Tuesday, May 12, 2009

Indications of a Credit Bubble

From Socializing Finance’s post Flashback: The Quality of Credit in Booms and Depressions, some commentary from 53 years ago:

In the past few years important new historical evidence has been developed on the cumulating deterioration in the quality of credit during the period of prosperity that precedes severe depression. […] With respect to the current situation we must concern ourselves with the fact that some, at least, of the economic conditions are in evidence today. What are these conditions? First and foremost is a rapid increase in the volume of credit or debt. Second, a rapid, speculative increase in the prices of the assets that are brought with the rapidly increasing credit, such as real estate, common stocks, or commodity inventories. Third, vigorous competition among leaders for new business. Fourth, relaxation of credit terms and lending standards. Fifth, a reduction in the risk premiums sought or obtained by lenders.” – Moore, G.H. (1956). The Quality of Credit in Booms and Depressions. Journal of Finance 11, 288-300.

How accurately did these conditions predict the current CRE bubble, and where are we today?

1. Rapid Increase in the Volume of Credit or Debt. This clearly occurred during the bubble. As of today, the amount of debt outstanding hasn’t really declined, because few assets have retraded at reduced value levels.

2. Rapid, Speculative Increase in the Price of Assets. Again, this obviously happened. Some distressed sales are starting to occur, but for the most part values have not been marked to market yet.

3. Vigorous Competition for New Business Among Lenders. That clearly went on. Today, there is very little competition occurring; the few lenders that are making loans can pick and choose.

4. Relaxation of Credit Terms and Lending Standards. Terms and lending standards were clearly relaxed during the bubble (Loan to Value, Debt Service Coverage, Interest Only payment structures, etc.). For the most part these standards have tightened, although arguably LTVs are still based on cap rates which are too low, and DSCs calculated on historically low interest rates may not be high enough to ensure an exit if rates return to historical averages.

5. Reduction in Risk Premiums. Again, this obviously occurred during the bubble, with spreads over Treasuries in the 100bp to 200bp range. Today, spreads are much wider, but again maybe not enough in light of the historically low Treasury rates.

So, it appears lenders in 2006 were not attuned to the risks publicized by this article 50 years earlier. And, it appears we are only part way to establishing a normal lending environment.