims are those who have lost their homes and suffered the embarassment of default. Should the Fed and other central banks intervened as they have? Consider what the root causes of this crisis are. Many subprime mortgages start with the first two, three, or five years at low fixed rates and then change over to variable rate loans. The rates charged on variable rate loans may be a high as a full five percent over LIBOR. In addition to income and a borrower's debt service ratio, the feasibility of refinancing will depend on the ratio of the amount of money that must be borrowed to retire the old debt and convert it into a new mortgage relative to the value of the home. With prepayment penalities and stagnant or falling home prices the amount to be borrowed climbs as well as the loan to value ratio rises. First lax regulation by the Fed and other regulatory bodies allowed banks to become increasingly cavalier about credit risk. Second, Fed policy since 2004 has been to tighten credit and push interest rates higher. The fed funds rate stands over 4% points higher than it was in June 2004. Fed monetary restraint, whatever the intention, in turn has contributed to the fall in the U.S. housing market. All of this has made payment of existing mortgages or refinancing difficult if not impossible for subprime borrowers. This crisis, like the foreign/Latin American debt crisis of the 1980s or the Dot.com bust of the late 1990s, is therefore due to no small degree to shifts in Fed policy. Since the current crisis is in part the Fed's doing, it is only right therefore that the Fed do something. I am little concerned that specualtors will come to expect the Fed to bail out markets when they falter significantly and therefore become more reckless still. It seems few involved with Fed policy understand how often in recent years they are simply being forced to offset the harmful effects of the sort of stop/go cycle that constitutes modern monetary policy. If Fed officials fail to discern this pattern why should one expect private investors, with a much narrower and a shorter time horizon, to see one? Since Hyman Minksy, inspired by Irving Fisher and Michal Kalecki, wrote about these issues in the 1960s and 1970s we have understood that the price we pay for a robust growing economy is the sort of excesses that we are seeing now. The Fed has again shown its incredible knack for tapping on the brakes just as we are starting to climb up a very steep hill. What is regrettable is how little attention is given to the low income homeowners being crushed under the wheels of our economic machine as it rolls backwards.