Credit squeeze from all corners. Blame whom?

In this new economic order where credit-risk from different classes of loans/debts was being sold to investors at the blink of an eye, fiascos of this nature (JULY 07 Credit/Stock Jitters) are bound to happen.

Investment bank:Bear Sterns, French bank:BNP Paribas, German bank:IKB, US Home builders:Beazer, Mortgage Companies:American Home Mortgage, Hedge Funds: Fortress…..list just gets bigger day by day. One common thread/theme connecting all these meltdowns is misunderstanding/ignorance of risk being taken.

Story starts like this:

1. Consumers tempted by low interest rates and appreciating house values got into mortgage commitments bigger than their repayment capability.
2. Builders impressed with thier margins were building hundreds of communities like crazy.
3. Mortgage banks trying to quench the insatiable appetite of the investment banks for mortgage pools, has been dishing loans to consumers with dubious financial track-records by inventing exotic loan packages like 1/2/3-ARM, ALT-A.
4. Investment banks trying to capitalize on this surprisingly huge demand from hedge-funds, university-endowments and state pension funds for high-yield instruments, were mixing up various pools of loans into CDOs in different tranches and getting these exotic bonds/instruments rated by rating agencies like Moody’s and S&P and offloading them to investors across the planet.

…..and ended like this:

1. House appreciation got to a grinding halt after historic streak of 4-5 straight double-digit growth.
2. Consumers/speculators with no capacity to pay monthly mortgages were caught off-guard with this screeching halt of appreciation and faced with ARM-triggered reset of monthly mortgages called it a day and surrendered.
3. The rising defaults of this subprime and borderline home-buyers gradually started hurting the other side, the investors who bought these CDOs as their CDO-coupon payments were depending upon monthly mortgage payments of this ARM generation of consumers.
4. Market started panicking and in the absence of a reliable measurement model to do a mark-to-market, no one knows the real value of any of these pools and CDO bonds. MarkIT indexes dropped faster then investor’s jaw and created a pandemonium in global markets.
5. List of casualities started to appear spanning most of the planet ranging from france to germany to australia to japan, highlighting the speed at which these instruments got shuttled around by our wallstreet wizards.

Now, the blame game starts from the other end..a) investor blaming the investment banks and rating agency b) investment bank blaming the loan originator for false representations ..etc.

As this is wrapping up, another story also touched climax.. the great LBO story of private equity groups. It again looks pretty familiar. Here it’s company-flipping instead of houses.

PE groups raising multi-billion dollar funds from high net worth investors, identifying low debt/cashflow companies with low P/E multiples, scooping them up by loading the company’s balance sheet with enormous liabilties by issuing bonds or taking debt which again got bundled into CLOs and tranched and sold to investors by investment banks.

All the above innovations in financial markets were genuine efforts by bankers to bring enormous liquidity into market, expand credit, calclulate and shift risk across various parties. But, the chain went broke owing to the absence of reliable pricing and valuation models.

Remember those 2 words..Pricing, valuation .. the fundamental pre-requisites for any financial instrument to flourish in a long-lasting manner.

Why did they miss that???

Is credit Growth the key to US economic expansion in the 1990s ?

Is credit Growth the key to US economic expansion in the 1990s than much proclaimed productivty?

Data Analysis:

STEP1:
Take a look at the data at Federal Reserve historical data on consumer credit. The raw data shows over a 90% growth in credit during the ’90s. When one adjusts these values for Department of Labor historical statistics of the Consumer Price Index, one finds that total consumer credit has grown by 70%.

STEP2:
An adjustment needs to be made for growth in real per capita earnings since as real income grows so does the capacity to carry credit. When using that data to adjust the consumer credit values, in the last decade there has been a 30% increase in real individual income for the nation (non-government). Scaling the 70% personal total credit growth against the income growth yields a net 30% growth in real consumer credit carried.

STEP3:

…how much has individual credit really been growing?…
Personal credit amounts are currently about $6k/person according to the aforementioned Federal Reserve data. The average household (2.6 people, $55k/year income … historical data from the Census Bureau household income tables) carries ~ 16 k$ in credit. This is a credit/income ratio of ~ 0.3. Applying this factor to the previously determined 30% credit growth/decade (or ~ 3% growth/year) by straight multiplication, then only about 1%/year would be attributable to credit growth IF the multiplier factor were only equal to 1.

STEP4:
GDP in the US has grown by about 31% in the last decade (see The Bureau of Economic Analysis’ historical data on GDP ), or about 3%/year. Depending upon the multiplier factor, you can see that credit probably makes up a substantial fraction of the GDP growth just by itself.
There is at least one more important factor in the the GDP that we can adjust for in this simplified analysis: population growth in the work force. Between Jan 1, 1990 and Jan 1, 2000, the US population grew from 248 million to 275 million …. (source data Census Bureau’s population statistics ) or about 10%. Assuming the workforce proportion is similar, the GDP adjustment per capita yields a growth rate of about 2%/year.
…What does this all mean?…

Conclusion 1: if the per capita GDP growth rate is ~2%/year, then credit growth–which is an absolute minimum of 1%/year and probably higher–makes up the bulk of the US economic growth in the 1990s.

…but what about productivity?…

Isn’t productivity the source of the economic expansion? Productivity gains between 1990-2000 were about 25% ( Bureau of Labor Standards Productivity Statistics ) and outstripped per-capita CPI-adjusted GDP gains which were about 18%. If GDP gains had exceeded productivity gains, then the increase in credit is a consequence, all else equal. But with the percentages reversed, productivity does not appear to yield as much “gain” (to use an engineering term) on economic growth as one would hope to see.
 
IT WOULD BE QUITE INTERESTING TO DO A KIND OF COUNTER ANALYSIS JUST FOR THE SAKE OF DSICOVERING THE REAL CAUSE OF THIS ECONOMIC GROWTH WITNESSED BY US IN LAST DECADE.

WOULD REALLY LOVE TO SEE PRO-PRODCTIVITY-TRUMPING PERSON TO DO A COUNTER ARGUMENT BASED ON HARD DATA AND FACTS, RATHER THAN THEORETICAL PRODUCTIVITY ARGUMENT!!!!!!!!

ANY ONE UP FOR THIS CHALLENGE???????