If there is anything we can learn from history it is that it will eventually repeat itself. When the last bubble burst (in 2007) we went into the worst recession since the Great Depression. As a 60 year old I have been through a few recessions myself (1973,1980,1990,2001,2007). Being in the real estate business I felt all of them. It appears that there are two consistencies to these crises. The first is that recessions are cyclical (and repetitive if changes are not made to correct the reasons for that particular recession) and the second is that we tend to fix the problems for the last recession, but we do not look forward to speculate on and correct what might be the next bubble by creating laws and policies to avoid it. (For those who want to see the actual history of recessions from 1776 through today follow this link.)
Most economists agree that this current recession was caused by three main reasons. The first is banking deregulation allowing for the merger of investment banks with traditional banks (reversal of the Glass-Steagall Act), the second is the lessening of requirements for home loans and the packaging of these loans to investors (at artificially high values) and the third was the foreign financing of the accumulated national debt. Of these three pieces of the puzzle, the only one that was corrected was the loan requirements of home buyers (although the process may have become safer, but more cumbersome.) We still have merged banks (that are too big to fail) and we still (at least for now) have foreign financing of the accumulated national debt. (We all are in agreement that the level of overall national debt is too high. We simply have too much debt for our federal income and it doesn't help putting 2 wars and two tax breaks on our federal credit card, both bad policy and high risk.)
For the purpose of this post I will look at the one ingredient of the bubble that is bound to cause or accelerate the bursting of the next bubble. With the last (or current) recession (and the devaluation of peoples prime asset, their home) many Americans find themselves in the position of having a home that is valued below their current mortgage (an upside down mortgage). Many of those people are hard working americans who simply won’t let themselves default on any loans that they have. Other have defaulted but due to the inaction on a federal level we still haven’t forced banks to either write off their losses or foreclosed on these properties thereby stabilizing the housing market. (We actually have a client who hasn't made a mortgage payment in 4 years and is still in their home.)
An unfortunate solution for some is seeking alternative financing and whether they are borrowing for personal use or business reasons they are going to be forced to borrow from non-standard lenders. These can be either consumer credit companies or Direct Lenders. As were the case with sub-prime mortgages, they tend to seek borrowers with credit scores of 700 or higher and charge interest rates in the 13%-15% range. For some borrowers there is little option. They can be very large banks like Wells Fargo or Bank of America or they can be part of the ever growing private placement companies (Direct Lending companies.) Some are righteous, some are not. All are betting on Americans paying their bills, but just like the housing market, these loans are being packaged and sold on the equity market to many investors who, as with sub-prime loans, simply don’t understand these s unregulated product.
Once sold, these security sellers do not care what happens. There is a lot of money to be made selling these large loan packages. Many buyer's (primarily hedge funds and private equity funds) bet that they are making safe investments based upon an assumption that the loans are properly rated. As with the housing loans, once the low risk borrowers are maxed out, the quality of the borrowers are reduced but the rating are not. It’s really a game of “hot potato” or “musical chairs”. The last holder (investor) is the loser. Sellers of debt only care about the sale, not the investor or the market. (It still amazes me how few investors of those sub-prime loan packages bit the bullet and never sued the investment houses that simply lied to them about the quality of those loans.)
Here's the problem, with investment rates so low on secure classic investments those with large investors are more and more seeking higher returns in this new marketplace of consumer credit. I don’t want to get sued so I’m not going to identify these companies but I recently was asked by a client about investing $25,000 in one of these funds. Understand that this market is now over a trillion dollar market. The particular company my client was planning on investing with promised a 10%-12% annual return. He was told that the fund was a 3 year commitment with a portfolio of 450+ borrowers (with 700 plus credit scores) paying 15% on the loans with a default rate of 4.7%, therefore allowing for this 10%-12% return.
As Bill Clinton said a few weeks ago, “it’s the arithmetic.” Think about who these people are who are willing to borrow at 15%. You don’t have to be a genius to figure out that these are high risk customers, under duress in many cases. As anyone in the last sub-prime crisis will tell you, the default rate on FHA guaranteed mortgages went from 4.5% to over 8% in less than a year. By 2007 the rate was over 14.5%. If you are borrowing at 15% you are either a business with no other borrowing options (and keeping your business open just waiting for the economic turn-a-round) or an individual with no other options available. Either way while most may get through this without having to go through bankruptcy, the default rate will surely go up. Whether it is enough to create a small recession or major double dip recession is still unclear but we should be careful, each time we see those “need cash” ads on TV we are watching the next big bubble getting bigger.
The solution is simple. Put back Glass-Steagall. As is, most economists believe that this could take a few years to implement. Additionally, while this may seem radical to some, the only other protection we need is the inclusion of federal Usury laws for consumer loans. A federal usury rate would not have all of the loopholes in current state usury laws and could be written in a way that protects both banks and consumers (most likely having an inflation factor included.)
I’m sure that the banking industry will freak out at first, but the point is that for almost all business borrowing these rates would be irrelevant (most current business loans are under 10%) and for individuals it would limit the crazy chances these individuals could take. Additionally, federal standards would simplify and clarify the ultimate amount of debt anyone could take on. (Currently states not only have usury rates that are too high, but the loopholes are big enough to drive a truck through. In New York, with a usury rate of 16%, with penalties and fees that rate can reach as high as 22%-25%. Is anyone really going to pay back a loan at 25%? These loans are destine to default and as with the last bank bale out, we all will be left holding the bag.
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