Chapter 35
Credit, the Carry Trade, Tax Rates, and the Residential Real Estate Market: A Retrospective
Abstract
The financial innovations in the credit markets, the tax treatment of residential real estate, and the Fed’s monetary policy combined to create a perfect storm in the real estate market. During the early part of the cycle, these three factors fueled a virtuous cycle that led to rising home prices, a boom in real estate, and an increase in leverage in the US economy. The rising net worth also stimulated aggregate spending on consumer goods. The economy prospered and grew. The rising real estate prices attracted new entrants, construction activity increased, and the supply of real estate increased. Over time, the increased supply reduced the excess returns in real estate and that combined with the unwinding of the Greenspan Put, it contributed to a decline in home prices. Credit tightened and homeowners had difficulty carrying their mortgage. As a result, their spending also declined. All of this further reinforced the downward spiral and the vicious cycle was created. The end game was a financial meltdown and a recession.
Keywords
carry trade
democratization of credit
Greenspan Put
income smoothing
loss of transparency
securitization
In early 2005, a front page Wall Street Journal article caught our attention [1]. The headline posed an interesting theory: while lagging behind the wealthy, many used debt to catch up. The argument was succinctly summarized in the following quote from the article:
….. More and more Americans are turning to debt to pay for lifestyles their current incomes can’t support. They are determined to live better than their parents, seduced by TV shows like “The O.C.” and “Desperate Housewives,” which take upper-class life for granted, and bombarded with advertisements for expensive automobiles and big-screen TVs. Financial firms have turned credit for the masses into a huge business, aided by better technology for analyzing credit risks. For Americans who aren’t getting a big boost from workplace raises, easy credit offers a way to get ahead, at least for the moment……
This interpretation led to some uncomfortable implications:
…….Yet many fear credit has spread so widely that many Americans are overextending themselves, leaving a growing number anxiously in debt and, increasingly, bankrupt. Outstanding household debt doubled to more than $10 trillion between 1992 and 2004, after accounting for inflation. Because of low interest rates, consumers’ monthly debt burden didn’t increase nearly as rapidly.
Economists disagree whether this relatively benign situation can continue. Interest rates are rising -- although long-term rates remain low -- and wage growth is sluggish. One danger: Housing prices could stall or decline, upending calculations ……
How prescient. One of the concerns raised by the above quote is how hard would the economy’s landing be? In the same article, the author suggested an alternative interpretation of the situation that did not produce such dire conclusions:
Despite the dicta of old sages, many economists -- led by Federal Reserve Chairman Alan Greenspan -- see the expansion of credit to lower-income families as a sign of progress. Some speak of the “democratization” of credit. In an April speech, Mr. Greenspan said that in colonial times through the late 19th century, only the affluent had access to credit and rates were high. In the early 20th century gasoline companies and retail stores started issuing credit cards, but cards didn’t spread widely until the late 1960s when banks piled into the business. Now, Mr. Greenspan says, “innovation and deregulation have vastly expanded credit availability to virtually all income classes.”
Those who celebrate credit’s new reach, such as University of Chicago economist Erik Hurst, talk about income “smoothing” -- the idea that debt enables people to borrow from their future earnings. In an earlier era, many people had no choice but to save first and spend later. Now, with credit, they can spend right away. For many young people, it’s realistic to expect their earnings to rise. Their spending isn’t just on baubles -- they may buy a house in a neighborhood with good schools, helping their children get ahead over the long term.
The previous quotes point to two different views of the world. In one, the current situation was inevitable. The second, while not ruling out the economic mishap, suggested that a necessary precondition for an unpleasant economic correction would require either a policy mistake or some unexpected shock to trigger a financial crisis.
The Democratization of Credit and Income Smoothing
According to street lore, the increase in consumer debt is mostly due to a secular decline in debt service ratio due to the interest rates charged on the loans. It allows consumers to support a higher level of debt. There is no question about that. However, as one looks at Fig. 35.1, one can see that from 1989 to 1992, the debt service figure steadily declined, while from 1994 to 2010 it appears to be on an upward secular trend. Yet throughout the period, bond yields were steadily declining (Fig. 35.2). The secular decline in bond yields took place during periods of both rising and falling debt service-to-disposable personal income ratios. This appears to contradict the view that the secular decline in bond yields drives the debt service. There is more to the debt service story than the decline in yields.
Figure 35.1 Debt service as a percent of disposable personal income.
Figure 35.2 T-bill and T-bond yields.
While we complain that the crisis was in part due to the excessive credit creation and lax standards, this does not mean that the financial innovations introduced always had a negative effect on the economy. We contend that the negative aspect was the excessive use of credit and the lack of standards. But for a large fraction of the population, the innovations made them much better-off.
The democratization of credit allowed access to the credit market to many “subprime” people that had to rely on alternative methods of financing, some which were not legal and others significantly affected the timing of the consumption patterns. One simple example to illustrate this point is to recall the layaway plans of yesteryears. In the layaway program one had to make payments, be it weekly or monthly, and could not take the item until it had been fully paid for. The introduction of credit cards allowed people to enjoy their consumption earlier and the pay for the item at a speed equal to or faster than the minimum payment installments. Similarly the financial developments of the last couple of decades allowed for the securitization of items that no one thought could be securitized. The securitization allowed people to expand their constraint beyond their current income to other assets and eventually to their net worth. The credit allowed people to smooth their consumption and not be constrained by the vagaries of the timing of their income.
The “consumption smoothing” is easily explained in terms of the current prevailing consumption theories, be it Milton Friedman or Franco Modigliani. As already mentioned, absent the credit markets, expenditures of individual consumers are constrained by their income flows and, thus, individual consumption has to match income each period. The consumption pattern will be one of famine during the low-income years and feast during the high-income years. This is opposed to steadier consumption over their lifetime that could be achieved in a world where borrowing and lending are allowed. Another implication of the absence of capital markets is that individuals will be forced to delay or slow down their investment in human capital. That, in turn, reduces the future benefits of any investment. Thus we can safely say that without the capital markets, the stock of human capital and the well-being of individuals would be lower than it otherwise would be. In contrast, in a perfect capital markets world, individuals face a single constraint: the net present value of their income must not exceed the net present value of their expenditures over their lifetime. Consumption will be smoothed out and, because of the availability of financing opportunities, more investments will be undertaken earlier in their lifecycle.
One final issue that needs to be discussed is that under an unregulated credit market, what is going to prevent the individual from borrowing in excess of their net worth or borrow an amount they cannot service? In asking the previous question, we have identified two potential sources of risks faced by the lending institutions that could lead to a borrowers default. For lack of a better term, we call them “balance sheet” or “net worth” risk, or the ability to obtain credit (i.e., credit crunch) which we call “income statement” or “cash flow” risk. To see the two types of risks, look at the perspective of the lenders. Then and now, all lenders want to insure that they get repaid and as such, they develop some decision rules that incorporate the vagaries of life. For example, they will never lend an amount higher than the borrower’s net worth thereby minimizing the balance sheet risk. Also they want to make sure that the borrower has enough cash flow to make periodic interest payments. The democratization of credit introduced an additional risk consideration into the system: the possibility that the expected income would not materialize in the future. In this case, the consumer will not be able to meet its financial obligations. Again, here the institutions have taken steps to attempt to minimize the income statement or cash flows risks. The loan to net worth and debt service to income ratios are two of the key variables used by the lenders to determine the ability of the borrowers to service and repay their debt. It is easy to see that to protect against the risk of default, lenders have developed rules that consider uncertainty related to the two types of risk previously outlined here.
The previous discussion leads us to a couple of very simple questions. Was the balance sheet risk and income risk out of line prior to the crisis? Were they deteriorating too fast? One way to answer these questions is to look at the data. Information on the debt service as a percent of household disposable income is presented in Fig. 35.1. It is interesting to note that the debt service increased around the time of the century date change, that is, Y2K, and during the Greenspan Put, a time when interest rates were low or declining. This information and the rising wealth at the time indicates that the debt service increase per household net worth was due to an increase in the household debt. This inference is corroborated by the data on the household credit as a percent of household net worth during the same time period reported in Fig. 35.3. The data also shows that the debt-to-net worth ratio doubled during this time, while the debt service only increased about 10%. Hence if there was any increase in risk, it came from the increase in total debt not form the debt service. It was a balance sheet risk, not an income statement risk.
Figure 35.3 Total credit as a percent of household net worth.
Other interesting points to note is that during the crisis, the debt-to-household net worth increased dramatically, but the increase was driven mostly by the denominator declining. It was mostly due to a decline in net worth. In the aftermath of the crisis, the household net worth recovered (Fig. 35.4), yet the debt-to-net worth ratio has declined significantly, suggesting that either the credit has become less scarce or that borrowers have become more income centric as far as their expenditures go. The traditional consumption theories point to the former.
Figure 35.4 Household net worth as a percent of disposable income.
The Role of Real Estate in the Credit Equation
Next, we argue that the tax treatment of residential real estate induced people to alter their behavior in significant ways. First, the advantageous tax treatment of owner-occupied houses induced individuals to forgo other investments at the expense of real estate. In retrospect, one can argue that the tax advantage made for an excessive investment in the sector. That, combined with the reduction in the regulatory burden and the ease of financing, fueled an increase in the demand and the valuation of real estate. The data presented in Fig. 35.5 shows the dramatic acceleration of real estate as a percent of household net worth, an acceleration that coincides with Y2K and the Greenspan Put and the modification of the loan qualification standards such as stated income or liar’s loans.
Figure 35.5 Real estate equity as a percent of household net worth.
Another key point in our analysis is the fact that the tax treatment of residential real estate made the deductibility of interest the preferential vehicle for homeowners to finance their personal expenditures. This would suggest that homeowners would use their equity as piggy bank. They did do that, but the data also shows that homeowners as a group were mindful of their loan-to-value ratio and kept it at what was then considered a prudent ratio or approximately 40% (Fig. 35.6). This information suggests that the homeowners with equity were not reckless spendthrifts which, in turn, suggests that some of the excesses of real estate were the result of not only easy credit but also the tax treatment of residential real estate and its financing.
Figure 35.6 Real estate equity as a percent of the real estate value.
The Advantages of Owner-occupied Residential Real Estate
The first advantage of owner-occupied real estate is that the imputed income from owning and living in one’s home is not taxed. Thus the greater the effective tax rates on personal income, the greater the advantage to owning a home. A second advantage that existed prior to 1997 was that the homeowner could rollover the gains on a house into the next one. This in effect allowed the home to compound the gains tax-free. More importantly, in the end, the gains would be taxed at the capital gains tax rate. Compare this to the IRA and 401k programs. They both allow for the compounding of the rate tax-free, but withdrawals at retirement are taxed at the ordinary income tax rate. Given that the tax advantage has been in place prior to the enactment of the IRA and 401k programs, one can safely conclude that that, in effect, owner-occupied housing enjoyed many of the tax advantage currently enjoyed by retirement plans. But over time the advantage has gotten better. Since 1997, married couples can keep up to $500,000 worth of capital gains tax-free every 2 years. This makes the owner-occupied housing gains tax-free for most investors. A third advantage is that for most people the investment is a leveraged investment. Given the historical uptrend in residential real estate and its buy and hold nature, the leverage is a definitive advantage. For example, considering the historically normal down payment, homeowners will initially have a leverage factor on the order of 4 to 1. Thus if the stock market historical return is in the order of 8%, the homeowner only needs a 2% appreciation to match the historical stock market gains. Put another way, just by having the house appreciate at the inflation rate, the homeowner will match the long-run average stock market return. Unfortunately, as people found out during the financial crash, leverage works both ways. A fourth advantage is that the interest payments on the mortgage are tax deductible. This is a big deal. Recall that other interest payments are only deductible against interest income, while mortgages, now with certain limits, are deductible against ordinary income. Thus residential real estate is the way that ordinary people make interest payments on their personal debts tax deductible. In other words, investors had a strong incentive to make residential real estate debt their preferred financing vehicle. Again, one can argue that the tax treatment of residential real estate pushed people into a higher debt-to-net worth ratio and a higher debt service ratio, thus increasing the risks associated with the democratization of the credit markets. A generalized decline in residential real estate values and the reset of some of the mortgages significantly increased the two risks of defaults associated with real estate.
Financial Innovations and the Loss of Transparency
The previous sections provide a very simple rationale for the credit explosion observed during the 15 years leading up to the financial crisis. A domestic price rule, an expanding economy, and a deepening of the financial markets all led to the democratization of the credit market. So far, we have a simple explanation for the increased supply in credit paper, as well as the real estate debt. Unfortunately the story does not end here.
During the three decades prior to the financial crisis, we learned the benefits of diversification, the concept of diversifiable risk, and so forth. The progress in financial economics led to the development of new instruments or “derivatives.” For example, individual loans that were considered illiquid or risky could now be packaged together and using the tools of modern finance one could show that collectively the bundle of loans was safer than the individual loans. From a risk perspective, the whole was more than the sum of the parts. Diversification was a wonderful concept that greatly enhanced the collective attractiveness of the individual loans.
A second innovation was to use the tools of modern finance to split the pooled funds into tranches of different risk reward combination and related derivatives. The application of modern financial developments led to the creation of the collateralized market. However, this proved to be the Trojan horse that contributed to the amplification of the financial crisis.
Once the various risk/return tranches were constructed, it was virtually impossible to disentangle a portion of the tranches and thus reconstruct the original loans. It became an all or nothing proposition. The price paid for the latter developments was a loss of transparency. To see the potential impact of the loss of transparency, let’s consider the following hypothetical example. Let’s say that you are given a portfolio of 20 stocks. Let’s also assume that you do not know the names of the companies and you are also told that for one of the stocks its value will go down to zero. What should we do? Given the information available, the way to minimize the impact of the demise of the stock is to equal weight the stocks in the portfolio. When asked about to estimate the possible loss to the portfolio, one is tempted to say 1/20 or 5%. However, that is not necessarily true. If there is any positive correlation between the stocks, the loss will exceed the 5%, the higher the correlation the higher the losses. That is the downside of the opaqueness produced by the collateralization.
Another misconception is the assumption related to the hedging of risk. This reminds of the 1980s when portfolio insurance was the rage. While it is true that through a swap arrangement one may shift the risk to another individual or institution, collectively society cannot hedge the risk. The question then is when the events that we tried to protect happens, how will the system respond? Is it able to absorb the shock? We know the answers to these questions. The financial crisis provided them for us.
We attribute some of the market troubles to misapplications of some of the instruments developed during the first few years of the new millennium. Yet looking back, we believe that these instruments were true innovations. We are not saying that these instruments were perfect. In fact, there were some design flaws and some misuse that could be easily corrected with some minor modifications and/or government regulation. What seems clear after the fact is that most people focused only on the potential benefits of the new instruments and no one focused on their downside or possible misapplications. It is clear now that many of the instruments were sold assuming a perfect environment where nothing would go wrong. In doing so, we created a very rigid system susceptible to contagion. The examples of this are obvious.
Securitization was one of the great financial innovations of the time. The logic was compelling. Using the basic principles of modern portfolio theory, it made sense that by pooling different instruments, a much safer pool could be created. The idea being that in this way some risk can be diversified away. So far, so good. The financial engineers then took the next step. They reasoned that they could break the overall instrument and separate it into tranches of different risks. This was done to satisfy some of the needs of different clients who could not invest in the riskier instruments. In separating the bundled instrument into the various tranches, the financial engineers would be able to collect higher fees. Doing so introduced some additional issues. The separation into tranches depends on the methodology used to evaluate risk and the assumptions made regarding the stability of the variance–covariance matrix. Here is where we believe that financial analysts failed to consider the downside of these instruments. All we need to do is go back and look at the Long Term Capital Management experience. They had two Nobel Prize winners but still could not get their statistical arbitrage right. Correlations broke down and the leverage worked in a way they did not expect.
The Credit Explosion
The first step in identifying the possible relationship between bank credit and the economy is to develop an estimate of the credit creation in the US economy. The broadest measure we could find is the household liabilities and it shows that the amount of credit per GDP was higher during the 1990s than the 1980s (Fig. 35.7). The data also shows that around the millennium, the total credit variable begins a steep secular ascent after peaking at the end of 2008. Why the sudden credit explosion during the time prior to 2008? Elsewhere we have argued that the surge in credit was largely due to a confluence of factors. The treatment of the housing markets and the deregulation of the financial system combined with a series of innovative products fueled the explosion of credit. We contend that the famous Greenspan Put contributed significantly to the credit explosion and increased leverage of the period. The Put removed the risks that the short end of the yield curve would rise and erase any profits made by arbitrating the spread between the short and long rates. Fig. 35.2 shows a time series for the 3-month T-bill yields and the 10-year T-bond yields. Notice the drop in interest rates shortly after the millennium and lasting until 2004, that is, the time period of the Greenspan Put was in effect before he gradually removed it. To the extent that Mr. Greenspan kept his word, and he did, the carry trade would be one-sided bet that the financial institutions and other borrowers would partake with gusto. Furthermore, if they knew the timing of the put, the speculators would know exactly when to get out. Notice also that it was not until 2007 when the carry trade benefits were completely erased. This raises another issue, if one knows the schedule for the wiping out of the put, the way to maintain the profits of the strategy is to increase the leverage factor and to bail out just as the put is fully removed. Something to ponder.
Figure 35.7 Total credit and bank credit as a percent of GDP.
Looking at Fig. 35.7, it is visually clear that the banks accelerated their lending during the Greenspan Put. The expansion peaked around the time the removal of the Greenspan Put began. The bank credit per unit of GDP slowed down and even declined. Fig. 35.7 also shows that this was not the case for nonbank credit, it continued unimpeded and it peaked around the time of the financial crisis.
Additional information regarding the banking system leverage factor is presented in Fig. 35.8 which shows the bank and credit multipliers. That is the amount of Money of Zero Maturity (MZM) money, and bank loans created per greenback in circulation. The multipliers confirm what we already inferred form the information in Fig. 35.2, that the banks’ credit creation peaked around 2004, and between then and 2007, the multiple declined slightly. But that was not the case for the nonbank credit. Fig. 35.7 shows that the increase in nonbank credit continued past the Greenspan Put period in an uninterrupted trend that did not end until the financial crisis in 2007. Taken together, these results suggest that the Greenspan Put contributed to the expansion of credit. However, the fact that the nonbank credit expansion continues suggests that there is much more than the Greenspan Put to the increased leverage in the economy and that the culprit was the nonbank sector.
Figure 35.8 Money multiplier and credit multiplier.
Excessive Credit Creation and the Economy
Excessive credit creation is considered by many as one of the main causes of the financial crisis of 2008. The information presented in Figs. 35.2, 35.7, and 35.8 are consistent with this interpretation. More importantly, the evidence presented suggests the increased demand for credit generated by the tax changes combined with the deregulation that took effect around this time of credit attracted many new entrants into the market. Add to this the developments in financial economics and one can anticipate the creation of many new instruments that promised to liquefy and reduce the risk of many heretofore illiquid or risky investments. Add to the mix the rising asset prices and the expectation of a continuation of price appreciation, and it is easy to see why all of this led many financial institutions, especially the less-regulated ones, to extend credit based on the prospects of capital gains realizations, thereby ignoring the net worth of the borrower at the borrowing time.
In many cases, the new investors were approaching infinite leverage as they put little or no money down. The math was perfect as long as everything went according to plan. Unfortunately leverage works both ways. However, once the rate of appreciation slowed, many of the leveraged investments became unprofitable. As there was little or no capital at risk on the part of borrowers, many walked away or had their properties repossessed. The lenders suffered many of the losses which, in turn, reduced their capital adequacy and the amount of loans they could create. A vicious cycle ensued and the markets and the economy went on a downward tailspin.
The Fed’s Role and the Carry Trade
Our view is that the principal role of the Fed is to provide price stability, and that the price rule does just that. However, that is not all the Fed does. It can also affect the credit creation of the banking system. According to the street lore in the wake of September 11th, the collapse of the dot-com bubble, and the economy’s confidence imploding, the Fed made a bet on the consumer to keep the economy afloat. The Maestro drove short-term rates down to 1% and that gave rise to the famous Greenspan Put. For those who had any doubt, the following quote from the Federal Open Market Committee (FOMC) at the time will clear any of the doubt [2]:
However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period.
The previous quote and other companion statements by the FOMC were interpreted as evidence that the Fed was committed to keeping short rates low. True to its word, since 2001 the Fed kept short rates low for a considerable time. It could be seen at the end of 2000, when the slope of the yield curve bottomed and then rose throughout 2001 and remained fairly high for a considerable period (see Fig. 35.2). The data on the T-bills and T-bonds combined show that the bulk of the interest rate action was at the short end of the curve. It is this interpretation that gave rise to the prevalence of the carry trade.
If you know that the Fed will keep rates low, then we know precisely the effect the carry trade will have on the fixed-income market as the carry trade equilibrating process induces a flattening of the slope of the yield curve. The long-end yields will decline. Another way to say the same thing is that the price of the long bonds will rise and that means that the people who put the carry trade on will make money. The downside of the carry trade is the risk of rising short-term rates. However the Fed took care of that in the previous announcement. More than that, it also gave investors ample warnings as to when it intended to raise the short-term rates. In effect, the Fed eliminated the downside risk of the carry trade, and it became a one-sided bet. It was all upside until the Fed changed its stance. If people knew that the Fed would be raising rates in an orderly fashion, in theory they would know when the carry trade would cease to work and thus they may be able to unwind it ahead of the Fed.
Investors devised several variations of the carry trade. In some cases they sold a low-interest rate instrument, say yen denominated short-term securities, and invested the proceeds in a higher-yielding instrument such as US T-bills and T-bonds. Another variant sold short-term dollar denominated securities, such as commercial paper, and bought longer maturities securities. Some of these were fixed-income securities or in other cases they chose assets with an expected return in excess of the short-term fixed-income securities. The necessary condition to implement these variations of the carry trade was the difference in yields or returns. However these variations introduced additional risks. In the case of the yen carry trade, the risk was the exchange rate. An adverse move in the exchange rate, (i.e., a yen appreciation) could wipe out the interest rate differential. Similarly, those who borrowed short at fixed rates to invest in appreciating assets with nonguaranteed nominal returns, the risk was that the return would fall below the short-term rate. Investors who speculated implicitly assumed that while the position was held, the exchange rate or asset values would not move against them.
Did the Carry Trade Fuel the Market?
Despite the terrorism risk and slow growth in employment, the 2001 recession was one of the mildest on record. By all accounts the consensus was that the Maestro’s strategy worked. However critics contend that easy credit created a housing/asset bubble, which was bound to break as the Fed corrected its easy money/credit mistake.
Low interest rates tend to lengthen investors’ horizons and abundant credit makes it easy to acquire durable assets. Thus the abundance of credit leads to an increase in the demand for durable assets resulting in what some may call asset inflation. Ultimately profit maximization and competition lead to a reduction in the yield or price to earnings ratio of the durable asset. In an expanding economy, the reduction in the yield is accomplished through asset appreciation. Viewed this way, we have a very simple explanation for the asset inflation during the 15 years leading up to the bubble bursting. The implication being that businesses would go on a borrowing binge and individuals too; however the tax treatment of residential real estate would channel a large portion of the personal borrowings to the home equity market.
In the end, any excessive borrowing against real estate can be blamed on Fed’s easy credit policy and the tax code. Homeowners would be able to say, and many did, that the tax code and the Maestro made them do it.
The Making of a Storm
The Fed’s public announcement of an orderly dismantling of the Greenspan Put would give the market participants ample time to unwind their carry trade position. Hence from this vantage point, the financial institutions would have been well equipped to handle the gradual increase in short-term rates and ultimately the delevering required by the unwinding of the carry trade. Any unwinding problem would not be directly related to the Fed’s publicly announced policy. This brings us to the issue if not the Fed, then what? Our answer is that one has to go back to the elements of the broadly defined carry trade. We argued in the previous section that in the broad definition of the carry trade, some investors were taking exchange rate risk while others were taking equity returns risk. It is the latter that we want to focus now.
Remember that we have argued that the tax code forced people to borrow on the equity on their homes if they wanted to make interest on their debt deductible. We also argued that real estate was significantly tax advantaged. Looking back, we can then argue that the tax treatment would lead to an increase in the net after tax income generated by the home. Thus the demand for residential real estate would increase. The value of the tax shield would be worth more the greater the income of the taxpayer and thus the higher the marginal tax rate they faced. This suggests a virtuous cycle for residential real estate. As the demand increased, home prices rose, and that had several effects on the economy. First, the higher return would make a home trade strategy more attractive. Second, the increase in home prices would also lead to an increase in homeowners’ net worth. That in turn results in higher consumption and very likely an increase in the use of the home equity lines of credit. This way the interest in the consumer discretionary expenditures were made tax deductible. All of these positive developments attracted new investors, which fueled the cycle. However these developments also attracted additional investments, and housing construction and condo conversion also increased. In an unfettered market, increases in demand are initially rationed through price increases if the supply is inelastic. However, over time, the supply will adjust and prices will converge to a new equilibrium. We know that at the new equilibrium the underlying factors of production will be earning normal rates of return. At that point, the benefits of the carry trade disappear, assuming that the Fed had in fact raised the interest rates as they projected. The point we want to make here is that if people underestimated the speed of adjustment, equilibrium would be reached faster than they expected and the profitability of the carry trade would turn into a loss. The question is whether a vicious cycle would now ensue? If so, how long would it last? The final question being whether economic policy could shorten the cycle and whether a wrong policy mix would lengthen the cycle and slow the recovery?
The Anatomy of a Crisis
The interaction between the credit markets and the carry trade has clear and important implications for the economy. Let’s illustrate it in the context of a decline in housing prices (however, as one can see, the phenomena is much more general than this). We have argued in the previous paragraphs that the housing market would be at the center of any storm for two distinct reasons. One being that home mortgages are one of the few interest deductions available to many borrowers, thus the deductibility resulted in a higher loan-to-value ratio than we would have seen otherwise. The carry trade, tax advantages, and economic prosperity all funneled into a higher demand for housing. The 1997 change in tax treatment of residential real estate led to an increase in the demand for owner-occupied housing. The low interest rate policy of the Fed reduced the carrying costs, not surprisingly the demand for and the price of owner-occupied housing surged. The price increase would be a signal for suppliers to supply, over time equilibrium would be reached, and the price appreciation would slow down to the long-run average. The return to normalcy would eliminate the speculative elements and that means that the price of residential real estate would decline. We have seen all that and we contend that the beginning of the financial crisis was the beginning of the adjustment stage. The question then was how bad the adjustment process was going to be and whether the government and monetary authority’s action would accelerate the recovery or exacerbate the crisis. The right policy mix would put out the economic fire, while the wrong policy could fuel it and or prolong it.
A decline in housing prices leads to a decline in household net worth and the net capital of lending institutions, which in turn leads to a secondary round of loan contractions and reduced spending. This could potentially create the preconditions for a vicious cycle that would spread to the rest of the economy. A reduction in real estate prices below their loan-to-value ratio will effectively wipe out much of the net worth of many families. A reset of the interest rate on the residential real estate loans effectively reduces the disposable income of the homeowners who kept their homes. The combination of lower net worth and higher payments has devastating effects on the finances of these homeowners. One clear implication here is that consumer discretionary spending would significantly decline. Looking back at the financial crisis, that appeared to have been the case. The sector returns posted large declines.
The combination of higher mortgage payments and lower home prices, in turn, reduced household credit worthiness and borrowing ability for the homeowners who stayed in their homes. In fact, the combination of these two destroyed any hope of refinancing at a lower rate and in some cases triggered the calling of other personal loans by banks. That put many homeowners in the position of considering whether to walk away from the loan by turning the house back to the lending institution. In the old days, walking away meant that the lending institution will send them a 1099 for the difference between the loan and the resale value of the house. Also if the resale of the house is higher than the cost basis, the homeowner may be also liable for capital gains taxes. In addition to getting an Internal Revenue Service (IRS) tax bill and having their credit ruined, households will have to pay rent on their new place. When all these factors are taken into consideration, for those who decide to stay, the solution is to hunker down, make the mortgage payments, and cut everything else. History has shown that real estate trends up secularly, thus waiting it out is a viable option. In due course, the value of the house will increase to the point that the homeowners are above water and they can get out. The alternative to waiting is bankruptcy, which will wipe out the debt but it will also ruin the household’s credit. A large enough decline in home prices could paralyze household spending for quite a long time. That is when the contagion in the housing market spreads to the overall expenditures of the consumer.
Recall that President Bush went on national TV to announce that the IRS would not do what we just outlined. This meant that people could walk away without fearing getting a bill from the IRS. The president significantly increased the attractiveness of short sales. People could walk away from their homes without having the IRS on their case and depending on how the short-sale negotiations are conducted, the damage to their credit would be much less than if they walked away or choose bankruptcy protection. The President’s action facilitated walking away from the homes and starting again with a clean slate and without the drag of the excessive mortgage payments in relation to the homeowners’ income. This has two clear effects on the economy. One is that the impact on consumer discretionary income is positive. The second is that the housing price decline would be much deeper. That, in turn, will effectively lower the rent for those who walk away [3].
The effect on the financial institutions was a bit different. If, as we have already argued, the changes in the economic environment facilitated walking away from the homes and that in turn resulted in an overshooting of the decline in home prices, the financial institutions would take it on the chin. They would have to shoulder the brunt of the decline and the downward revaluation. It impacts their capital and thus the capital adequacy ratio and their ability to extend loans. If these institutions did not replenish their capital, then their loan creation ability would be impaired and that would have a negative impact on the level of economic activity as it did. A decrease in the value-to-loan ratio below one reduced the net capital of the lending institutions. The major point is that as net capital declined, even if the institution kept the same capital adequacy ratio, their credit creation ability was reduced. To add insult to injury, in many cases prudence and/or the regulatory bodies forced an increase in the capital adequacy ratio that further reduced the credit creation of the institution. Finally, at the time we argued that there was the possibility that the capital adequacy becomes a binding constraint and even when the Fed eases, the increased availability of reserves would not be put to work. In other words, the banks would not increase their loans. Be it because the lack of capital adequacy ratio or the lack of credit worthy clients. The bottom line is that under these conditions, the increased reserves will be held as excess reserves and the interest rates will then decline. For those who doubted this scenario, we argued that Japan is the poster child for this scenario. So if the banks’ capital is not adequate, the banking system credit creation will be greatly diminished and that could lead to an economic slowdown. We believe that the regulations enacted have reduced the banking sector’s credit creation ability and that contributed to the subpar economic recovery.
..................Content has been hidden....................
You can't read the all page of ebook, please click here login for view all page.