Americans’ addiction to borrowing root of crisis
By Dean Calbreath
UNION-TRIBUNE STAFF WRITER
September 21, 2008
Even if the bailout stabilizes the financial sector, it will probably not lead to cheaper credit, since banks and other lenders still face major hurdles ahead. Tougher terms on credit, they add, could force Americans to do something that they have avoided for much of the past decade: live within their means.
Credit has already sharply contracted because of the downfall of the mortgage market. Lenders have increased their restrictions and cut back on their extension of loans for autos, credit cards and college educations. Because of the lack of credit, consumer spending has already slowed to anemic growth rates, damaging the fragile economy.
And foreign investors, who bought up mortgage securities and other U.S. debt, could become less willing to fund U.S. borrowing.
“Consumers will actually have to pay their credit cards down each month and save money for down payments on a home,” Morici said.
Daniel Penrod, industry analyst for the California Credit Union League, said that if consumers started saving money and turned away from relying on credit to maintain their lifestyles, it would be good for the economy in the long run.
“But given the current situation, with unemployment growing and costs of goods like gasoline rising, that’s a difficult path,” he said.
Easy money
Economists trace the rapid growth of debt to the economic slowdown of 2001, when the Federal Reserve began slashing interest rates and injecting massive amounts of money to prevent the economy from going into recession after the dot-com crash.
Those rock-bottom interest rates – the lowest in 40 years – triggered massive borrowing by banks and other financial institutions, which saw an opening to make money. By borrowing money at low rates and then relending it to consumers at higher rates, they could generate huge profits.
Investors increasingly saw an opportunity to boost their returns by using borrowed money. That leverage can pay off spectacularly when an investment does well, but it can lead to disaster in a down market.
Financial sector borrowing rose at a rate of 10 percent a year from 2002 to 2007. Even after adjusting for inflation, financial sector debt is now 74 percent higher than it was in 2000 and 10 times as high as it was in 1980.
The banks used that money to extend cheap loans and credit cards to U.S. consumers. To attract customers, they stripped away the normal requirements for loans, offering easy credit terms to borrowers. Between 2002 and 2006, household debt grew at an annual rate of 11 percent, far outpacing overall economic growth. Much of that came through home equity loans.
During the height of the housing boom, home buyers used the loans to buy necessities as well as such luxuries as SUVs or flat-screen TVs. Between 2002 and 2007, homeowners took out $1.7 trillion more in home loans than they spent on their homes or home improvements.
Scott Lilly, a senior fellow at the Center for American Progress, a liberal think tank in Washington, said the cheap mortgages made up for the fact that growth in U.S. wages stalled in 2000 and has since fallen behind the inflation rate.
Lilly said that under normal circumstances, the slowdown in wage growth would have led to an economic recession. But the availability of cheap credit helped Americans afford goods and services they could not have afforded with their salaries alone.
“The prescription was easy credit – car loans, credit cards, and most importantly, mortgages,” he said.
The lenders then repackaged the loans into mortgage-backed securities that they sold on Wall Street and overseas. Financial institutions in China, Japan, Europe and the oil-rich nations of the Middle East vied to buy the loans, since they saw the United States as being a safe, predictable place to invest.
There was such demand from abroad for U.S. mortgages that lenders competed with one another to attract borrowers, offering “teaser” rates of as low as 1 percent to pull people in. They assured borrowers that by the time the rates adjusted upward, they would be able to refinance at cheap rates or resell the home for a profit.
The cheap lending drove demand for homes to record highs. In San Diego County, the median price of a home hit $517,500 at its peak in November 2005 – almost double what it had been just four years earlier.
When the interest rates began to adjust upward, however, many of those borrowers found they could not pay for their loans. And with home values falling, they couldn’t sell the homes at the price they had paid for them. Many stopped making payments, driving down the value of the mortgage-backed securities being peddled on Wall Street.
In the wake of the collapse – the bursting of one of the biggest financial bubbles in the nation’s history – dozens of mortgage firms went bankrupt or were acquired by competitors, including Countrywide Mortgage and San Diego’s Accredited Home Lenders. Wall Street firms that dealt in the securities – such as Bear Stearns, Merrill Lynch and Lehman Brothers – also nose-dived. The semi-privatized Fannie Mae and Freddie Mac mortgage agencies were seized by the federal government.
Because so many foreign investments were tied to the U.S. mortgage market, the crash resounded throughout the world. Stock markets in Tokyo, Hong Kong, London and Frankfurt swooned. Russia temporarily closed the Moscow exchange to prevent a panic.
‘Already broke’
Although the federal move has temporarily stanched the bleeding, economists are skeptical about what the government can do.
Sylvain Champonnois, a finance specialist at the University of California San Diego, compared the federal initiative to a similar move by the Japanese government in the early 1990s, which took place after Tokyo’s stock market imploded at the tail end of a real estate bubble.
“In Japan, they call the 1990s ‘the lost decade’ because of the crisis. And the level of debt in Japan remains enormous,” he said. “Hopefully, things will rebound faster here, because our government is acting faster than the Japanese did.”
Laurence Kotlikoff, an economist at Boston University, questioned the government’s ability to take on much more debt. He noted that in addition to offering a bailout of the mortgage-related assets on Wall Street, the government has also committed itself to backing money-market funds and checking accounts.
“The government is already broke,” Kotlikoff said. “The official debt level is the least of our problems. When you consider all the baby boomers that will be retiring in the next few years, requiring Medicare benefits and Social Security, we have huge fiscal problems hanging over the marketplace. This administration has been the most fiscally profligate in modern times.”
Dean Calbreath: (619) 293-1891; dean.calbreath@uniontrib.com
[ed. Financial bubbles are not a new thing. I think the writer's headline that consumers' "addiction" is the root of the problem is overstated. The consumer credit economy has provided a comfortable lifestyle to more people than any economic system in history. The majority of families live well within their means and are not overextended on credit. Better to have less credit avaialble for the rest of us than panic into into a full blown socialist system.]
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[...] because of the downfall of the mortgage market. Lenders have increased their restrictions and cut back on their extension of loans for autos, credit cards and college educations. Because of the lack of credit, consumer spending has already slowed to anemic growth rates, [...]