I recently watched a report on CNN that said more than 40 percent of American households have credit card debt of $5,000 to $20,000, and more than 3 percent of U.S. households carry credit card debt of more than $40,000.
Average credit card debt per home is more than $8,000. The rapid growth of credit card debt is a relatively recent phenomenon. In 1980 the average credit card debt was about $500 per household and $3,000 in 1990. These statistics left me thinking: How did we get into this financial crisis? And is there a way out?
How We Got Here
In 2004 and 2005 there was a tremendous amount of speculative home buying. Home prices rose rapidly, as houses were flipped for a profit. I read about the markets in Phoenix, Southern California, and Las Vegas where a developer would grade a lot and a buyer would purchase the spec home on a graded lot. Concrete would go down. Sticks would start to go up. The home would sell again. As it was finished, the new owner would sell it again. It was not unusual for a home to turn over as many as two or three times before being completed, each for a 5 to 15 percent profit. This speculative behavior was fueled by easy credit and an increased tolerance for risk.
Access to credit and an increased tolerance for risk and debt evolved slowly for many years. The beginning of this can be traced to the presidencies of Richard Nixon and Jimmy Carter. Nixon suspended the dollar's conversion into gold at a standard rate. Carter's administration moved to deregulate currency trading and exchange rates further. The ability to widely invest abroad set in motion the creation of markets to trade off currencies. President Ronald Reagan and Prime Minister Margaret Thatcher believed strongly in the power of the free markets and abolished controls related to capital transfers across borders. The result was that financial institutions, such as investment funds, pension funds, and insurance companies, could easily invest abroad.
In 1992 Congress amended the Community Reinvestment Act, which encouraged banks and savings associations to lend to a broader segment of the communities, including low- and middle-income neighborhoods. The amendment required Freddie Mac and Fannie Mae to support affordable housing by purchasing and securitizing a percentage of the low-income loans. Freddie Mac and Fannie Mae had been in the business of buying mortgages and bundling them into mortgage backed securities for some time. These were highly rated securities because of the credit worthiness underlying mortgages. But now subprime mortgages were being packaged, securitized, and sold. These instruments were assumed to have a high-risk adjusted rate of return because underlying property prices continued to increase. The assumption was that if you had to foreclose, the asset value would be greater than the mortgage value. Because of the earlier deregulation of the capital markets, investors around the world were attracted to the relatively high rates and perceived low risk of subprime mortgage obligations. The demand was huge.
My firm works with many financial institutions in Japan, particularly regional banks and insurance companies. They have been dealing with low interest rates since the early 1990s. This low interest rate environment has made it difficult for financial institutions to earn much from their investments in bonds. Bundled subprime mortgages were considered to be a blessing, and many regional institutions and insurance companies bought them assuming they were credit good.
The demand for the securitized mortgage products created an environment in which money was available to lend and the bank issuing loans bore little risk. Several years ago a CEO of a relatively large Northwest bank told me their mortgage banking business had dried up. He said, “With the collapse of the collateral debt obligation market, we have to assume now that if we lend on a home, we're going to have to carry that mortgage for fifteen to twenty years. If I'm going to do that, I'm going to have to charge a premium to reflect the risk.” His bank had money to lend, but no one wants to borrow at the bank's higher rates. He went on to say: “We had no risk before. In large part we were selling mortgages before they closed. If we held a mortgage, it would be over a weekend. We're not atypical of most banks. We've really become a loan originator.”
Originators and banks sold mortgages to Fannie Mae and Wall Street, which packaged these instruments and sold them to investors around the globe. Investors bought them because they were rated by well-known credit rating agencies and because of the assumed low risk. A banker in Japan told me that everybody else was buying them, so it seemed like there was absolutely no risk.
Demand for subprime debt obligations increased the demand for subprime mortgages. Mortgage banks sprang up overnight to meet the demand for mortgages, resulting in expedited and relaxed credit reviews that in turn fueled the speculative housing bubble.
We knew the housing bubble would eventually collapse. Even if it didn't collapse and housing prices just slowed or stopped rising, the risk profile for securitized mortgage obligations would change because loss estimates were based on prices continuing to rise. The slowing housing market was the first domino to fall. A majority of the subprime mortgages were adjustable rate mortgages. As housing prices began to decline, refinancing became more difficult, and adjustable rate mortgages began to reset at higher rates. The default rate increased rapidly, which put more downward pressure on housing prices. The result of this negative spiral was the near collapse of the financial sector.
In the short term, the government intervened by injecting capital into financial institutions. Intervention is something that we've seen happen in the past. We saw Chrysler bailed out in 1979. When Ronald Reagan and Margaret Thatcher were in office, they oversaw the bailout of banks such as Continental Illinois and Johnson Matthey. The justification for bailouts is that when a downfall of an industry will hurt the greater citizenship, governments must intervene and back up the failed systems.
Where We're Going
We can't think the government will save us. I spent most of the last twenty years in Japan and saw the Japanese government intervention fail to resolve its decade-long recession in the 1990s. The economy did not begin to recover until 2003, and now Japan is back in a recession. The government's large fiscal stimulus and hands-on regulation of the financial sector in the 1990s failed to prevent what is now being called the lost two decades.
Bailouts can create huge moral hazards, particularly if you involve politics. Governments can minimize some of these risks. For example, the U.S. Department of Treasury included two prerequisites for its $152 billion credit line to AIG. First, the Federal Reserve Bank received a 79.9 percent ownership stake in the company. The second thing was that the company was required to fire AIG's top executives. Sadly, I'm a shareholder of some of these financial institutions, yet I don't think that all should be rescued. When the government takes an equity stake in these institutions, it should be done with the focus of setting them back on firm ground and spinning them back out to the market.
Politicians claim they understand the great importance of this concept. But we've seen from mistakes in the past that when banks are run by governments, they are not always run efficiently. Proven private market leaders should be allowed to operate these financial institutions in a semiprivate market environment. By doing so, it is possible, in AIG's case for example, that after three to four years the government will sell its 79.9 percent equity stake. The $152 billion dollars wasn't a gift to the company; the company has to pay that loan back and at an interest rate of LIBOR plus 8.5. AIG has a very strong incentive to pay that back, and they will do that primarily through selling property they own around the world. Once AIG pays down the credit facilities, the U.S. government will still own almost 80 percent.
If this transaction is managed properly, the government could profit. The same possibility exists with the banks.
Many of today's problems could have been avoided if there had been checkpoints along the way. One of the most important missing checkpoints was credit rating agencies' failure to recognize and reflect the risks of securitized mortgage obligations in their ratings. Much of the criticism of Moody's, Fitch, and s&p is directed at their apparent conflict of interest. The companies that pay them are the companies and their securities that they rate. Because of their close relationships with the financial industry, it is perceived that they are not incentivized to be really hard on companies. Now that the environment has changed, the rating agencies have tightened their standards.
There are some calls for consumer-financed ratings. I'm not sure if you can do that because of potential conflict between the consumers and the companies being rated. I don't think you can completely eliminate conflicts of interest. However, conflicts can be controlled with strong governance practices and transparent rating standards.
Heavy regulation doesn't necessarily prevent future failures. Instead, government should manage risk and not regulate risk because long-term consequences of regulation are not easily predicted. What's needed is not more government but better government regulation. For example, capital requirements should be revamped to require banks and other institutions to accumulate increased reserves. It's important during this period of intervention that governments help companies rebuild sound financial footings.
The housing market must be stabilized. Housing prices fell because of overbuilding—too much supply and not enough demand. But as supply falls and as demand stays constant, demand will eventually drive supply back up. It may take time, but the housing sector will rebound.
History shows that more rules are not necessarily better than fewer rules, but in the short term, rules are going to be needed. We have also learned that economic reason doesn't necessarily prevail. Sometimes panic tends to rule. In the end, economies are stronger if markets are allowed to work through problems. The government and private enterprise can learn to work together to better regulate and manage the market risks. We have learned new lessons from the current financial crisis. For all its flaws, capitalism is the strongest and most enduring economic system invented. It will continue to succeed.
Gospel Perspective
I've given a great deal of thought about the current economic crisis and have reflected on the counsel from our church leaders. I've thought back to a talk President Gordon B. Hinckley gave in the October 1998 priesthood session. He told us there would be stormy weather ahead. He was very specific and said many people were living beyond their means and taking out more credit than they could afford.
I remember thinking, “This is really interesting. We're in great economic times. The world has never been better.” In 1998 the United States was doing well. Because of the growth of the global economy, including China, India, and Brazil, our standard of living had benefitted and improved significantly.
I have to be honest, when I realized that the average credit card debt per person is now $8,000, I was astounded. That's a lot of money.
Think back to what church leaders have said: save, pay your tithing first, pay yourself second, put resources away for times of need, and live within your means; don't buy the most expensive house or car. We can use that as a model not only for our individual behavior but also for our business behavior.
I feel fortunate that I've worked for companies that are run on a disciplined basis. Companies that manage their debt and work within their capital budgets and have grown prudently are strong right now. They'll continue to be successful.
Take these gospel principles, and apply them directly to business. It's my hope that you will think about what we've been taught in terms of prudence, discipline, and focus. These are essential concepts you can apply in your personal life, in your studies, and in your careers going forward.
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Article written by Todd Hollingshead
Photography by Alisia Packard
About the Speaker
Allan O'Bryant is president and CEO of Yunzei Capital Advisors. He was president of AFLAC International, Inc., and was a senior manager at KPMG. He earned his macc from byu in 1985. He is married to Christina O'Bryant, and they have four daughters. This text is adapted from a speech O'Bryant gave to Marriott School students 23 October 2008.
