New and innovative financial products all too often sound scary.
Credit default swaps, negative amortization mortgages, synthetic collateralized debt obligations…
Doesn’t Wall Street ever get its marketing guys to work on these things? You know, just to make them more friendly.
Because the truth is, innovation in finance isn’t scary at all. Entrepreneurs and investors should embrace it if they want to get rich. Money loves innovation, and their offspring’s called credit.
The credit bubble: the race to innovate
In fact, what’s really scary in finance is failing to innovate. Refuse to offer easy new products on new, easier, terms…and your business will wither and die.
• If your stock broker won’t give you a margin account, then in the end he’ll go bust – losing business to brokers who will.
• If a Wall Street bank won’t float a new issue of high-risk junk bonds, then the bank will lose out – and the commission fees will just go to Europe.
• And if your mortgage lender won’t give you 125% of a property’s value – leaving you short of money for buying furniture once you’ve moved in – well, then you’ll just go and find yourself a lender who will.
The same applies to mutual funds, credit card companies, department stores, auto retailers…you name it. If they’re dealing with money, then their success is driven by credit.
And being driven by credit always means you need to drive faster. Just so long as the cycle points upwards.
Call it a race to the bottom in terms of security. As the supply of credit increases, financial firms need to sit right on the cusp, out on the leading edge. Either that, or they’ll lose out to competitors who will.
You need to ‘push the envelope’ and think ‘outside the box’ of underwriting standards, sensible lending and proof of income. Just look at the opportunities that await!
‘As many as 22 million households – 20% of US households – are unbanked,’ noted a 2005 report from the Center for Financial Services Innovation in Chicago. Experian put the total number of ‘unbanked’ Americans at 55 million, nearly one-fifth of the population.
‘At least 53% of Mexican immigrants are unbanked,’ the CFSI report went on. ‘The combined unbanked and subprime credit population may be 30-40 million households.’
Credit bubble: how subprime sector snowballed
Fast forward two years to early 2007, and credit has now gone where credit never dared tread before. Innovation has made sure of that.
‘Creative new subprime loans – ‘piggyback’, ‘interest-only’, and ‘no-doc’ loans, among others – accounted for 47% of total loans issued last year,’ reported the Wall Street Journal recently.
‘At the start of the decade, they were less than 2% of total mortgage loans.’
But that’s the nature of innovation. It either accelerates…or grinds to a halt. Scream if you wanna go faster!
‘As long as lenders made loans available on virtually non-existent terms,’ writes Paul McCulley, managing director at Pimco, ‘the price didn’t really matter all that much to borrowers. The availability of credit trumped the price of credit. Such is always the case in manias.’
Hence the Fed’s failure to touch the US credit bubble with its 17 hikes in interest rates. For as long as credit remained innovative, the inflationary trend would stay on track.
And now?
‘The ongoing meltdown in the subprime mortgage market,’ says McCulley, will ‘unambiguously render any given stance of Fed policy more restrictive…Just as mortgage demand seemed inelastic to rising short rates when availability was riding relaxed terms, so too will demand seem inelastic to falling short rates when availability faces the headwind of restrictive terms.’
Credit bubble: the effect of interest rate hikes
In short, the Fed couldn’t stop lenders from lending simply by raising its rates. Nor could the Bank of England, ECB or anyone else.
The Bank of England began raising its rates at the end of 2003. So did the Australian and New Zealand central banks, too. The US Fed started to hike Dollar rates in 2004, and a year later, the European Central Bank tagged along too.
Japan and Switzerland finally began hiking rates – albeit from near-zero – in 2006. But the effect on world money supply has been negligible up until now. Indeed, the ‘reflation’ unleashed by record-low interest rates starting in 2003 just couldn’t be tamed, not by a few measly basis points at least.
A quarter-point here and a quarter-point there was nothing against the forces of financial innovation.
Seventeen hikes in US rates? So what! US broad money, according to John Williams at ShadowStats.com, is growing by 11% annually. Eurozone money supply has been growing at 9.8% year on year. Britain’s enjoying a 14% year-on-year bubble in money, even though short Sterling rates have risen by one half.
The global money supply has come to have little to do with interest rates, or so it would seem. Some three-quarters of all liquidity comes in the form of derivatives and securitized debt, as the analysts at Independent Strategy have observed. And if raising rates did nothing to slow it, the bubble in money might just start to deflate even if short-term rates now get clipped back towards zero.
Have we reached the top of the credit cycle?
The top of the credit cycle may be in – not because real Dollar rates have finally turned positive (which they haven’t, by the way…), but because the lenders themselves are shuffling back from the edge.
Leave the market-leader’s position to somebody else. The innovative step in finance today is to retrench…ask for secure credit ratings…demand proof of income…switch from digital and paper promises to hard, physical assets.
Once everyone’s crept back to tight lending standards and a hatred of credit, the time will have come to step forwards again – and clean up in finance by lending on easy terms yet again.
But that time’s not now. The retrenchment has only begun. Be brave – and step back.
Adrian Ash is head of research at BullionVault.com, the fastest growing gold bullion service online. Formerly head of editorial at Fleet Street Publications Ltd, he is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek.