When Alan Greenspan has a nightmare there’s a good chance “sub-prime lending” is at the center of the dark plot that’s unfolded in his subconscious.
Sub-prime lending refers to risky loans made to individuals. They include home equity loans that are more than the value of the house and mobile homes mortgages. Many of these loans are unsecured and nearly all carry relatively high interest rates – consumer junk bonds, if you will.
Their popularity has soared. Between 1993 and 1999, the dollar amount of sub-prime loans has increased 1,300 percent, according to Federal Reserve Governor Edward Gramlich.
Why would such loans trouble Greenspan? Because if the economy falls even harder, many will not be repaid. And such defaults could have wider repercussions in the financial services industry and, ultimately, throughout the U.S. economy.
Understanding the origins of those instruments – which includes significant activity in Minnesota – sheds light on what’s happening today and what may happen tomorrow in sub-prime lending.
For decades, few companies attempted to raise money by selling bonds unless their financial situation was such that their debt was rated as “investment grade,” that is, a lender was taking a reasonable risk.
. Many states had laws that prohibited pension plans or insurance companies from buying any bond that did not meet the investment-grade criterion. Nor could the managers of any trust fund buy such bonds because doing so would be a violation of their fiduciary duty.
But in the 1970s, smart financiers – notably Michael Milken – noticed that the bonds of many firms whose financial condition was too poor to get acceptable ratings were nevertheless good investments. The higher interest that such bonds more than compensated for the additional risk of default.
Milken and others encouraged firms to issue such bonds and marketed them aggressively to investors not barred by law from buying them. Smaller, shakier or less well-capitalized firms suddenly had a new source of financing.
Of course, defaults on such bonds were substantially higher than some had anticipated in the recessions of 1982 and 1991. But, generally, junk bonds were a socially useful innovation in financial markets.
In Minnesota, an astute scoundrel named Harold Greenwood reached similar insights about lending to credit-risky households.
Historically, banks had been wary about lending to people with low incomes or poor credit records. But credit card issuers began to market their products more aggressively in the 1970s and 1980s and made money, despite cyclically high write-offs.
Greenwood – then best known as the owner of Midwest Federal Savings and Loan – set up a subsidiary named Green Tree Financial in the mid-1970s. Green Tree specialized in financing mobile homes, especially through dealers. It packaged such loans into multi-million dollar blocks and sold these to institutional investors.
As with junk bonds, defaults generally were higher than on loans to higher-income, more credit-worthy individuals. During recessions, write-offs could be dauntingly high. But the interest rates were healthy enough so that, that on average, such lending was profitable.
Greenwood eventually got into legal trouble over his management of Midwest Federal during the savings-and-loan collapse in the late 1980s. But Green Tree Financial grew, branching out into high-risk home equity loans and unsecured, high-interest lines of credit. Sub-prime lending had entered the big time.
Soon, other institutions, including American Express Financial Services and Citibank, piled into the business. Green Tree was purchased by Indiana-based Conseco, whose stock took a meteoric path in the 1990s.
Most of the growth in sub-prime lending took place during the go-go expansion of the late 1990s. Unlike junk bonds, which weathered slumps in 1982, 1987 and 1991, sub-prime lenders haven’t really been tested until now.
But with the economy just now passing the threshold of recession, some sub-prime lenders are already in trouble.
Conseco’s mounting write-offs and broader management problems have tanked its stock. It has laid off employees here in Minnesota and elsewhere.
The Bank of America said two weeks ago that it was writing off $1.25 billion and curtailing its sub-prime business. And two other large lenders, Citigroup and Household International, have also experienced large losses.
The worry for the Fed comes from the possibility that a serious recession will cause high defaults on such loans leading to the bankruptcy of some major lender that in turn owes large sums to major investors. This sort of chain reaction has led to past financial panics.
Even in a modern economy, one result might be a brutal contraction in lending to consumers, whose continued strong spending has contributed to whatever remaining strength there is in the economy.
As you read the news in coming weeks, watch for items about sub-prime lending. Alan Greenspan certainly is.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.