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How Low Interest Rates Contributed to the Credit CrisisExcerpt from The Wall Street Journal - 2008-08-18; Page A15
"What inning are we in?" How many times have we all heard that inane question asked and answered in the credit-driven downturn that we've been suffering through for over a year now?
We've heard many answers from financial industry and government leaders, such as "the worst is behind us," or "we'll not need to raise any further capital" -- only to learn in short order that our leaders really did not have the ability to make the market bend to their will.
To understand exactly what is happening, one needs to properly understand what occurred in the late stages of the prior cycle. Interest rates had been driven to historical lows in the U.S. and throughout the world. The cause of this can be debated. However, it is clear that economic globalization, with the migration of jobs to low-wage nations, had a profound impact on inflation, and thus on interest rates.
In general, low interest rates are beneficial, as the low cost of capital encourages business borrowing for research and development, capital investment or expansion initiatives, which lead to job growth. Low interest rates also reduce the cost of homeownership, and, in fact, the cost of servicing any debt at all, thereby freeing up capital for more productive uses.
The flip side of a low-interest rate environment is that it reduces the absolute level of returns that are available to investors. This has significant implications for the massive wave of baby boomers, which holds many billions of dollars in retirement savings, either through direct investment or through managed pension-fund systems.
It is estimated by those in the pension-fund world that in order to meet the retirement needs of those baby boomers, their investments will need to yield a minimum of 8% per annum. When their money was set aside with this yield target in mind, rates on U.S. Treasuries hovered at high levels. However, in our most recent low-rate period, with U.S. Treasuries yielding 4% and below, achieving 8% became quite a challenge. The threat of not achieving it became both real and quite frightening for those whose retirement livelihood depends upon their pensions.
With a large portion of pension-fund asset allocations directed toward fixed-income investments that were yielding closer to 4%, the pressure to achieve an overall 8% on their portfolios drove investment managers to allocate large pools of capital to the strategies that promised higher returns. Even beyond the pension investment world, the global investor base had become comfortable in the last cycle with the notion that achieving an annual 20% or greater yield was possible. Thus huge amounts of investment capital migrated to funds promising lofty returns, and fund managers were pressured to advertise a 20% targeted yield or risk not attracting any capital.
It can be argued that it was the low interest-rate environment that actually fueled the huge boom in the hedge-fund and private-equity world that we've witnessed in the past decade. A major flaw in all this was that targeted returns became disconnected from the risk-free U.S. Treasury yield benchmark, to which all investments are implicitly pegged.
There is a direct relationship between returns and risk. If a five-year U.S. Treasury bond is yielding 8%, as it once did, a five-year corporate AAA-rated bond must provide a yield higher than 8% for it to be attractive to an investor, given its increased credit risk. And, further out on the risk spectrum, a five-year investment in a closed-end private equity fund must provide a much higher yield still -- perhaps as high as 20%.
If, however, the yield on the five-year Treasury bond falls to 3%, then the competitive market is set up such that yields on the more risky assets move down in relation, and a AAA-rated, five-year corporate bond will surely no longer be available at a yield above 8%. By extension, the yields available/achievable by the private equity fund, without taking heightened risk, must also fall to a number far below 20%.
Yet, in a low-rate environment, investors still insisted on this high yield target, and, in competing for capital, investment managers strived to achieve it -- mostly through the use of increased leverage or the acquisition of assets with greater risk profiles.
The system became burdened with the need to produce high returns, with many investors chasing that magic 20%, in spite of the fact that the yield targets had little to do with the realities of the low-rate environment.
The preferred formula for manufacturing high returns in a low-rate environment is actually quite simple: utilize large amounts of leverage. If, for example, you can buy an asset that produces a cash-flow yield of 6.5%, and leverage that 9:1 at a cost of borrowing of 5%, you've achieved your 20% target. This use of excessive leverage to capitalize upon low rates, and the easy availability of credit, began in the period after 9/11. Policy makers moved assertively to counteract the potentially devastating effect that tragedy might have had on our economy.
As investors scoured the market for assets with yields of 6.5%, the competition drove prices higher and yields lower. Investors started to buy assets with yields of 5%-5.5%, just barely above the cost of debt. They would justify the price by either borrowing still more or by creating a pro forma budget that reflected a plan for increasing revenues in time to levels that would achieve and surpass that 6.5% level, and that would ultimately produce the magic 20%.
The risk became that those ambitious growth goals would not be met -- and the buyer of the asset would be stuck with an overpriced and overleveraged investment, and a suboptimal yield.
As the market became more frenzied and prices continued to escalate in this competition to find yield, opportunistic buyers stepped in to buy an asset, almost without regard for its ability to create a suitable yield. They figured that someone flush with capital and in need of assets would buy it from them shortly at a quick-flip profit. These asset flippers, or traders, employed very little equity, and were granted large amounts of leverage for their activity, which had proved to be quite brilliant for a time.
Ultimately, as is always the case, there comes a time when someone rears his or her head and questions the sanity of a deal, and by implication, the entire market. At that moment, when everyone is fully invested and market participants have become most complacent about risk-management concerns, everything turns and the party ends abruptly. And thus begins the reversing of the leverage-driven run-up in asset values, with valuations ultimately returning to a level that is sensible and not predicated upon either excessive leverage or pro forma assumptions that everything will work out just perfectly.
Today, the pendulum has clearly swung very hard. Credit availability and cost have moved from one extreme to the other. In time, credit spreads will moderate, as lenders, whoever they will be in the next cycle, motivated by the need to earn revenue, will begin competing for good credits once again. Sadly, the benefits of this reduction in spread will more than likely be offset by an increase in the levels of real rates as the signs of inflation continue to appear.
In the meantime, we are still in the midst of what some analysts have dubbed "The Big Unwind," during which our system unwinds the excessive leverage of the past half-decade. We will likely see asset levels continue to adjust lower in order to come into alignment with today's more conservative lending environment and produce yields that would attract investment capital. There is no silver bullet that government or the financial community can shoot to bring this to a quick end.
By ETHAN PENNER
Mr. Penner, a pioneer in real estate finance, is an executive managing director and member of the executive committee with CB Richard Ellis Investors.
We'll All Pay for the Fed's Loose Money FolliesExcerpt from The Wall Street Journal - 2008-08-18; Page A13
In the dozen or so years until 2007, it had become as close to a global orthodoxy in economic policy making as we ever see: Central banks should target a low and stable rate of inflation.
This replaced earlier orthodoxies -- such as that central banks should maintain a fixed exchange rate with an ounce of gold, which was abandoned in 1971. Though inflation targeting left far more latitude for government officials to expand the money supply, it too ultimately proved too great a shackle on the exercise of central bank wisdom.
The U.S. Federal Reserve, the European Central Bank, the Bank of England and other rich-country central banks have generally made 2% inflation, give or take a smidge, the touchstone of good performance. Fed officials have for 20 years paid public obeisance to their statutory "dual mandate," to maximize employment as well as stabilize prices. But in practice, until recently, they treated it much like a mildly embarrassing biblical injunction that could be safely ignored, if not repudiated.
Yet one of the great attractions of inflation targeting was that it only appeared to constrain central bankers' discretion. Other objectives which today's central bankers actually think are far more important -- in particular, keeping growth of that great aggregate of aggregates, "gross domestic product," above 0% -- can be safely pursued in place of price stability.
This is because the inflation target is what's called a "medium-term objective." The Fed is actually free to slash its key interest rate from 5.25% to 2%, stuffing the world with dollars, even as inflation soars past 5.6% (a 17-year high), because the public's inflation expectations will supposedly remain "well anchored." That is, we will eventually stop charging and paying each other ever higher prices for stuff, in spite of the flood of Fed money, because we know that once the Fed prints enough of it to fix our problems it will get really mad over the inflation we produced and target it with a vengeance. Unless, of course, it hurts the GDP number, in which case the "medium term" will just be a bit longer. You get the picture.
The irony of the collapse of inflation targeting's intellectual edifice is that it has long been championed by Fed Chairman Ben Bernanke, not to mention departing Fed Governor Frederick Mishkin, who recently made a call for "establishing a transparent and credible commitment to a specific numerical [inflation] objective." This after siding with the doves on every rate vote, even as inflation soared to triple his preferred target.
The logic behind central bank discretion is that the economy is like a giant factory churning out 100 widgets a year, all of which are happily bought by consumers without prices rising. A sudden "exogenous shock" cuts demand to 98 widgets. But the central bank can then print money to induce consumers to buy up the two excess widgets, thereby stopping the factory from cutting production capacity and causing a "recession." It claws back the excess money when "equilibrium" is restored.
But what if this analogy is deeply flawed? What if the economy is much more like two factories than one? One factory produces, say, real-estate widgets, and the other produces everything else. If consumers decide they want fewer real-estate widgets and more of some other widgets, it will take time and resources for capacity to shift from the first factory to the second. "GDP" growth will decline during that time. But the process is normal and desirable. By printing more money, the central bank only makes it longer and more painful, not least by producing significant and prolonged inflation.
This is the serious mistake the Fed has made. And in so doing, it has probably killed the last great hope for a sound, durable global fiat money system -- inflation targeting.
By BENN STEIL
Mr. Steil is director of international economics at the Council on Foreign Relations, and a co-author of "Money, Markets and Sovereignty" (Yale University Press, forthcoming).
Lenders Should Do Their Job ProperlyExcerpt from The Wall Street Journal - 2008-08-04; Page A12
So Treasury Secretary Henry Paulson and great institutions such as Bank of America Corp. and Citigroup have come up with an idea that would require that a mortgage applicant supply "fully documented income" and that the mortgage be "held on an issuer's balance sheet" ("Banks Act to Aid Mortgage Lending," July 29). I think I learned that in Economics 101, as a freshman.
When I purchased my home in 1972, I had to submit two years of income tax returns, a letter on company letterhead stating my income, my most recent paycheck stub and a letter from my employer saying that I was an employee in good standing.
Today, the very institutions that tell us how to invest and why we should invest with them can't even handle their own finances, and almost daily write down billions of dollars of their own investments. The chickens have come home to roost, and now all parties are saying "I was taken advantage of." In reality, all parties looked the other way, as long as the commissions kept coming in and the housing market rose.
New City, N.Y.