Sub-Prime Culprit: Irrational Exuberance

Source : The Business Times, August 30, 2007

The Bottom Line
(WASHINGTON) We are now in the 'blame phase' of the economic cycle. As the US housing slump deepens and financial markets swing erratically, Americans have embarked on the usual search for culprits. Who got us into this mess?

Our investigations will doubtlessly reveal, as they already have, much wishful thinking and miscalculation. They will also find incompetence, predatory behaviour and probably some criminality. But let me suggest that, though inevitable and necessary, this exercise is also simplistic and deceptive. It assumes that, absent mistakes and misdeeds, we might remain in a permanent paradise of powerful income and wealth growth. The reality, I think, is that the economy follows its own Catch-22: by taking prosperity for granted, people perversely subvert prosperity. The more we - business managers, investors, consumers - think that economic growth is guaranteed and that risk and uncertainty are receding, the more we act in ways that raise risk, magnify uncertainty and threaten economic growth. Prosperity destabilises itself.

This is not a new idea. Indeed, it explains why terms such as 'the business cycle' and 'boom and bust' survive. But it gets overlooked in periods of finger-pointing: now, for instance. The housing downturn and credit fears are undeniable. Someone or something must be held responsible. Here's a rundown of popular suspects:

# The Federal Reserve. It allegedly held short-term interest rates too low for too long. From late 2001 to late 2004, the overnight Fed funds rate was 2 per cent or less. Credit was supposedly 'too easy'.

# The Chinese. They funnelled their huge export surpluses (mostly in US dollars) into US Treasury bonds. That kept long-term interest rates low even after the Fed began raising short-term rates in 2004. China's foreign exchange reserves now exceed US$1.3 trillion.

# Mortgage bankers. They relaxed lending standards for weak borrowers, leading to numerous defaults. In 2006, about 90 per cent of new 'sub-prime' mortgages had adjustable interest rates. That exposed borrowers to future rate increases - which many now can't afford.

# Wall Street. The mortgage bankers got giddy only because they could sell the loans to pension funds, hedge funds and others as mortgage-backed securities (bonds created by bundling loans).

# Credit rating agencies. Moody's and Standard & Poor's - which rate the creditworthiness of bonds - allegedly weren't tough enough on sub-prime mortgages. That fanned investor appetite.

Did the Fed foster easy credit for too long? Maybe. But economist Mark Gertler of New York University argues that if this were so, inflation would have exploded. It didn't. From 2003 to 2005, it rose modestly, from 1.9 per cent to 3.4 per cent.

What seems to have happened was a broad and mistaken reappraisal of risk. Bonds that were once considered highly risky were judged much less so. China's appetite for Treasury bonds may account for some of this. It may have lowered interest rates on Treasuries and sent investors scurrying into riskier bonds with higher rates (corporate 'junk' bonds, mortgage bonds, and bonds of 'emerging market' countries like Brazil).

But that can't fully explain the extraordinary drop of interest rate 'spreads' - the gap between rates on riskier bonds and safer Treasuries. In early 2003, junk bonds carried rates eight percentage points above Treasuries; early this year, the gap was less than three percentage points. Somehow, junk bonds were no longer so risky; therefore, it was okay to accept lower rates.

Paradoxically, the fact that the US economy grew in spite of so many daunting obstacles - corporate scandals, 9/11, higher oil prices - may have created a false sense of confidence that it could overcome almost anything.

Sophisticated investors and ordinary consumers alike seem to have fallen under the spell of this logic. Believing risks had declined, the first group actually adopted ever riskier investment strategies - and unknowingly increased financial risk. The second, believing in continuing economic growth and rising home prices, assumed ever heavier debt burdens - and created potential obstacles to future spending. In 2000, household debt was 103 per cent of disposable income; in 2007, it's 136 per cent.

Mistakes and misdeeds do not occur in a vacuum. The ultimate culprit here may be irrational exuberance. As economic expansions lengthen, people become more complacent and careless. The very fact that the economy has done well creates conditions in which it may - at least temporarily - do less well. Prosperity inevitably interrupts itself with losses, popped bubbles and recessions. This produces recriminations and promises to do better, but there is always a next time. -- The Washington Post Writers Group