Paul McCulley works for PIMCO, a huge international investment management firm. Paul uses the theories of economist Hyman Minsky as a framework for explaining our current housing bust.
This is as complete an explanation as I’ve seen of the housing boom and bust. Even better, it rings true, too.
The following except is from “The Shadow Banking System and Hyman Minsky’s Economic Journey,” by Paul McCulley of PIMCO.
The bubble in the U.S. housing market provides a plain illustration of the forward Minsky journey in action, as people bet that prices would stably rise forever and financed that bet with excessive debt. Indeed, the mortgage debt market followed Minsky’s three-step path almost precisely. The first type of debt, the hedge unit, is actually quite stable ““ the borrower’s cash flow is sufficient to both fully service and amortize the debt. In the mortgage arena, this is known as an old-fashioned loan, like my parents had, as well as the one I used to have. Every month, you write a check that pays the interest plus nibbles away at the principal, and voila, when the last payment is made many years down the road, usually thirty, the mortgage simply goes away and you own the house free and clear. You may even throw a little party and ritually burn the mortgage note.
The next, more risky unit of debt, the speculative unit, comes about when people are so confident in stably rising house prices that they find the hedge unit to be, let us say, boring. Technically, Minsky defined the speculative unit as a loan where the borrower’s cash flow is sufficient to fully service the debt, but not amortize the principal. Thus, when the loan matures, it must be refinanced. In the mortgage arena, this type of loan is called an interest only, or IO, with a balloon payment at maturity equal to the original principal amount. Thus, these types of borrowers are speculating on at least three things at the time of refinancing: the interest rate hasn’t risen; terms and conditions, notably the down payment, haven’t tightened; and perhaps most importantly, the value of the house hasn’t declined.
Minsky taught that when credit is evolving from hedge units to speculative units, there is no fear, as the journey increases demand for the underlying assets that are being levered, and drives up their prices. Think about it this way: Most people don’t mentally take out a mortgage for X dollars, even though they literally do, but rather take out a mortgage that requires Y dollars for a monthly payment. In the mortgage arena, that means that a speculative borrower can take on a larger mortgage than a hedge borrower, because the monthly payment is lower for the speculative borrower ““ he’s paying only interest, not that extra amount every month to pay off the principal over time. Thus, the speculative borrower can pay a higher price for a house than a hedge borrower with the same income. Accordingly, as the marginal mortgage is taken down by a speculative borrower, it drives up home prices, truncating the risk that the value of the house will fall before the balloon payment comes due.
Of course, speculative financing makes sense only so long as there is an infinite pool of speculative borrowers driving up the price, de facto collectively validating the speculative risk they took. Sounds like a recipe for a bubble, no? Demographics assure us there is a finite pool of homebuyers. In this case, expectations of stably rising home prices ultimately run into the reality of affordability ““ but that doesn’t in and of itself stop the game.
There is a final leg to a forward Minsky journey, thanks to the reality that humans are not inherently value investors, but momentum investors. Human beings are not wired to buy low and sell high; rather, they are wired to buy that which is going up in price. This seems to make no sense, particularly when there is a known limit to size and affordability constraints ““ why would rational people buy a house for a higher price than other folks in the same financial circumstances could afford to pay? But we are not talking about rationality here, but human nature. They are not one and the same thing. Humans are not only momentum investors, rather than value investors, but also inherently both greedy and suffering from hubris about their own smarts. It’s sometimes called a bigger fool game, with each individual fool thinking he is slightly less foolish than all the other fools. And yes, a bigger fool game is also sometimes called a Ponzi Scheme.
Fittingly, the last debt unit on the forward Minsky journey is called a Ponzi unit, defined as a borrower who has insufficient cash flow to even pay the full interest on a loan, much less pay down the principal over time. Now, how and why would such a borrower ever find a lender to make him a loan? Simple: as long as home prices are universally expected to continue rising indefinitely, lenders come out of the woodwork offering loans with what is called negative amortization, meaning that if you can’t pay the full interest charge, that’s okay; they’ll just tack the unpaid amount on to your principal. At the maturity of the loan, of course, the balloon payment will be bigger than the original loan.
As long as lenders made loans available on virtually non-existent terms, the price didn’t really matter all that much to borrowers; after all, housing prices were going up so fast that a point or two either way on the mortgage rate didn’t really matter. The availability of credit trumped the price of credit. Such is always the case in manias. It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policymakers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.
Clearly, the explosion of exotic mortgages ““ subprime; interest only; pay-option, with negative amortization; etc. ““ in recent years have been textbook examples of Minsky’s speculative and Ponzi units. But they seem okay, as long as expectations of stably rising home prices are realized. Except, of course, they can’t forever be realized. At some point, valuation does matter! How could lenders ignore this obvious truth? Because while it was going on, they were making tons of money. Tons of money does serious damage to the eyesight, and our industry’s moral equivalent of optometrists, the regulators and the rating agencies, are humans too. As long as the forward Minsky journey was unfolding, rising house prices covered all shameful underwriting sins. Essentially, the mortgage arena began lending against asset value only, rather than asset value plus the borrowers’ income. The mortgage originators, who were operating on the originate-to-distribute model, had no skin in the game ““ no active interest ““ because they simply originated the loans and then repackaged them.
But who they distributed these packages to, interestingly enough, were the shadow banks. So we had an originate-to-distribute model and no skin in the game for the originator, and the guy in the middle was being asked to create product for the shadow banking system. The system was demanding product. Well, if you’ve got to feed the beast that wants product, how do you do it? You have a systematic degradation in underwriting standards so that you can originate more. But as you originate more, you bid up the price of property, and therefore you say, ” These junk borrowers really aren’t junk borrowers. They’re not defaulting.” So you drop your standards once again and you take prices up. And you still don’t get a high default rate. The reason this system works is that you, as the guy in the middle, had somebody bless it: the credit rating agencies. A key part of keeping the three bubbles (property valuation, mortgage finance and the shadow banking system) going was that the rating agencies thought the default rates were low because they were low. But they were low because the degradation of underwriting standards was driving up asset prices.
Both regulators and rating agencies were beguiled into believing that the very low default rates during the period of soaring home prices were the normalized default rates for low quality borrowers, particularly ones with no down payment skin in the game. The rating agencies’ Mr. Magoo act was particularly egregious, because the lofty ratings they put on securities backed by these dud loans were the fuel for explosive growth in the shadow banking system, which issued tons of similarly highly-rated commercial paper to fund purchases of the securities.
It all went swimmingly, dampening volatility in a self-reinforcing way, until the bubbles created by financial alchemy hit the fundamental wall of housing affordability. Ultimately, fundamentals do matter! We have a day of reckoning, the day the balloon comes due, the margin call, the Minsky Moment. If the value of the house hasn’t gone up, then Ponzi units, particularly those with negatively-amortizing loans, are toast. And if the price of the house has fallen, speculative units are toast still in the toaster. Ponzi borrowers are forced to ” make position by selling out position,” frequently by stopping (or not even beginning!) monthly mortgage payments, the prelude to eventual default or jingle mail. Ponzi lenders dramatically tighten underwriting standards, at least back to Minsky’s speculative units ““ loans that may not be self-amortizing, but at least are underwritten on evidence that borrowers can pay the required interest, not just the teaser rate, but the fully-indexed rate on ARMs.
From a microeconomic point of view, such a tightening of underwriting standards is a good thing, albeit belated. But from a macroeconomic point of view, it is a deflationary turn of events, as serial refinancers, riding the back of presumed perpetual home price appreciation, are trapped long and wrong. And in this cycle, it’s not just the first-time homebuyer ““ God bless him and her! ““ that is trapped, but also the speculative Ponzi long: borrowers who weren’t covering a natural short ““ remember, you are born short a roof over your head, and must cover, either by renting or buying ““ but rather betting on a bigger fool to take them out (” make book”, in Minsky’s words). The property bubble stops bubbling and when it does, both the property market and the shadow banking system go bust.
When the conventional basis of valuation for the originate-to-distribute (to the shadow banking system) business model for subprime mortgages was undermined, the asset class imploded violently. And the implosion was not, as both Wall Street and Beltway mavens predicted, contained. Rather it became contagious, first on Wall Street, with all risk assets re-pricing to higher risk premiums, frequently in violent fashion, and next on Main Street, with debt-deflation accelerating in the wake of a mushrooming mortgage credit crunch, notably in the subprime sector, but also up the quality ladder.
Yes, we are now experiencing a reverse Minsky journey, where instability will, in the fullness of time, restore stability, as Ponzi debt units evaporate, speculative debt units morph after the fact into Ponzi units and are severely disciplined if not destroyed, and even hedge units take a beating. The shadow banking system contracts implosively as a run on its assets forces it to delever, driving down asset prices, eroding equity ““ and forcing it to delever again. The shadow banking system is particularly vulnerable to runs ““ commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis ““ a need to tap their back-up lines of credit with real banks or to liquidate assets at fire sale prices. Real banks are in a risk-averse state of mind when it comes to lending to shadow banks, lending when required by backup lines but not seeking to proactively increase their footings to the shadow banking system but, if anything, reduce them. Thus, there is a mighty gulf between the Fed’s liquidity cup and the shadow banking system’s parched liquidity lips.
The entire progression self-feeds on the way down, just like it self-feeds on the way up. It’s incredibly pro-cyclical. The regulatory response is also incredibly pro-cyclical. You have a rush to laxity on the way up, and you have a rush to the opposite on the way back down. And essentially, on the way down, you have the equivalent of Keynes’s paradox of thrift ““ the paradox of delevering. It can make sense for each individual institution, for a shadow bank or even a real bank, to delever, but collectively, they can’t all delever at the same time.
End except from “The Shadow Banking System and Hyman Minsky’s Economic Journey,” by Paul McCulley of PIMCO.